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ALASKA COMMUNICATIONS SYSTEMS GROUP INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) FORWARD-LOOKING STATEMENTS AND ANALYSTS' REPORTS This Form 10-Q and our future filings on Forms 10-K, 10-Q and 8-K and the documents incorporated therein by reference include forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934 ("Exchange Act"), as amended. We intend such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements. All statements other than statements of historical fact are "forward-looking statements" for purposes of federal and state securities laws, including statements about anticipated future operating and financial performance, financial position and liquidity, growth opportunities and growth rates, pricing plans, acquisition and divestiture opportunities, business prospects, strategic alternatives, business strategies, regulatory and competitive outlook, investment and expenditure plans, financing needs and availability and other similar forecasts and statements of expectation and statements of assumptions underlying any of the foregoing. Words such as "anticipates", "believes", "could", "estimates", "expects", "intends", "may", "plans", "projects", "seeks", "should" and variations of these words and similar expressions are intended to identify these forward-looking statements. These forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from our historical experience and our present expectations or projections. Forward-looking statements by us are based on estimates, projections, beliefs and assumptions of management and are not guarantees of future performance. Such forward-looking statements may be contained in this Form 10-Q under "Item 2 - Management's Discussion and Analysis of Financial Condition and Results of Operations" and elsewhere. Actual future performance, outcomes, and results may differ materially from those expressed in forward-looking statements made by us as a result of a number of important factors. Examples of these factors include (without limitation): • our already strong competitive environment will become even more competitive by the expected entry of Verizon Wireless ("Verizon") in 2013; • our ability to consummate the AWN Transaction entered into on June 4, 2012; • our substantial debt which requires us to dedicate a significant portion of our cash flow from operating activities to make debt payments and places pressure on our ability to access the capital markets and to fund capital opportunities; • our ability to comply with the covenants and other terms contained in our Senior Credit Facility; • governmental and public policy changes, including on-going changes in our revenues resulting from regulatory actions affecting inter-carrier compensation, Universal Service Funding ("USF") for Competitive Eligible Telecommunications Carriers ("CETC") and high cost support, and lifeline revenues; • the cost and availability of future financing in the amounts, at the terms, and subject to the conditions necessary, to support our business and pursue growth opportunities; • our ability to keep pace with rapid technological developments and changing standards in the telecommunications industry, including on-going capital expenditures needed to upgrade our access network to industry competitive speeds, and our limited access to in-state middle mile infrastructure; • our ability to develop attractive, integrated products and services making use of our substantial investments in fiber optic cable facilities, including our Alaska Oregon Network ("AKORN®") and Northstar fiber optic cables that connect Alaska to the contiguous states; • unanticipated damage to one or more of our fiber optic cables resulting from construction or digging mishaps, fishing boats or other reasons; • changes in general industry and market conditions, and structural declines for voice and other legacy services within the telecommunications industry; • a maintenance or other failure of our network or data centers; • a failure of back-office information technology ("IT") systems; • a third party claim that the Company is infringing upon their intellectual property, resulting in significant litigation or licensing expenses, or the loss of our ability to sell or support certain products including certain wireless devices; • changes in overall national, regional or local economic conditions; 16 -------------------------------------------------------------------------------- Table of Contents • unanticipated costs required to fund our post-retirement benefit plans, or contingent liabilities associated with our participation in a multi-employer pension plan; • the success or failure of any future acquisitions; • geologic or other natural disturbances relevant to the location of our operations; • recruitment and retention of key personnel; and • the matters described under "Item 1A, Risk Factors" in our Annual Report on Form 10-K for the fiscal year ended December 31, 2012 and this Quarterly Report on Form 10-Q. In light of these risks, uncertainties and assumptions, you should not place undue reliance on any forward-looking statements. Additional risks that we may currently deem immaterial or that are not currently known to us could also cause the forward-looking events discussed in this Form 10-Q or our other reports not to occur as described. Except as otherwise required by applicable securities laws, we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events, changed circumstances or any other reason after the date of this Form 10-Q. Investors should also be aware that while we do, at various times, communicate with securities analysts, it is against our policy to disclose to them any material non-public information or other confidential information. Accordingly, investors should not assume that we agree with any statement or report issued by an analyst irrespective of the content of the statement or report. To the extent that reports issued by securities analysts contain any projections, forecasts or opinions, such reports are not our responsibility. OVERVIEW We provide leading integrated communications services to consumer and business customers in and out of Alaska. Our communications network extends throughout Alaska and connects to the contiguous states via our two diverse undersea fiber optic cable systems. Our network is among the most expansive in Alaska and forms the foundation of service to our customers. Our significant wireless spectrum holdings are used in the delivery of our wireless services. The sections that follow provide information about important aspects of our operations and investments and include discussions of our results of operations, financial condition and sources and uses of cash. In addition, we have highlighted key trends and uncertainties to the extent practicable. The content and organization of the financial and non-financial data presented in these sections are consistent with information we use in evaluating our own performance and allocating our resources. We also monitor the state of the economy in general. In doing so, we compare Alaska economic activity with broader economic conditions. In general, we believe that the Alaska telecommunications market, as well as general economic activity in Alaska, is affected by certain economic factors, which include: • investment activity in the oil and gas markets; • tourism levels; • governmental spending and activity of military personnel; • the price of bandwidth; • the growth in demand for bandwidth; • decline in demand for voice and other legacy services; • local customer preferences; • unemployment levels; and • housing activity. We have observed variances in the factors affecting the Alaska economy as compared to the U.S. as a whole. Some factors, particularly the price of oil and gas, usually have a greater direct impact on the Alaska economy compared to other macro-economic trends impacting the U.S. economy as a whole. Prior to 2012, although the Company had been experiencing a steady decline in its retail customer base, total revenues remained relatively unchanged. This was accomplished by generating higher foreign roaming and wireless CETC revenue to offset lower retail revenue. In 2011, two significant events arose that impact this overall revenue stability. The first is Verizon's anticipated entry into the Alaska market, and the second is future declines in wireless CETC and other wireline high cost support revenue as a result of changes enacted by the FCC. Foreign roaming revenue, CETC and high cost support revenues represented approximately 26% and 25% of our total revenue in 2012 and 2011, respectively, and profit margins on these revenues streams are relatively high. 17 -------------------------------------------------------------------------------- Table of Contents In part as a result of these adverse events, management in 2012 implemented a long-term business plan that focused on driving growth in retail broadband services across multiple market segments - business and wholesale, consumer and wireless. Previously, the Company had focused on select market segments, primarily wireless and enterprise, with the intent to maximize returns. The adverse external events necessitated a broader view of all market segments, and a move away from reliance on support and roaming revenues. Management's assessment of the telecom market in Alaska indicated an estimated $1 billion market growing approximately five to six percent annually. This long-term business plan required investments in sales, service, marketing and product development and other initiatives. These investments allow the Company to pursue the market opportunity in a deliberate manner, driving growth in service revenues. At the same time, management has indicated that the impact of the erosion of foreign roaming and CETC revenue, as well as increased spending to drive growth, will result in margin erosion of 500 to 600 basis points from 2011 levels. Additionally, because of the future adverse impacts, management and the Board of Directors recognized that the Company needed to reduce its outstanding debt to sustainable levels. In the fourth quarter of 2011 our Board of Directors reduced our quarterly common stock dividend from $0.215 to $0.05 and, in the fourth quarter of 2012, completely suspended the cash dividend. On June 5, 2012, the Company announced the AWN Transaction, allowing it to combine its wireless network with that of GCI. AWN will own and operate the wireless networks of ACS and GCI, and receive all roaming, CETC and backhaul revenue from other wireless carriers associated with these networks. In return for providing wholesale plans and services to its owners, ACS and GCI will pay AWN a wholesale rate of approximately 70% of the recommended retail rates that both companies charge their wireless customers. AWN will reimburse its owners for wireless equipment subsidies. The primary financial impact to ACS of the AWN Transaction is as follows: 1. GCI will pay ACS $100.0 million at closing, and we are designating $65.0 million of these proceeds for paying down our senior term loan facility; 2. AWN will pay ACS a preferred distribution over the first four years after formation totaling up to $190.0 million; and 3. ACS will continue to provide wireless services to its retail wireless customers, and as compensation for using the AWN network, will pay AWN a wholesale charge for providing wholesale plans and services to ACS. The preferred distributions are expected to provide a higher degree of certainty for our future wireless cash flow performance than we otherwise would have expected to generate as a standalone wireless operator. This transaction is also expected to improve our long term competitive position for wireless services. By combining the ACS and GCI wireless networks, AWN will operate Alaska's largest wireless network covering more than 95% of the state's population, allowing us to better provide the fastest and most geographically expansive wireless services for our subscribers. While significantly mitigating the financial impact of competitive entry, we will continue to have exposure to significant risks associated with Verizon's entry. Although we expect to reduce our outstanding debt, the AWN cash distributions were structured to serve as a surrogate for the Free Cash Flow (as defined in "Non-GAAP Financial Measures") historically generated by our wireless assets. Regulatory Update The items reported under Part I, Item 1: "Business - Regulation" in our Annual Report on Form 10-K for the fiscal year ended December 31, 2012, are updated as follows. This section should be read in conjunction with the corresponding items previously disclosed in our Annual Report. Federal Universal Service Support The Connect America Fund Price-cap ILECs, such as us, must use the frozen universal service support we receive under Connect America Fund ("CAF") Phase I to support modern communications networks capable of supporting broadband and voice services, and over time must increasingly target areas that are substantially unserved by any unsupported competitor providing such services. Specifically, under FCC rules, the ACS ILECs receive a total of $19.7 million annually in frozen CAF Phase I support. In 2013, we must spend one-third of this total to build and operate broadband-capable networks used to offer our own retail broadband service in areas substantially unserved by an unsubsidized competitor. On April 9, 2013, we filed a request for the FCC to waive certain restrictions on the use of this portion of our frozen CAF Phase I support in order to permit us to use this support more effectively to achieve the purposes of the rule. That petition remains pending at the FCC. 18 -------------------------------------------------------------------------------- Table of Contents On April 22, 2013, the FCC adopted a model platform that will be used to establish CAF Phase II support levels for price cap carriers operating in the 48 contiguous states. In its order, the FCC made clear that it was not deciding whether to apply this platform to other areas of the United States, including Alaska. Previously, in February 2013, the FCC sought comment on alternate means through which it might determine CAF Phase II support levels for areas outside of the contiguous 48 states. We have advocated that the FCC should establish a separate, dedicated portion of its CAF Phase II fund for these areas because we believe that the FCC's model platform, as adopted, provides insufficient support to Alaska and other insular areas of the nation. The Mobility Fund The FCC has scheduled the $50 million "Tribal Mobility Fund Phase I" reverse auction for October 24, 2013. That auction will allocate one-time support to deploy mobile voice and broadband services to unserved Tribal lands, including Alaska Native regions established pursuant to the Alaska Native Claims Settlements Act. In March 2013, the FCC sought comment on the rules that will govern this auction. Once those rules are established, we will evaluate the level of our participation in that auction. 2013 Focus Our results of operations, financial position and sources and uses of cash in the current and future periods reflect our focus on being the most successful broadband solutions company in Alaska by delivering the best customer experience in the markets we choose to serve. To do this we will continue to: • Develop Our Workforce to Build Our Sales and Service Capabilities. We believe an engaged workforce is critical to our success. • Provide a Delightful Customer Experience Every Time. We believe the economics of retaining a customer always prevails over those of adding a customer. We invest in training, process and systems improvements to continuously improve the customer experience we create. • Simplify How We Do Business. We believe we must reduce waste in non-value-added activities. We are accelerating our investments in technology and process improvement and expect these efforts to meaningfully impact margins in the next two to three years. • Offer Broadband Solutions to Our Customers at Home, at Work and Everywhere in Between. We are building on strength in designing, building and operating quality networks and providing new products and solutions to our customers. We believe we can create value for our shareholders by carefully investing cash flows generated by the business in specific opportunities and transactions that support these imperatives, and by deleveraging our balance sheet. During 2013 we will continue to focus on consummation of the AWN Transaction, including obtaining the required regulatory approvals and meeting the other conditions detailed in the Asset Purchase and Contribution Agreement, followed by integration of AWN by us and GCI. We believe that consummation of the transaction and the subsequent successful performance of AWN will benefit our future cash flows and create value for our shareholders. We currently expect that the AWN Transaction will close during the second quarter of 2013. We are also focusing on executing to specific, detailed plans supporting development of our workforce, improving our customers' experience, simplifying our business processes and enhancing our product offerings. Expanded product offerings are expected to include Voice over Internet Protocol ("VoIP") products to our larger business customers, the introduction of additional IT, professional and cloud-based services to our business and governmental customers and higher bandwidth speed to our residential customers. We are also working with the FCC to seek ways to provide more predictable and appropriate funding sources to fulfill our broadband build out obligations as required by this agency. Revenue Sources by Customer Group We manage our revenues based on the sale of services and products to the following major customer groups: • Business and Wholesale: We provide communications and managed services including voice and broadband data network hosting, IT management, cloud-based services, billing and collection, and local and long distance services to carriers, business and government customers. 19 -------------------------------------------------------------------------------- Table of Contents • Consumer: We provide broadband, Internet access, local and long distance voice, and other communications products and services to residential customers. • Wireless: We provide wireless voice and broadband services, and other value-added wireless products and services, such as wireless devices and other equipment, statewide across Alaska with roaming coverage available in the contiguous states, Hawaii and Canada. • Access and CETC: We provide voice and broadband termination services to interstate and intrastate carriers who provide services to our retail customers. We also receive interstate and intrastate high cost universal support funds and other revenue streams as structured by state and federal regulatory agencies that have historically allowed us to recover our costs of providing universal service in Alaska. Executive Summary The following summary should be read in conjunction with "Non-GAAP Financial Measures" included in this Management's Discussion and Analysis of Financial Condition and Results of Operations. Operating Revenues Consolidated operating revenue of $91.1 million increased $5.1 million, or 5.9%, in the first quarter of 2013 compared with the first quarter of 2012. Revenue growth was driven by higher foreign roaming revenue and higher broadband revenue in all customer groups. Broadband revenue accounted for 50.4% of our total service revenue in the first quarter. These increases were partially offset by lower voice revenue across all customer groups and lower Access and CETC revenues. Adjusted EBITDA Adjusted EBITDA, as defined in "Non-GAAP Financial Measures" ("Adjusted EBITDA") of $31.0 million increased $4.7 million, or 17.9%, compared with the first quarter of 2012 due primarily to the growth in foreign roaming and broadband revenue and the favorable impact of our process improvement initiatives on our operating expenses. Operating Metrics Business broadband connections of 19,466 and average monthly revenue per user ("ARPU") of $163.22 at March 31, 2013 and in the first quarter of 2013, respectively, were up from connections of 19,076 and ARPU of $141.60 in the comparable periods of 2012. The growth in broadband ARPU reflects customer demand for increasing amounts of bandwidth. We count connections on a unitary basis regardless of the size of the bandwidth. For example, a customer that has a 10MB connection is counted as one connection as does a customer with a 1MB connection. We believe that ARPU is an important metric indicating the increasing amounts of bandwidth that we provide to our customers, and that it is expected to grow at a faster rate than connections. In the first quarter of 2013, consumer broadband connections of 39,334 increased for the third consecutive quarter and were up 2.3% year over year. Consumer broadband ARPU also improved to $44.75 in the first quarter of 2013 compared with $37.56 in the first quarter of 2012 as the result of customers taking our higher bandwidth products. Wireless connections of 114,091 at March 31, 2013 decreased 2.6% from 117,156 at March 31, 2012 primarily as a result of new certification rules for lifeline customers enacted by FCC which resulted in the disconnection of 3,115 customers in 2012. Lifeline customers are treated as postpaid wireless connections. We are experiencing an erosion of our postpaid customer base, which is being partially offset by strength in our prepaid wireless business. Postpaid wireless connections fell to 99,857 at March 31, 2013 from 106,133. Weakness in postpaid was attributable to several factors, including: (i) erosion of customers from the Lifeline certification process; (ii) erosion in our 3G MiFi devices of approximately 500 as we tightened our usage policies and as customers enabled the Wi-Fi feature on their phones; (iii) delay in availability of the iPhone 5 devices relative to our competition; (iv) market share losses to competitors who are expanding their network coverage and aggressively pricing and promoting to gain market share; and (v) the effects of network transition as we move from CDMA to LTE/HSPA+/GSM. Over the same period, our prepaid wireless connections increased to 14,234 from 11,023 year over year. The success of prepaid offerings was attributable to the launch of significant prepaid offerings in 2012 and expansion of our indirect sales channel. 20 -------------------------------------------------------------------------------- Table of Contents Churn on wireless connections of 2.6% in the first quarter of 2013 increased from 2.3% in the first quarter of 2012 due to several of the factors we have previously identified. Wireless churn improved from 3.7% in the fourth quarter of 2012 following the lifeline certification process in 2012. Our wireless equipment subsidy increased 96.1%, to $3.5 million in the first quarter of 2013 from $1.8 million in the first quarter of 2012. We sold 14,919 and 15,901 devices in the first quarter of 2013 and 2012, respectively. Our subsidy per device increased to $243.00 in the first quarter of 2013 from $185.00 in the fourth quarter of 2012 and $122.00 in the first quarter of 2012. The higher per device subsidy is primarily attributable to the higher cost devices that our customers increasingly are buying. 21 -------------------------------------------------------------------------------- Table of Contents The table below provides certain key operating metrics as of or for the periods indicated. ARPU is defined as average monthly revenue per user. March 31, 2013 2012 Voice: At quarter end: Consumer access lines 54,037 61,422 Business access lines 80,770 82,317 Quarter: ARPU - consumer $ 26.21 $ 26.55 ARPU - business $ 23.61 $ 24.35 Broadband: At quarter end: Consumer connections 39,334 38,449 Business connections 19,466 19,076 Quarter: ARPU - consumer $ 44.75 $ 37.56 ARPU - business $ 163.22 $ 141.60 Wholesale lines at quarter end 19,228 22,157 Wireless: At quarter end: Postpaid connections 99,857 106,133 Prepaid connections 14,234 11,023 Total 114,091 117,156 Quarter: ARPU - retail $ 52.17 $ 51.83 ARPU - broadband $ 22.63 $ 17.35 Churn: Voice access lines 1.3 % 1.3 % Broadband connections 1.9 % 2.3 % Wireless connections 2.6 % 2.3 % Wireless equipment subsidy (in thousands) Quarter $ 3,527 $ 1,799 Liquidity We generated $25.6 million of cash from operating activities in the first quarter of 2013 compared with $19.6 million in the first quarter of 2012. This growth was primarily the result of improved revenue and operating expense performance. The increase in cash generated from operating activities combined with a $3.5 million reduction in total capital spending and a $2.3 million reduction in cash dividend payments was utilized, in part, to fund the $15.0 repayment of debt, representing an $8.6 million increase over debt repayments in the first quarter of 2012. Other Initiatives During the first quarter we achieved Carrier Ethernet 2.0 Certification for certain broadband services, becoming the first carrier in Alaska, second in the United States, and third in the world to achieve the standard. The qualifications for these certifications bring standardized definitions for reliability, class and quality of service as 22 -------------------------------------------------------------------------------- Table of Contents well as security and scalability. Initial reception from carrier customers and retail customers alike has been positive. The certification represents a multi-phase product enhancement roadmap which will include deployment of customer portals for performance visibility and self-service management. During 2013, we are also implementing several process improvement initiatives which are expected to result in improved customer experience and cost savings. Examples of these initiatives include moving to a Vendor Managed Inventory ("VMI") model for our warehouse functions, outsourcing of our internal IT Service Desk to a third party vendor at a lower cost and improved level of service, changing our model for internal facilities management, and several other initiatives. We are incorporating the LEAN framework into our process improvement initiatives to provide an ongoing program of waste elimination to improve service delivery and productivity. 23 -------------------------------------------------------------------------------- Table of Contents RESULTS OF OPERATIONS All amounts are discussed at the consolidated level after the elimination of affiliate revenue and expense. Three Months Ended March, 2013 Compared to Three Months Ended March, 2012 Three Months ended March 31, (in thousands) 2013 2012 Change % Change Operating revenues: Business and wholesale Retail service revenue Voice $ 5,723 $ 6,040 $ (317 ) -5.2 % Broadband 9,467 8,118 1,349 16.6 % Equipment sales 554 336 218 64.9 % Wholesale and other 11,422 11,954 (532 ) -4.5 % Total business and wholesale revenue 27,166 26,448 718 2.7 % Consumer Retail service revenue Voice 4,319 4,936 (617 ) -12.5 % Broadband 5,242 4,349 893 20.5 % Equipment sales 38 42 (4 ) -9.5 % Other 414 266 148 55.6 % Total consumer revenue 10,013 9,593 420 4.4 % Wireless Retail service revenue Voice 11,101 12,667 (1,566 ) -12.4 % Broadband 6,803 5,551 1,252 22.6 % Equipment sales 1,248 1,172 76 6.5 % Foreign roaming 15,026 8,776 6,250 71.2 % Other 1,101 946 155 16.4 % Total wireless revenue 35,279 29,112 6,167 21.2 % Access and CETC CETC 4,924 5,527 (603 ) -10.9 % High cost support 4,162 4,949 (787 ) -15.9 %Switched, special and other access 9,515 10,318 (803 ) -7.8 % Total access and CETC 18,601 20,794 (2,193 ) -10.5 % Total operating revenues 91,059 85,947 5,112 5.9 % Operating expenses: Cost of services and sales 35,447 35,162 285 0.8 % Selling, general and administrative 26,797 25,495 1,302 5.1 % Depreciation and amortization 12,632 12,942 (310 ) -2.4 % Gain on disposal of assets, net 41 280 (239 ) -85.4 % Total operating expenses 74,917 73,879 1,038 1.4 % Operating income 16,142 12,068 4,074 33.8 % Other income and expense: Interest expense (10,029 ) (9,559 ) (470 ) 4.9 % Loss on extinguishment of debt - (323 ) 323 n/a Interest income 10 10 - 0.0 % Total other income and expense (10,019 ) (9,872 ) (147 ) 1.5 % Income before income tax expense 6,123 2,196 3,927 178.8 % Income tax expense (2,655 ) (1,067 ) (1,588 ) 148.8 % Net income $ 3,468 $ 1,129 $ 2,339 207.2 % 24 -------------------------------------------------------------------------------- Table of Contents Operating Revenue Business and Wholesale Business and Wholesale revenue of $27.2 million increased $0.7 million, or 2.7%, in the three-month period of 2013 from $26.5 million in the same period of 2012. This improvement was primarily driven by $1.3 million from new and existing business customers using our advanced network services such as MPLS, dedicated Internet and Enhanced Metro Ethernet. Although broadband connections continue to grow modestly, growth of broadband ARPU reflects customer demand for increasing amounts of bandwidth. Broadband ARPU increased to $163.12 in the first quarter of 2013 from $141.60 in the first quarter of 2012, an increase of 15.2%. This increase was partially offset by a $0.6 million decrease in carrier customers' use of long haul services, and a $0.3 million decrease in traditional voice revenue due to 1,547 fewer connections year over year and lower ARPU of $23.61 from $24.35 in the prior year due to price compression. Consumer Consumer revenue of $10.0 million increased $0.4 million, or 4.4%, in the three-month period of 2013 from $9.6 million in the same period of 2012. Broadband revenue increased $0.9 million. Broadband connections increased slightly year over year and customers are subscribing to higher levels of bandwidth speeds, which resulted in an increase in ARPU to $44.75 from $37.56 in the first quarter of 2013, an increase of 19.1%. Launch of our Home Internet product in 2012 contributed to the growth in broadband connections. In spite of the level of competition in our local market, we expect our retail customers to continue to demand higher bandwidth speeds as new products and services in the marketplace require it. Voice revenue decreased $0.6 million primarily due to 7,385 fewer connections and marginally lower ARPU of $26.21 from $26.55 in the first quarter of 2012. This trend is expected to continue as more customers cut their fixed landline voice service and move to wireless alternatives. Wireless Wireless revenue of $35.3 million increased $6.2 million, or 21.2%, in the three-month period of 2013 from $29.1 million in the same period of 2012. Our wireless subscriber base of 114,091 connections decreased 3,065 year over year due to a decrease of 6,276 in postpaid connections resulting in part from the loss of 3,115 lifeline customers during that program's recertification process in the fourth quarter of 2012. We recertified approximately 75% of our lifeline customers. This decline was partially offset by an increase of 3,211 in prepaid connections. Retail wireless ARPU increased slightly to $52.17 compared to $51.83 while broadband ARPU increased 30.4% to $22.63 from $17.35 in the prior year due to customers consuming higher amounts of data. The percentage of postpaid customers using data centric devices has grown to 56.4% in the first quarter of 2013 from 44.8% in the first quarter of 2012, and we expect this trend to continue as consumers move to devices with these features. Foreign roaming revenue increased $6.3 million, or 71.2%, due to the large number of customers from other carriers roaming on our network, and broadband revenue increased $1.3 million primarily due to the continued increase in demand for data rich cell phone plans. Partially offsetting these increases, voice revenue decreased $1.6 million primarily due to lower demand for voice services and the shift in connections from postpaid to prepaid, which are generally lower priced plans. Access and CETC Access and CETC revenue of $18.6 million decreased $2.2 million, or 10.5%, in the three-month period of 2013 from $20.8 million in the same period of 2012. This decline was due to reduced Interstate carrier compensation and USF changes of $0.6 million, reduced access lines of $0.8 million and reduced high cost support of $0.8 million. Operating Expenses Cost of Services and Sales Cost of services and sales of $35.4 million increased $0.3 million, or 0.8%, in the three-month period of 2013 from $35.2 million in the same period of 2012. This increase was due to a $1.8 million increase in device and accessory expenses primarily driven by our customers purchasing higher cost wireless devices and increases of $0.6 million in Home Internet and advanced network services costs reflecting customer premise equipment such as modems and third party leased circuits to carry higher amounts of bandwidth between certain of our local exchange markets. These increases were partially offset by a $1.0 million reduction in circuit costs, a $0.6 million reduction in labor costs and a $0.4 million reduction in USF expense. 25 -------------------------------------------------------------------------------- Table of Contents Selling, General and Administrative Selling, general and administrative expenses of $26.8 million increased $1.3 million, or 5.1%, in the three-month period of 2013 from $25.5 million in the same period of 2012. This growth was due to an increase of $1.0 million in labor primarily associated with sales and customer service. In addition, we incurred $0.8 million in transaction costs and other administrative expenses associated with the AWN Transaction in the first quarter of 2013 compared to $0.3 million in the first quarter of 2012, and $0.3 million in contingent litigation costs. These items were partially offset by a $0.3 million reduction in bad debt expense and a $0.2 million reduction in advertising expense. Depreciation and Amortization Depreciation and amortization expense of $12.6 million decreased $0.3 million, or 2.4%, in the three-month period of 2013 from $12.9 million in the same period of 2012 due primarily to a number of pooled asset classes reaching their maximum depreciable lives. These decreases were partially offset by depreciation on the build out of our LTE core and new wireless sites. Gain on Disposal of Assets, Net The loss on the disposal of assets in the first quarter of 2013 was associated with the sale of excess property. The $0.3 million loss on the disposal of assets recorded in the first quarter of 2012 was associated asset disposals associated with the optimization of our wireless network. Other Income and Expense Interest expense of $10.0 million in the three-month period of 2013 increased $0.4 million compared with $9.6 million in the same period of 2012 due to a higher weighted average interest rate, partially offset by lower average borrowings. The higher interest rate reflects $0.9 million associated with forward floating-to-fixed interest rate swap agreements which became effective in the third quarter of 2012. The impact of the interest rate swaps was partially offset by the pay down of our 5.75% Notes during 2012, which carried a higher effective rate than our 6.25% Notes. The 5.75% Notes were paid off in their entirety during the first quarter of 2013. In the fourth quarter of 2012, an interest rate swap in the notional amount of $192.5 million no longer met the criteria for prospective hedge accounting treatment. In the first quarter of 2013, the $0.4 million favorable change in the fair value of this swap was credited to interest expense and $0.4 million of unrealized losses previously recorded to accumulated other comprehensive loss was charged to interest expense. A $0.3 million loss on extinguishment of debt was recorded in 2012 in connection with the repurchase of $5.0 million aggregate principal amount of our 5.75% Notes. Income Taxes Income tax expense and the effective tax rate in the three-month period of 2013 were $2.7 million and 43.4%, respectively, compared with $1.1 million and 48.6%, respectively, in the three-month period of 2012. Net Income Net income was $3.5 million in the three-month period of 2013 compared to $1.1 million in the same period of 2012. The year over year improvement reflects the revenue and operating expense items discussed above. FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES Cash Flows We satisfied our cash requirements for operations, capital expenditures and debt service in the first three months of 2013 primarily through internally generated funds. At March 31, 2013, we had $19.1 million in cash and cash equivalents, $3.9 million in restricted cash and a $30.0 million undrawn revolving credit facility. Outstanding standby letters of credit commit $2.0 million of that available revolving credit facility at March 31, 2013. 26 -------------------------------------------------------------------------------- Table of Contents Our major sources and uses of funds in the three months ended March 31, 2013 and 2012 are as follows: Three Months Ended March 31, (in thousands) 2013 2012 Net cash provided by operating activities $ 25,568 $ 19,571 Capital expenditures $ (5,968 ) $ (9,653 ) Change in unsettled capital expenditures $ (3,151 ) $ (3,131 ) Proceeds on sale of assets $ 1,935 $ - Net debt repayments $ (15,015 ) $ (6,417 ) Payment of cash dividend on common stock $ - $ (2,268 ) Payment of withholding taxes on stock-based compensation $ (630 ) $ (231 ) Cash Flows from Operating Activities Cash provided by operating activities of $25.6 million in the first quarter of 2013 reflected net income of $21.8 million excluding non-cash income and expenses. Payment of AWN Transaction related costs totaled $0.9 million in the first quarter of 2013. The Company will incur additional AWN Transaction costs up to and following the consummation of the transaction. The Company currently expects to fund these costs primarily through a combination of internally generated funds and proceeds from the transaction. Cash provided by operating activities of $19.6 million in the first quarter of 2012 reflected net income of $18.4 million excluding non-cash income and expenses and a $2.6 million decrease in accounts receivable, reduced by a $1.4 million increase in inventory due to the iPhone launch in the second quarter of 2012. Payment of AWN Transaction related costs totaled $0.2 million in the first quarter of 2012. Interest payments, net of cash interest income and including capitalized interest, were $7.2 million and $7.0 million in the first quarter of 2013 and 2012, respectively. Through a series of interest rate swap transactions, interest on 90% of our term loan at March 31, 2013 is effectively fixed at an annual rate of 6.72% for the period April 2013 through May 2013, 6.97% for the period June 2013 through July 2013, and 7.22% for the period August 2013 through September 2015. Our $120.0 million convertible debt has a fixed coupon rate of 6.25%. Cash Flows from Investing Activities Cash used in investing activities of $7.7 million in the first quarter of 2013 consisted of capital expenditures totaling $9.6 million associated primarily with our IT infrastructure and construction of our 4G LTE wireless network, partially offset by $1.9 million of proceeds from the sale of excess property. Cash used in investing activities of $13.3 million in the first quarter of 2012 consisted of capital expenditures totaling $13.1 million associated primarily with construction of our 4G LTE wireless network. Our historical capital expenditures have been significant. Our networks require the timely maintenance of plant and infrastructure. Future capital requirements may change due to impacts of regulatory decisions that affect our ability to recover our investments, changes in technology, the effects of competition, changes in our business strategy, our decision to pursue specific acquisition and investment opportunities and the future funding of capital expenditures relative to wireless operations which become the responsibility of AWN subsequent to closing. We intend to fund future capital expenditures with cash on hand and net cash generated from operations. Cash Flows from Financing Activities Cash used in financing activities of $15.6 million in the first quarter of 2013 consisted primarily of repayments of long term debt of $15.0 million, including the $13.0 million remaining outstanding balance of our 5.75% Notes and scheduled payments on the term loan component of our Senior Credit Facility of $1.8 million. Cash used in financing activities of $8.9 million in the first quarter of 2012 consisted primarily of repayments of long-term debt of $6.4 million and cash dividends of $2.3 million. Debt payments included $5.0 million on our 5.75% Notes and $1.1 million on the term loan component of our Senior Credit Facility. Effective in the fourth quarter of 2011, the Company's Board of Directors reduced the quarterly cash dividend from $0.215 per share to $0.05 per share. Following announcement of the AWN Transaction, and after assessing further deleveraging 27 -------------------------------------------------------------------------------- Table of Contents approaches, the Board of Directors suspended the cash dividend. The suspension was incorporated as a term modification to our Senior Credit Facility effective November 1, 2012, which prohibits the payment of a common dividend unless the Company's Total Leverage Ratio is in excess of 3.5 times Adjusted EBITDA as defined in the Senior Credit Facility. Liquidity and Capital Resources Consistent with our history, our current and long-term liquidity could be impacted by a number of challenges, including, but not limited to: (i) servicing our substantial debt and funding principal payments; (ii) the annual funding of other obligations, including our pension plans and lease commitments; (iii) potential future reductions in our revenues resulting from governmental and public policy changes, including regulatory actions affecting inter-carrier compensation and changes in revenue from Universal Service Funds; (iv) the entrance of Verizon into the Alaska wireless market and the potential negative impact on our roaming revenues beginning in 2013; (v) other competitive pressures in the markets we serve; (vi) the capital intensive nature of our industry; (vii) our ability to respond to and fund the rapid technological changes inherent to our industry, including new products; (viii) funding cash dividends to the extent permitted; (ix) the potential funding of certain contingent liabilities; and (x) our ability to obtain adequate financing to support our business and pursue growth opportunities. We are responding to these challenges by (i) driving retail growth in broadband revenues to business and consumers; (ii) working towards the consummation of the AWN Transaction, which is expected to accelerate the pay down of debt and provide more predictability in our wireless cash flows through the preferred distribution structure contained in the relevant agreements; (iii) reducing the amount of capital spending from the levels we incurred in 2012; and (iv) the suspension of the cash dividend on our common stock in 2012. Senior Credit Facility Our existing Senior Credit Facility matures on October 21, 2016 and the revolver matures on October 21, 2015. Our Senior Credit Facility contains a number of restrictive covenants and events of default, including covenants limiting capital expenditures, incurrence of debt and the payment of dividends. The Senior Credit Facility also requires that we maintain certain financial ratios as defined under Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2012. As disclosed below, we were in compliance with all such ratios as of March 31, 2013. Total Leverage Ratio: Our "total leverage ratio" may not exceed 5.25 to 1.00 and was 4.13 to 1.00 as of March 31, 2013. Senior Secured Leverage Ratio: Our "senior secured leverage ratio" may not exceed 4.40 to 1.00 and was 3.42 to 1.00 as of March 31, 2013. Fixed Charges Coverage Ratio Leverage Ratio: Our "fixed charges coverage ratio" may not be less than 2.75 to 1.00 and was 3.52 to 1.00 as of March 31, 2013. Substantially all of our assets (including those of our subsidiaries) have been pledged as collateral for our Senior Credit Facility. We believe that we will have sufficient cash on hand, cash provided by operations and availability under our Senior Credit Facility to service our debt and fund our operations, capital expenditures and other obligations over the next twelve months. However, our ability to make such an assessment is dependent upon our future financial performance, which is subject to future economic conditions and to financial, business, regulatory, competitive entry and many other factors, many of which are beyond our control and could impact us during the time period of this assessment. See "Item 1A Risk Factors" in our Annual Report on Form 10-K and this report for further information regarding these risks. NON-GAAP FINANCIAL MEASURES In an effort to provide investors with additional information regarding our financial results, in particular with regards to our liquidity and capital resources, we have disclosed certain non-GAAP financial information which management utilizes to assess performance and believe provides useful information to investors. We have disclosed earnings before interest expense and income, loss on extinguishment of debt, depreciation and amortization, loss on disposal of assets, AWN Transaction related costs, income taxes and stock-based compensation and long term cash incentives ("Adjusted EBITDA"), as defined and reconciled below, and Adjusted EBITDA Margin, defined as Adjusted EBITDA divided by operating revenues, because we believe they 28 -------------------------------------------------------------------------------- Table of Contents are important performance indicators and provide information about our ability to service debt, pay dividends to the extent permitted and fund capital expenditures. We also disclose Free Cash Flow, as defined and reconciled below, because we believe it is an important measure of our ability to fund business activities. Adjusted EBITDA, Adjusted EBITDA Margin and Free Cash Flow are not GAAP measures and should not be considered a substitute for operating income, net cash provided by operating activities, or net cash provided or used. Adjusted EBITDA as computed below is not consistent with the definition of Adjusted EBITDA referenced in the Fixed Charges Coverage Ratio covenant of our Senior Credit Facility. 29 -------------------------------------------------------------------------------- Table of Contents The following table provides the computation of Adjusted EBITDA and Free Cash Flow for the three months ended March 31, 2013 and 2012: Three Months Ended March 31 2013 2012 Net cash provided by operating activities $ 25,568 $ 19,571 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization (12,632 ) (12,942 ) Unrealized gain on ineffective hedge 420 - Amortization of debt issuance costs and debt discount (1,426 ) (1,606 ) Amortization of ineffective hedge (430 ) - Stock-based compensation (1,219 ) (717 ) Deferred income tax expense (2,655 ) (1,063 ) Provision for uncollectible accounts (268 ) (550 ) Other non-cash expense, net (81 ) (429 ) Changes in operating assets and liabilities (3,809 ) (1,135 ) Net income $ 3,468 $ 1,129 Add (subtract): Interest expense 10,029 9,559 Loss on extinguishment of debt - 323 Interest income (10 ) (10 ) Depreciation and amortization 12,632 12,942 Loss on disposal of assets, net 41 280 Income tax expense 2,655 1,067 Stock-based compensation and long term cash incentives 1,388 717 AWN transaction related costs 845 328 Adjusted EBITDA $ 31,048 $ 26,335 Less: Incurred capital expenditures (5,968 ) (9,653 ) AWN transaction related capital costs, net change (55 ) - Cash interest expense (7,164 ) (7,016 ) Free cash flow $ 17,861 $ 9,666 Operating revenues $ 91,059 $ 85,947 Adjusted EBITDA Margin 34.1 % 30.6 % OUTLOOK Our outlook for the remainder of 2013 is impacted by the timing of the closing of the AWN transaction and the timing of Verizon's launch of its wireless services. Although Verizon has not yet formally announced the timing of their launch of wireless services in Alaska, we believe that they have substantially completed the construction of their main switching facility and are actively turning up cell site locations. Until the timing of these two events is confirmed, we will not provide specific earnings guidance for 2013. 30 -------------------------------------------------------------------------------- Table of Contents Broadband revenue growth across all customer groups is expected to continue to offset lower Access, CETC and voice revenues. Up until the point that Verizon enters the market, we expect our wireless retail service revenue to be consistent with current levels. Following Verizon's entry, we expect our wireless retail revenue to decline. We expect our rate of spending increase to decline from 2012 levels, and the long-term level of spending to be favorably impacted by the implementation of various operational initiatives associated with our efforts to relentlessly simplify the way we do business. As a result of the above factors and the structure of the AWN preferred distributions, and in spite of the year over year improvement in the first quarter, we expect that our Adjusted EBITDA and Free Cash Flow will decline for the full year 2013 compared with 2012. LEGAL We are involved in various claims, legal actions, personnel matters and regulatory proceedings arising in the ordinary course of business and as of March 31, 2013, we have recorded litigation reserves of $1.1 million against certain of those claims and legal actions. We believe that the disposition of these matters will not have a material adverse effect on our consolidated financial position, comprehensive income or cash flows beyond the amounts already recorded. Estimates involved in developing these litigation reserves could change as these claims, legal actions and regulatory proceedings progress. See also "Part II, Item 1, Legal Proceedings." Additionally, this section should be read in conjunction with "Note 10 - Commitments and Contingencies" and "Note 11 - Subsequent Events" in the Notes to Consolidated Financial Statements, which report on a NOPA reissued by the IRS on November 2, 2010 with respect to the 2006, 2007 and 2008 taxable years of Crest, which we acquired on October 30, 2008. On April 4, 2013, the IRS issued notification to the Company that agreement had been reached and approved in favor of all Company positions relative to the Crest matter. The case was categorized as a "no change" case whereby there is no deficiency or overassessment and no further action is required by the Company. EMPLOYEES As of March 31, 2013 we employed 809 regular full-time employees, 8 regular part-time employees and 9 temporary employees. Approximately 66% of our employees are represented by the International Brotherhood of Electrical Workers, Local 1547 ("IBEW"). Our Master Collective Bargaining Agreement with the IBEW governs the terms and conditions of employment for all IBEW represented employees working for us in the state of Alaska through December 31, 2015. Management considers employee relations to be generally good. CRITICAL ACCOUNTING POLICIES AND ACCOUNTING ESTIMATES We have identified certain policies and estimates as critical to our business operations and the understanding of our past or present results of operations. For additional discussion on the application of these and other significant accounting policies, see "Note 1 - Summary of Significant Accounting Policies," to our Annual Report on Form 10-K for the fiscal year ended December 31, 2012. These policies and estimates are considered critical because they had a material impact, or have the potential to have a material impact, on our financial statements and because they require significant judgments, assumptions or estimates. The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Among the significant estimates affecting the financial statements are those related to the realizable value of accounts receivable, materials and supplies, long-lived assets, goodwill, intangible assets, equity method investments, deferred income taxes and network access revenue reserves. Actual results may differ from those estimates as the collection of those balances is not reasonably assured. |