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QWEST CORP - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
[November 13, 2012]

QWEST CORP - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Edgar Glimpses Via Acquire Media NewsEdge) Unless the context requires otherwise, references in this report to "QC" refer to Qwest Corporation on an unconsolidated basis, stand-alone bases, references to "Qwest," "we," "us" and "our" refer to Qwest Corporation and its consolidated subsidiaries, references to "QSC" refer to our direct parent company, Qwest Services Corporation, and its consolidated subsidiaries, references to "QCII" refer to QSC's direct parent company and our indirect parent company, Qwest Communications International Inc., and its consolidated subsidiaries, and references to "CenturyLink" refer to QCII's direct parent company and our ultimate parent company, CenturyLink, Inc., and its consolidated subsidiaries.

All references to "Notes" in this Item 2 refer to the Notes to Consolidated Financial Statements included in Item 1 of this quarterly report.

Certain statements in this report constitute forward-looking statements. See "Risk Factors" in Item 1A of Part II of this report for a discussion of certain factors that could cause our actual results to differ from our anticipated results.


Overview Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") included herein should be read in conjunction with MD&A and the other information included in our Annual Report on Form 10-K for the year ended December 31, 2011. The results of operations for the first nine months of the year are not indicative of the results of operations that might be expected for the entire year.

We are an integrated communications company engaged primarily in providing an array of communications services to our residential, business, governmental and wholesale customers. Our communications services include local, network access, private line (including special access), broadband, data, wireless and video services. In certain local and regional markets, we also provide local access and fiber transport services to competitive local exchange carriers. We strive to maintain our customer relationships by, among other things, bundling our service offerings to provide our customers with a complete offering of integrated communications services.

We generate the majority of our revenues from services provided in the 14-state region of Arizona, Colorado, Idaho, Iowa, Minnesota, Montana, Nebraska, New Mexico, North Dakota, Oregon, South Dakota, Utah, Washington and Wyoming. We refer to this region as our local service area.

As discussed in Note 2-Acquisition of QCII by CenturyLink, on April 1, 2011, our indirect parent, QCII, became a wholly owned subsidiary of CenturyLink.

Since April 1, 2011, our consolidated results of operations have been included in the consolidated results of operations of our ultimate parent, CenturyLink. CenturyLink has accounted for its acquisition of QCII and us under the acquisition method of accounting, which resulted in the assignment of the purchase price to the assets acquired and liabilities assumed based on estimates of their acquisition date fair values. The aggregate consideration payable to QCII's stockholders that is attributable to us exceeded the aggregate estimated fair value of the assets acquired and liabilities assumed by $9.369 billion, which we have recognized as goodwill. This goodwill is attributable to strategic benefits, including enhanced financial and operational scale, market diversification and leveraged combined networks that we expect CenturyLink and its consolidated subsidiaries, including us, to realize. None of the goodwill associated with this acquisition is deductible for income tax purposes. The recognition of assets and liabilities at fair value is reflected in our consolidated financial statements and therefore has resulted in a new basis of accounting for the "successor period" beginning on April 1, 2011. This new basis of accounting means that our consolidated financial statements for the successor periods will not 18 -------------------------------------------------------------------------------- Table of Contents be comparable to our previously reported consolidated financial statements, including the predecessor period consolidated financial statements in this report.

We have accounted for CenturyLink's acquisition of us under the acquisition method of accounting, which resulted in the assignment of the aggregate consideration to the assets acquired and liabilities assumed based on their acquisition date fair values. The fair value of the aggregate consideration transferred exceeded the acquisition date fair value of the recorded tangible and intangible assets, and assumed liabilities by $9.369 billion, which has been recognized as goodwill. The impairment testing is done at the reporting unit level; in reviewing the criteria for reporting units when allocating the goodwill resulting from our acquisition by CenturyLink, it was determined that we are one reportable unit, Qwest. We are required to review goodwill recorded in business combinations for impairment at least annually, or more frequently if events or circumstances indicate there may be impairment. Our annual measurement date for testing goodwill impairment is September 30. We are required to write-down the value of goodwill only in periods in which the recorded amount of goodwill exceeds the fair value.

The discussion in MD&A of our performance for the nine months ended September 30, 2011 is presented on a combined basis for the predecessor and successor periods in 2011. We believe this presentation allows the consolidated results of operations for this period to be more readily compared to the comparable nine-month period in 2012.

We have incurred operating expenses related to CenturyLink's indirect acquisition of us, which consist primarily of integration and severance expenses. The table below summarizes our acquisition-related expenses: Successor Predecessor Combined Three Months Three Months Nine Months Six Months Three Months Nine Months Ended Ended Ended Ended Ended Ended September 30, September 30, September 30, September 30, March 31, September 30, 2012 2011 2012 2011 2011 2011 (Dollars in millions) Acquisition-related expenses $ 9 16 33 139 2 141 CenturyLink has cash management arrangements between certain of its subsidiaries, including us, under which the majority of our cash balance is transferred on a daily basis to CenturyLink. We report the balance of these transfers on our consolidated balance sheet as advances to affiliates.

Since the April 1, 2011 closing of CenturyLink's indirect acquisition of us, our operations have been integrated into and reported as part of the segments of CenturyLink. CenturyLink's chief operating decision maker ("CODM") has become our CODM, but reviews our financial information on an aggregate basis only in connection with our quarterly and annual reports that we file with the Securities and Exchange Commission ("SEC"). Consequently, we do not provide our discrete financial information to the CODM on a regular basis.

We currently categorize our products, services and revenues among the following three categories: º • º Strategic services, which include primarily private line (including special access), broadband, video (including resold satellite video services) and Verizon Wireless services; º • º Legacy services, which include primarily local, integrated services digital network ("ISDN") (which uses regular telephone lines to support voice, video and data applications), switched access and traditional wide area network ("WAN") services (which allows a local communications network to link to networks in remote locations); and º • º Affiliates and other services, which consist primarily of universal service funds ("USF") revenues and surcharges and services we provide to our non-consolidated affiliates. We provide to our affiliates telecommunications services that we also provide to external customers. In addition, we 19 -------------------------------------------------------------------------------- Table of Contents provide to our affiliates computer system development and support services and network support and technical services.

During the first quarter of 2012, we reclassified certain prior period revenues between the aforementioned three categories to conform to the current period presentation.

As of the successor date of September 30, 2012, we operated approximately 8.2 million access lines, which are telephone lines reaching from the customers' premises to a connection with the public switched telephone network. We count access lines when we install the service. Our methodology includes only those access lines that we use to provide services to external customers and excludes lines used solely by us and our affiliates. It also excludes unbundled loops and includes stand-alone broadband subscribers. Our methodology for counting our access lines may not be comparable to those of other companies. As of the successor date of September 30, 2012, we also served approximately 3.3 million broadband subscribers. As described below, during the second quarter of 2012, we updated our methodology for counting broadband subscribers to include residential, business and wholesale subscribers instead of only residential and small business subscribers.

Our analysis presented below is organized to provide the information we believe will be useful for understanding the relevant trends affecting our business. This discussion should be read in conjunction with our consolidated financial statements and the notes thereto in Item 1 of this report.

Business Trends Our financial results were impacted by several significant trends, which are described below. We expect that these trends will continue to affect our consolidated results of operations, cash flows or financial position.

º • º Strategic services. We continue to see shifts in the makeup of our total revenues as customers move to strategic services, such as private line, broadband and video services, from legacy services, such as local and access services. Revenues from our strategic services represented 38% and 36% of our total revenues for the successor three months ended September 30, 2012 and 2011, respectively, and 37% and 36%of our total revenues for the successor nine months ended September 30, 2012 and the combined nine months ended September 30, 2011, respectively, and we expect that this percentage will continue to grow. We continue to focus on increasing subscribers of our broadband services, particularly among consumer and small business customers. We believe that continually increasing connection speeds is important to remaining competitive in our industry. As a result, we continue to invest in our fiber to the node ("FTTN") deployment, which allows for the delivery of higher speed broadband services than would otherwise generally be available through a more traditional telecommunications network made up of only copper wires. In addition to our FTTN deployment, we continue to expand our product offerings, including Ethernet and MPLS, and enhance our marketing efforts as we compete in a maturing market in which most consumers already have broadband services. While traditional broadband services are declining, they have been more than offset by growth in fiber based broadband services. We expect these efforts will improve our ability to compete and increase our broadband revenues. Another trend impacting our strategic services is the deployment of fiber-based special access services provided to wireless carriers, which in many cases replaces existing copper-based special access services. We believe the growth in fiber-based special access services provided to wireless carriers for backhaul will, ultimately, over time, offset the decline in copper-based special access services provided to wireless carriers as they migrate to Ethernet services, although the timing and magnitude of this technological migration is uncertain.

º • º Legacy services. Revenues from our legacy services represented 39% and 42% of our total revenues for the successor three months ended September 30, 2012 and 2011, respectively, and 20 -------------------------------------------------------------------------------- Table of Contents 40% and 43% of our total revenues for the successor nine months ended September 30, 2012 and the combined nine months ended September 30, 2011, respectively, and we expect that this percentage will continue to decline. Our legacy services revenues have been, and we expect they will continue to be, adversely affected by access line losses. Intense competition and product substitution continue to drive our access line losses. For example, many consumers are replacing traditional voice telecommunications service with substitute services, including (i) cable and wireless voice services and (ii) electronic mail, texting and social networking services. We expect that these factors will continue to negatively impact our business. As a result of the expected loss of access line revenues, we continue to offer service bundling and other product promotions to help mitigate this trend, as described below.

º • º Service bundling and product promotions. We offer our customers the ability to bundle multiple products and services. These customers can bundle local services with other services such as broadband, video and wireless. While our video and wireless services are an important piece of our customer retention strategy, they do not significantly contribute to our strategic services revenues. However, we believe customers value the convenience of, and price discounts associated with, receiving multiple services through a single company. While bundle price discounts have resulted in lower average revenues for our individual products, we believe service bundles continue to positively impact our customer retention and our ability to compete with other telecommunications service providers. In addition to our bundle discounts, we also offer from time to time limited time promotions on our broadband service, which we believe further aids our ability to attract and retain customers and increase usage of our services.

º • º Operating efficiencies. We continue to evaluate our operating structure and focus. This involves balancing our workforce in response to our workload requirements, productivity improvements and changes in industry, competitive, technological and regulatory conditions.

º • º Pension and post-retirement benefits expenses. Our indirect parent QCII is required to recognize in its consolidated financial statements certain expenses relating to its pension and post-retirement health care and life insurance benefits plans. These expenses are calculated based on several assumptions, including among other things discount rates and expected rates of return on plan assets that are generally set at December 31 of each year. Changes in these assumptions can cause significant changes in the combined net periodic benefits expenses QCII recognizes. QCII allocates the expenses of these plans to us and certain of its other affiliates. The allocation of expenses to us is based upon the demographics of our employees and retirees.

Changes in QCII's assumptions can cause significant changes in the net periodic pension and post-retirement benefits expenses we recognize.

º • º Strategic capital investment. Our capital expenditures continue to be focused on our strategic services such as broadband and the deployment of fiber to the tower ("FTTT"). FTTT is a type of telecommunications network consisting of fiber-optic cables that run from a wireless carrier's mobile telephone switching office to cellular towers to enable the delivery of higher bandwidth services supporting mobile technologies than would otherwise generally be available through a more traditional copper-based telecommunications network.

While these trends are important to understanding and evaluating our financial results, the other transactions, additional events, uncertainties and trends discussed in "Risk Factors" in Item 1A of Part II of this report may also materially impact our business operations and financial results.

21-------------------------------------------------------------------------------- Table of Contents Results of Operations The following table summarizes our results of operations: Successor Predecessor Combined Three Months Three Months Nine Months Six Months Three Months Nine Months Ended Ended Ended Ended Ended Ended September 30, September 30, September 30, September 30, March 31, September 30, 2012 2011 2012 2011 2011 2011 (Dollars in millions) Operating revenues $ 2,183 2,190 6,638 4,421 2,268 6,689 Operating expenses 1,724 1,778 5,258 3,639 1,630 5,269 Operating income 459 412 1,380 782 638 1,420 Other income (expense) (114 ) (95 ) (390 ) (184 ) (148 ) (332 ) Income tax expense 133 118 382 234 191 425 Net income $ 212 199 608 364 299 663 The following table summarizes certain of our operational metrics: Successor As of As of September 30, September 30, Increase/ 2012 2011 (Decrease) % Change (in thousands) Broadband subscribers 3,282 3,134 148 5 % Access lines 8,167 8,658 (491 ) (6 )% Employees 21.5 25.0 (3.5 ) (14 )% During the second quarter of 2012, we updated our methodology for counting broadband subscribers to better align with the methodology used by our ultimate parent company, CenturyLink. We have restated our previously reported amounts to reflect this change. For additional information on our counting methodologies, see "Overview" above.

22 -------------------------------------------------------------------------------- Table of Contents Operating Revenues The following tables summarize our operating revenues: Successor Three Months Three Months Ended Ended September 30, September 30, Increase/ 2012 2011 (Decrease) % Change (Dollars in millions) Strategic services $ 819 794 25 3 % Legacy services 860 928 (68 ) (7 )% Affiliates and other services 504 468 36 8 % Total operating revenues $ 2,183 2,190 (7 ) nm -------------------------------------------------------------------------------- nm-Percentages greater than 200% and comparisons between positive and negative values or to/from zero values are considered not meaningful.

Increase/ Successor Predecessor Combined (Decrease) % Change Nine Months Six Months Three Months Nine Months Successor Successor Ended Ended Ended Ended 2012 v 2012 v September 30, September 30, March 31, September 30, Combined Combined 2012 2011 2011 2011 2011 2011 (Dollars in millions) Strategic services $ 2,442 1,585 792 2,377 65 3 % Legacy services 2,634 1,882 1,003 2,885 (251 ) (9 )% Affiliates and other services 1,562 954 473 1,427 135 9 % Total operating revenues $ 6,638 4,421 2,268 6,689 (51 ) (1 )% Strategic Services Strategic services revenues increased in both of the comparative periods reflected in the tables above due primarily to increases in the volume of our Ethernet services and increased sales of higher speed broadband services. Our growth in revenues was partially offset by decreased sales volumes of our private line and special access services.

Legacy Services Legacy services revenues decreased in both of the comparative periods as a result of lower local and long-distance services revenues due to access line loss and reduced access services usage related to the above-described competitive pressures and product substitution. Legacy services revenues also decreased in both of the comparative periods due to lower revenues from our traditional WAN services caused by customer migration, product substitution and increased competition. Part of the decrease in legacy services revenues for the successor nine months ended September 30, 2012 compared to the combined nine months ended September 30, 2011 is attributable to lower amortization of deferred revenue due to predecessor deferred installation and activation revenue being assigned no value at the acquisition date.

Affiliates and Other Services Affiliates and other services revenues increased in both of the comparative periods primarily due to a change in methodology effective January 1, 2012 that resulted in both higher affiliate revenues and expenses for us. See Note 1-Basis of Presentation. A portion of the increase in affiliates and other 23-------------------------------------------------------------------------------- Table of Contents services revenues for the successor nine months ended September 30, 2012 compared to the combined nine months ended September 30, 2011 is attributable to telecommunications services we provided to affiliates since CenturyLink's April 1, 2011 indirect acquisition of us. The remainder of this increase is attributable to the increased USF rates.

Operating Expenses The following tables summarize our operating expenses: Successor Three Months Three Months Ended Ended September 30, September 30, Increase/ 2012 2011 (Decrease) % Change (Dollars in millions) Cost of services and products (exclusive of depreciation and amortization) $ 737 731 6 1 % Selling, general and administrative 249 351 (102 ) (29 )% Operating expenses-affiliates 169 76 93 122 % Depreciation and amortization 569 620 (51 ) (8 )% Total operating expenses $ 1,724 1,778 (54 ) (3 )% Increase/ Successor Predecessor Combined (Decrease) % Change Nine Months Six Months Three Months Nine Months Successor Successor Ended Ended Ended Ended 2012 v 2012 v September 30, September 30, March 31, September 30, Combined Combined 2012 2011 2011 2011 2011 2011 (Dollars in millions) Cost of services and products (exclusive of depreciation and amortization) $ 2,174 1,444 742 2,186 (12 ) (1 )% Selling, general and administrative 899 803 385 1,188 (289 ) (24 )% Operating expenses-affiliates 474 149 52 201 273 136 % Depreciation and amortization 1,711 1,243 451 1,694 17 1 % Total operating expenses $ 5,258 3,639 1,630 5,269 (11 ) nm -------------------------------------------------------------------------------- nm-Percentages greater than 200% and comparisons between positive and negative values or to/from zero values are considered not meaningful.

Effective January 1, 2012, we changed our rates of capitalized labor as we transitioned certain legacy systems to the historical systems of our ultimate parent, CenturyLink. This transition resulted in an estimated $30 million to $45 million increase in the amount of labor capitalized as an asset compared to the amount that would have been capitalized if we had continued to use our legacy systems and a corresponding estimated $30 million to $45 million decrease in operating expenses for the successor nine months ended September 30, 2012.

This change is expected to result in an estimated operating expense reduction of approximately $35 million to $60 million for the successor year ending December 31, 2012.

Cost of Services and Products (exclusive of depreciation and amortization) Cost of services and products (exclusive of depreciation and amortization) are expenses incurred in providing products and services to our customers. These expenses include: employee-related expenses directly attributable to operating and maintaining our network (such as salaries, wages, benefits and professional fees); facilities expenses (which are expenses we incur from using other carriers' networks to provide services to our customers); rents and utilities expenses; equipment sales expenses (such as 24-------------------------------------------------------------------------------- Table of Contents modem expenses); costs for USF (which reflect our contributions to certain federal and state funds that are established to promote the availability of telecommunications services to all consumers at reasonable and affordable rates, among other things); and other expenses directly related to our network operations. These expenses increased slightly in the successor three months ended September 30, 2012 compared to the successor three months ended September 30, 2011 reflected in the tables above primarily due to increased customer premise equipment costs, professional fees, facility costs, and USF contribution rates partially offset by decreased salaries and wages and benefits. These expenses decreased in the successor nine months ended September 30, 2012 compared to the combined nine months ended September 30, 2011 reflected in the table above primarily due to decreased salaries and wages and benefits.

Selling, General and Administrative Selling, general and administrative expenses are expenses incurred in selling products and services to our customers, corporate overhead and certain other operating expenses. These expenses include: employee-related expenses (such as salaries, wages, internal commissions, benefits and professional fees) directly attributable to selling products or services and employee-related expenses for administrative functions; marketing and advertising; taxes (such as property and other taxes) and fees; external commissions; bad debt expense; and other operating expenses.

During the first quarter of 2012, we reclassified certain operating expenses from our selling, general and administrative expenses to our cost of services and products (exclusive of depreciation and amortization) to better reflect our expenses related to providing services to our affiliates. As a result, we reclassified previously reported amounts to conform to the current period presentation. For the predecessor three months ended March 31, 2011 and the successor six months ended September 30, 2011, this reclassification resulted in a reduction of selling, general and administrative expenses of $116 million and $229 million, respectively.

These expenses decreased in both of the comparative periods reflected in the tables above primarily due to decreased salaries and wages, benefits, and marketing and advertising expense during both of the comparative periods presented.

Operating Expenses-Affiliates Effective January 1, 2012, in connection with post-acquisition systems integration activities, we adopted the affiliate expense allocation methodology used by our ultimate parent. This methodology results in certain overhead costs incurred by us and by our ultimate parent that were previously assessed to us on a net basis now being assessed on a gross basis both to and from our ultimate parent, resulting in both higher affiliate revenues and expenses for us. We believe this change, resulting from systems integration activities, did not have a significant impact to our net income for the successor three and nine months ended September 30, 2012.

Since CenturyLink's indirect acquisition of us, we have incurred affiliates expenses related to our use of telecommunications services, marketing and employee related support services provided to us by CenturyLink and certain of its subsidiaries. A portion of the increase in operating expenses-affiliates for the successor nine months ended September 30, 2012 compared to the combined nine months ended September 30, 2011 is attributable to incurring these intercompany expenses for the entire 2012 period compared to only six months of the 2011 period as well as an increase in the volume of intercompany transactions.

25-------------------------------------------------------------------------------- Table of Contents Depreciation and Amortization The following tables provide detail regarding depreciation and amortization expense: Successor Three Months Three Months Ended Ended September 30, September 30, Increase/ 2012 2011 (Decrease) % Change (Dollars in millions) Depreciation $ 295 302 (7 ) (2 )% Amortization 274 318 (44 ) (14 )% Total depreciation and amortization $ 569 620 (51 ) (8 )% Increase/ Successor Predecessor Combined (Decrease) % Change Nine Months Six Months Three Months Nine Months Successor Successor Ended Ended Ended Ended 2012 v 2012 v September 30, September 30, March 31, September 30, Combined Combined 2012 2011 2011 2011 2011 2011 (Dollars in millions) Depreciation $ 876 606 393 999 (123 ) (12 )% Amortization 835 637 58 695 140 20 % Total depreciation and amortization $ 1,711 1,243 451 1,694 17 1 % In connection with us being acquired as of April 1, 2011, our property, plant and equipment was recognized at fair value, which reduced the recognized amounts of our net property, plant and equipment. This decrease in asset value resulted in $92 million lower depreciation expense for the successor nine months ended September 30, 2012, as compared to the combined nine months ended September 30, 2011. Effective January 1, 2012, we also changed our estimates of the economic lives of certain telecommunications equipment. These changes resulted in an additional decrease to depreciation expense of approximately $13 million and $39 million for the successor three and nine months ended September 30, 2012, respectively.

The accounting for CenturyLink's indirect acquisition of us also resulted in additional amortizable intangible customer relationship assets, which increased amortization expense approximately $173 million for the successor nine months ended September 30, 2012, as compared to the combined nine months ended September 30, 2011. In addition, our capitalized software was also recognized at fair value, which resulted in an increase of $59 million in amortization expense for the successor nine months ended September 30, 2012, as compared to the combined nine months ended September 30, 2011.

Excluding the effects of CenturyLink's indirect acquisition of us, depreciation and amortization expense decreased $12 million and $52 million for the successor three and nine months ended September 30, 2012, respectively, due to annual updates of our depreciation rates for capitalized assets.

26-------------------------------------------------------------------------------- Table of Contents Other Consolidated Results The following tables summarize our total other income (expense) and income tax expense: Successor Three Months Three Months Ended Ended September 30, September 30, Increase/ 2012 2011 (Decrease) % Change (Dollars in millions) Interest expense $ (113 ) (95 ) 18 19 % Loss on early retirement of debt (1 ) - 1 nm Total other income (expense) $ (114 ) (95 ) 19 20 % Income tax expense $ 133 118 15 13 % Increase/ Successor Predecessor Combined (Decrease) % Change Nine Months Six Months Three Months Nine Months Successor Successor Ended Ended Ended Ended 2012 v 2012 v September 30, September 30, March 31, September 30, Combined Combined 2012 2011 2011 2011 2011 2011 (Dollars in millions) Interest expense $ (342 ) (183 ) (150 ) (333 ) 9 3 % Loss on early retirement of debt (47 ) (1 ) - (1 ) 46 nm Other (expense) income (1 ) - 2 2 3 nm Total other income (expense) $ (390 ) (184 ) (148 ) (332 ) 58 17 % Income tax expense $ 382 234 191 425 43 10 % -------------------------------------------------------------------------------- nm-Percentages greater than 200% and comparisons between positive and negative values or to/from zero values are considered not meaningful.

Interest Expense Interest expense for the three and nine months ended September 30, 2012 increased compared to the successor three and combined nine months ended September 30, 2011 primarily due to a substantial reduction in the amount of debt premium amortization recorded at acquisition primarily due to the retirement of several issuances of debt during the affected periods. This was substantially offset by a significant decrease in bond coupon interest due to the retirement of several debt issuances during the nine months ended September 30, 2012, in some cases replaced with lower coupon debt along with increased capitalized interest. See Liquidity and Capital Resources for the details of these net redemptions.

Loss on Early Retirement of Debt On April 18, 2012, we completed a premium-priced cash tender offer to purchase a portion of our $811 million of 8.375% Notes due 2016 and our $400 million of 7.625% Notes due 2015. With respect to our 8.375% Notes due 2016, we received and accepted tenders of approximately $575 million aggregate principal amount of these notes, or 71%, for $722 million including a premium, fees and accrued interest. With respect to our 7.625% Notes due 2015, we received and accepted tenders of approximately $308 million aggregate principal amount of these notes, or 77%, for $369 million including a premium, fees and accrued interest. The completion of this tender offer resulted in a loss of $46 million.

27-------------------------------------------------------------------------------- Table of Contents Income Tax Expense Income tax expense for the successor nine months ended September 30, 2012 was $382 million, or an effective tax rate of 38.6%, as compared to income tax expense for the combined nine months ended September 30, 2011 of $425 million, or an effective tax rate of 39.1%. The decrease in the effective tax rate is primarily due to a decrease in the state tax rate for 2012.

Liquidity and Capital Resources Overview We are an indirectly wholly owned subsidiary of CenturyLink. As such, factors relating to, or affecting, CenturyLink's liquidity and capital resources could have material impacts on us, including impacts on our credit ratings, our access to capital markets and changes in the financial market's perception of us.

CenturyLink has cash management arrangements between certain of its subsidiaries that include lines of credit, affiliate obligations, capital contributions and dividends. As part of these cash management arrangements, affiliates provide lines of credit to certain other affiliates. Amounts outstanding under these lines of credit and intercompany obligations vary from time to time. Under these arrangements, the majority of our cash balance is advanced on a daily basis to CenturyLink. From time to time we may declare and pay dividends to QSC, using cash repaid to us under these advances, which has the net effect of reducing the amount of these advances. Our debt covenants do not limit the amount of dividends we can pay to QSC. Given our cash management arrangement with our ultimate parent, CenturyLink, and the resulting amounts due to us from CenturyLink, a significant component of our liquidity is dependent upon CenturyLink's ability to repay its obligation to us.

As of the successor date of September 30, 2012, we had a working capital deficit of $1.2 billion, reflecting current liabilities of $2.9 billion and current assets of $1.7 billion, compared to a working capital deficit of $917 million as of the successor date of December 31, 2011. The change in our working capital position is primarily due to an increase in the current maturities of long-term debt of $741 million and notes payable-affiliates of $685 million which were partially offset by an increase in the amounts owed to us by our affiliates of $533 million as of the successor date of September 30, 2012, as well as decreases in accounts payable and accounts payable-affiliates of $345 million, and a decrease in dividends payable of $310 million. Our current maturities of long-term debt balances were high as of the successor date of September 30, 2012 substantially due to the scheduled maturity of our $750 million floating rate notes on June 1, 2013. We have historically operated with a working capital deficit due to our practice of declaring and paying regular cash dividends to QSC. As long as we continue declaring cash dividends to QSC, it is likely that we will continue to operate with a working capital deficit in the future. We anticipate that any future liquidity needs not met through our cash provided by operating activities and amounts due to us from CenturyLink could be met through capital contributions or advances from CenturyLink if and to the extent CenturyLink has available funds that it is willing and able to contribute or advance.

Revolving Promissory Note QC has a revolving promissory note with an affiliate of CenturyLink that provides us with a funding commitment with an aggregate principle amount available to $1.0 billion through June 30, 2022 and $685 million outstanding as of the successor date of September 30, 2012. The revolving promissory note is subordinated to our Senior Notes. Interest is accrued on the outstanding balance using a weighted average per annum interest rate of CenturyLink's outstanding borrowings for the interest period. As of September 30, 2012, the weighted average interest rate was 6.0917%. The accrued interest and outstanding principle balance are payable on demand, and if no demand, then on June 30, 28-------------------------------------------------------------------------------- Table of Contents 2022. This revolving promissory note is reflected on our consolidated balance sheets under "Notes payable-affiliates".

Debt and Other Financing Arrangements Subject to market conditions, we expect to continue to issue debt securities from time to time to refinance our maturing debt. The availability, interest rate and other terms of any new borrowings will depend on the ratings assigned us by the three major credit rating agencies, among others.

As of the successor date of September 30, 2012, we believe we were in compliance with the provisions and covenants of our debt agreements.

Capital Expenditures We incur capital expenditures on an ongoing basis in order to enhance and modernize our networks, compete effectively in our markets and expand our service offerings. We evaluate capital expenditure projects based on a variety of factors, including expected strategic impacts (such as forecasted revenue growth or productivity, expense and service impacts) and our expected return on investment. The amount of capital investment is influenced by, among other things, demand for our services and products, cash generated by operating activities and regulatory considerations. Our 2012 capital expenditures will be determined in part by the strategic initiatives of our ultimate parent, CenturyLink.

Our capital expenditures continue to be focused on primarily our broadband services. In particular, we will continue to focus on expanding our fiber infrastructure, including installations of "fiber to the tower", or FTTT. FTTT is a type of telecommunications network consisting of fiber-optic cables that run from a wireless carrier's mobile telephone switching office to cellular towers to enable the delivery of higher bandwidth services supporting mobile technologies than would otherwise generally be available through a more traditional copper-based telecommunications network.

CenturyLink, our ultimate parent, has agreed to accept approximately $35 million of the $90 million available to it from Phase 1 of the Federal Communications Commission's ("FCC") Connect America Fund ("CAF") established by Congress to help telecommunications carriers defray the cost of providing broadband access to remote customers. Of the $35 million, we will receive approximately $30 million and intend to use the funds to deploy broadband service for up to 39,000 homes in unserved rural areas principally in Colorado, Minnesota, New Mexico and Washington. CenturyLink has determined that restrictions on the use of these funds have made acceptance of additional CAF funds uneconomical. CenturyLink has, however, filed with the FCC a waiver application, which, if granted, would allow us to deploy broadband services with CAF funds to approximately 56,000 more homes in high-cost unserved areas in our markets.

Pension and Post-retirement Benefit Obligations QCII is subject to material obligations under its existing defined benefit pension and other post-retirement benefit plans. The plans are measured annually at December 31. As of the successor date of December 31, 2011, the accounting unfunded status of QCII's pension and other post-retirement benefit obligations was $650 million and $2.7 billion, respectively.

A substantial portion of our employees participate in the QCII pension plan.

Historically, QCII has only required us to pay our portion of its pension contribution. Our contributions are not segregated or restricted to pay amounts due to our employees and may be used to provide benefits to other employees of QCII's affiliates.

Benefits paid by QCII's qualified pension plan are paid through a trust.

Based on current laws and circumstances, QCII will not be required to make a cash contribution to this plan in 2012 and based on 29-------------------------------------------------------------------------------- Table of Contents current funding laws and regulation it is unlikely QCII will be required to make a cash contribution in 2013. The amount of required contributions to QCII's plan in 2013 and beyond will depend on earnings on plan investments, prevailing interest and discount rates, demographic experience, changes in plan benefits and any further changes in funding laws and regulations.

Certain of QCII's post-retirement health care and life insurance benefits plans are unfunded. A trust holds assets that are used to help cover the health care costs of certain retirees. As of December 31, 2011, the fair value of the trust assets was $643 million; however, a portion of these assets is comprised of investments with restricted liquidity. QCII estimates that the more liquid assets in the trust will be adequate to provide continuing reimbursements for covered post-retirement health care costs for approximately four years, based on current circumstances. Thereafter, covered benefits will be paid either directly by QCII or from the trust as the remaining assets become liquid. This projected four year period could be substantially shorter or longer depending on changes in projected health care costs, returns on plan assets, the timing of maturities of illiquid plan assets and future changes in benefits.

QCII's estimated annual long-term rate of return on the pension and post-retirement plans trust assets is 7.5% based on the assets currently held; however, actual returns could vary widely in any given year.

Historical Information The following table summarizes our cash flow activities: Increase/ Successor Predecessor Combined (Decrease) Nine Months Six Months Three Months Nine Months Successor Ended Ended Ended Ended 2012 v September 30, September 30, March 31, September 30, Combined 2012 2011 2011 2011 2011 (Dollars in millions) Net cash provided by operating activities $ 2,713 1,575 869 2,444 269 Net cash used in investing activities (1,784 ) (1,403 ) (335 ) (1,738 ) 46 Net cash used in financing activities (923 ) (366 ) (525 ) (891 ) 32 Net cash provided by operating activities increased in the successor nine months ended September 30, 2012 as compared to the combined nine months ended September 30, 2011 primarily due to changes in affiliate balances which were somewhat offset by changes to deferred income taxes.

Net cash used in investing activities increased in the successor nine months ended September 30, 2012 as compared to the combined nine months ended September 30, 2011 primarily due to changes in our advances to affiliates resulting from the majority of our cash balance being transferred on a daily basis to CenturyLink. This increase is partially offset by proceeds from the sale of property received in the 2012 period.

Net cash used in financing activities increased in the successor nine months ended September 30, 2012 primarily due to a an increase in the net pay down of debt offset by a decrease in dividends paid.

On July 20, 2012, we redeemed all $484 million of our 7.50% Notes due 2023, which resulted in an immaterial loss.

On June 25, 2012, we issued $400 million aggregate principal amount of 7.00% Notes due 2052 in exchange for net proceeds, after deducting underwriting discounts and expenses, of $387 million. The Notes are unsecured obligations and may be redeemed, in whole or in part, on or after July 1, 2017 at a redemption price equal to 100% of the principal amount redeemed plus accrued interest.

30-------------------------------------------------------------------------------- Table of Contents On April 18, 2012, we completed a cash tender offer to purchase a portion of our $811 million of 8.375% Notes due 2016 and our $400 million of 7.625% Notes due 2015. With respect to our 8.375% Notes due 2016, we received and accepted tenders of approximately $575 million aggregate principal amount of these notes, or 71%, for $722 million including a premium, fees and accrued interest. With respect to our 7.625% Notes due 2015, we received and accepted tenders of approximately $308 million aggregate principal amount of these notes, or 77%, for $369 million including a premium, fees and accrued interest. The completion of this tender offer resulted in a loss of $46 million. In connection with consummating this tender offer, we borrowed from a CenturyLink affiliate approximately $583 million under a revolving promissory note, payable upon demand. The promissory note is unsecured and is pari passu to our senior notes.

On April 2, 2012, we issued $525 million aggregate principal amount of 7.00% Notes due 2052 in exchange for net proceeds, after deducting underwriting discounts and expenses, of $508 million. The Notes are unsecured obligations and may be redeemed, in whole or in part, on or after April 1, 2017 at a redemption price equal to 100% of the principal amount redeemed plus accrued interest.

Certain Matters Related to CenturyLink's Indirect Acquisition of Us Effective after CenturyLink's indirect acquisition of us, we are included in the consolidated federal income tax return of CenturyLink. CenturyLink is in the process of developing a post-acquisition intercompany agreement for allocation of consolidated income tax liabilities. We will continue to account for income tax expense on a stand-alone basis. We are also included in certain combined state tax returns filed by CenturyLink and the same accounting will apply.

As of the successor date of September 30, 2012, we paid certain costs that were associated with CenturyLink's indirect acquisition of us. These costs include compensation costs comprised of retention bonuses and severance. The final amounts and timing of the compensation costs to be paid is partially dependent upon personnel decisions that continue to be made as part of the continuing integration process. These amounts may be material.

In accounting for CenturyLink's indirect acquisition of us, we recognized our debt securities at their estimated fair values, which totaled $8.498 billion as of April 1, 2011. Our acquisition date fair value estimates were based primarily on quoted market prices in active markets and other observable inputs where quoted market prices were not available. The fair value of our debt securities exceeded their stated principal balances on the acquisition date by $530 million, which we recorded as premium.

The table below summarizes the premiums recognized as a reduction to interest expense or extinguished during the periods indicated: Successor Nine Months Nine Months Ended Ended September 30, December 31, Total Since 2012 2011 Acquisition (Dollars in millions) Amortized $ 51 135 186 Extinguished(1) 128 59 187 Total premiums recognized $ 179 194 373 -------------------------------------------------------------------------------- º (1) º See "Debt and Other Financing Arrangements" for more information.

The remaining premium of $157 million as of the successor date of September 30, 2012 will reduce interest expense in future periods, unless otherwise extinguished.

31-------------------------------------------------------------------------------- Table of Contents Other Matters CenturyLink and QCII are involved in various legal proceedings that could have a material adverse effect on their financial position. As a wholly owned subsidiary of CenturyLink and QCII, our business and financial condition could be similarly affected. You can find descriptions of these legal proceedings in CenturyLink's and QCII's quarterly and annual reports filed with the SEC.

Because we are not a party to any of the matters, we have not accrued any liabilities for these matters.

Approximately 60% of our employees are subject to collective bargaining agreements that expired on October 6, 2012. Our ultimate parent company, CenturyLink, is currently negotiating the terms of new agreements. In the meantime, the predecessor agreements have been extended, and the unions have agreed to provide us with at least a twenty-four hour advance notice before terminating those predecessor agreements. Any strikes or other changes in our labor relations could have a significant impact on our business. See "Risk Factors-Other Risks" in Item 1A. of Part II of this report. If we fail to extend or renegotiate our collective bargaining agreement with our labor unions as they expire from time to time, or if our unionized employees were to engage in a strike or other work stoppage, our business and operating results could be materially harmed. To help mitigate this potential risk, we have established contingency plans in which we would assign trained, non-represented employees to cover jobs for represented employees in the event of a work stoppage to provide continuity for our customers.

Off-Balance Sheet Arrangements There were no substantial changes to our contractual obligations in the successor nine months ended September 30, 2012, when compared to the disclosures provided in our Annual Report on Form 10-K for the year ended December 31, 2011.

Market Risk We are exposed to market risk from changes in interest rates on our variable rate long-term debt obligations. We seek to maintain a favorable mix of fixed and variable rate debt in an effort to limit interest costs and cash flow volatility resulting from changes in rates.

From time to time, we have used derivative instruments to (i) lock-in or swap our exposure to changing or variable interest rates for fixed interest rates or (ii) to swap obligations to pay fixed interest rates for variable interest rates. As of the successor date of September 30, 2012, we had no such instruments outstanding.

There were no material changes to market risks arising from changes in interest rates for the successor nine months ended September 30, 2012, when compared to the disclosures provided in our Annual Report on Form 10-K for the year ended December 31, 2011.

Other Information Our website is the same as that of our ultimate parent company, CenturyLink, which is www.centurylink.com. We routinely post important investor information in the "Investor Relations" section of our website at ir.centurylink.com. The information contained on, or that may be accessed through, our website is not part of this quarterly report. You may obtain free electronic copies of our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports in the "Investor Relations" section of our website (ir.centurylink.com) under the heading "SEC Filings." These reports are available on our website as soon as reasonably practicable after we electronically file them with the SEC.

In addition to historical information, this MD&A includes certain forward-looking statements that are based on current expectations only, and are subject to a number of risks, uncertainties and assumptions, 32-------------------------------------------------------------------------------- Table of Contents many of which are beyond our control. Actual events and results may differ materially from those anticipated, estimated or projected if one or more of these risks or uncertainties materialize, or if underlying assumptions prove incorrect. Factors that could affect actual results include but are not limited to: the timing, success and overall effects of competition from a wide variety of competitive providers; the risks inherent in rapid technological change; the effects of ongoing changes in the regulation of the communications industry (including those arising out of the Federal Communications Commission's October 27, 2011 order regarding intercarrier compensation and the USF, among other things); our ability to successfully negotiate collective bargaining agreements on reasonable terms without work stoppages; our ability to effectively adjust to changes in the communications industry and changes in the composition of our markets and product mix caused by CenturyLink's recent acquisitions of Savvis, QCII and Embarq; CenturyLink's ability to successfully integrate the recently acquired operations of Savvis and QCII (including us) into its incumbent operations, including the possibility that the anticipated benefits from these recent acquisitions cannot be fully realized in a timely manner or at all, or that integrating the acquired operations will be more difficult, disruptive or costly than anticipated; CenturyLink's and QCII's ability to use net operating loss carryovers in projected amounts; CenturyLink's ability to effectively manage its expansion opportunities, including retaining and hiring key personnel; possible changes in the demand for, or pricing of, our products and services; our ability to successfully introduce new product or service offerings on a timely and cost-effective basis; our continued access to credit markets on favorable terms; our ability to collect our receivables from financially troubled communications companies; any adverse developments in legal proceedings involving CenturyLink or QCII; unanticipated increases or other changes in our future cash requirements, whether caused by unanticipated increases in capital expenditures, increases in CenturyLink's or QCII's pension funding requirements or otherwise; the effects of adverse weather; other risks referenced from time to time in this report (including in "Risk Factors" in Item 1A of Part II of this report) or other of our filings with the SEC; and the effects of more general factors such as changes in interest rates, in tax rates, in accounting policies or practices, in operating, medical, pension or administrative costs, in general market, labor or economic conditions, or in legislation, regulation or public policy. You should be aware that new factors may emerge from time to time and it is not possible for us to identify all such factors nor can we predict the impact of each such factor on the business or the extent to which any one or more factors may cause actual results to differ from those reflected in any forward-looking statements. You are further cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this report. We undertake no obligation to update any of our forward-looking statements for any reason.

33-------------------------------------------------------------------------------- Table of Contents

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