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FAIRPOINT COMMUNICATIONS INC - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion should be read in conjunction with our consolidated financial statements and the notes thereto in "Item 8. Financial Statements and Supplementary Data" included elsewhere in this Annual Report. The following discussion includes certain forward-looking statements. For a discussion of important factors, including the continuing development of our business, actions of regulatory authorities and competitors and other factors which could cause actual results to differ materially from the results referred to in the forward-looking statements, see "Item 1A. Risk Factors" and "Cautionary Note Regarding Forward-Looking Statements" included elsewhere in this Annual Report. Our discussion and analysis of financial condition and results of operations are presented in the following sections: •Overview •Executive Summary •February 2013 Refinancing •Regulatory and Legislative •Fresh Start Accounting •Basis of Presentation •Results of Operations •Non-GAAP Financial Measures •Liquidity and Capital Resources •Off-Balance Sheet Arrangements •Summary of Contractual Obligations •Critical Accounting Policies and Estimates •New Accounting Standards •Inflation Overview We are a leading provider of advanced communications services to business, wholesale and residential customers within our service territories. We offer our customers a suite of advanced data services such as Ethernet, high capacity data transport and other IP-based services over our Next Generation Network in addition to Internet access, HSD, and local and long distance voice services. Our service territory spans 17 states where we are the incumbent communications provider primarily serving rural communities and small urban markets. Many of our LECs have served their respective communities for more than 80 years. We operate with approximately 1.2 million access line equivalents, including approximately 330,000 broadband subscribers, in service as of December 31, 2013. We own and operate our Next Generation Network, an extensive, next generation fiber network with more than 16,000 miles of fiber optic cable, in Maine, New Hampshire and Vermont, giving us capacity to support more HSD services and extend our 35-------------------------------------------------------------------------------- Table of Contents fiber reach into more communities across the region. The IP/MPLS network architecture of our Next Generation Network allows us to provide Ethernet, transport and other IP-based services with the highest level of reliability at a lower cost of service. This fiber network also supplies critical infrastructure for wireless carriers serving the region as their bandwidth needs increase, driven by mobile data from smartphones, tablets and other wireless devices. As of December 31, 2013, we provide cellular transport, also known as backhaul, through over 1,300 mobile Ethernet backhaul connections. We have fiber connectivity to more than 1,000 cellular telecommunications towers in our service footprint. Executive Summary Our executive management team is focused on our 'four pillar' strategy of improving operations, changing the regulatory environment, transforming and growing revenue and aligning our human resources. Our mission is to provide reliable communications services with outstanding customer support across the 17 states we serve. During fiscal year 2013, we continued to make substantial progress on our 'four pillar' business strategy to continue our transformation from a traditional telephone company into a provider of advanced communications services. Access lines have historically been an important element of our business. Communications companies, including FairPoint, continue to experience a decline in access lines due to increased competition from CLECs, wireless carriers and cable television operators, increased availability of alternative communications services, including wireless and VoIP, and challenging economic conditions. Our objective is to transform our revenue by continuing to add advanced data products and services such as Ethernet, high capacity data transport and other IP-based services over our Next Generation Network in addition to HSD services, to minimize our dependence on voice access lines. We will continue our efforts to retain customers to mitigate the loss of voice access lines through bundled packages, including video and other value added services. Over the past few years, we have made significant capital investments in our Next Generation Network to expand our business service offerings to meet the growing data needs of our customers and to increase broadband speeds and capacity in our consumer markets. We have also focused our sales and marketing efforts on these advanced data solutions. Specifically, within the last couple of years, we built and launched high capacity Ethernet services to allow us to meet the capacity needs of our business customers as well as supply high capacity infrastructure to our wholesale customers. These advanced data services are our flagship product and are laying the foundation not only for new business but also for additional IP-based voice services in the future. Additionally, we believe the bandwidth needs of cellular backhaul will continue to grow with the continued adoption of bandwidth-intensive technology. We believe that our extensive fiber network, with over 16,000 miles of fiber optic cable, including over 1,000 cellular telecommunications towers currently served with fiber, puts us in an excellent position to grow our revenue base as demand for cellular backhaul services increases. We expect to see demand increase on existing fiber connected towers where we would provision or expand mobile Ethernet backhaul connections or construct new fiber routes to cellular telecommunications towers. Coupled with recent regulatory reform in the states of Maine, New Hampshire and Vermont that will serve to promote fair competition among communication services providers in the region, we believe that there is a significant organic growth opportunity within the business and wholesale markets given our extensive fiber network and IP-based product suite, combined with our relatively low market share in these areas. Our collective bargaining agreements with the IBEW and the CWA in Northern New England cover approximately 1,800 employees in the aggregate and expire in August 2014. We expect to begin good faith negotiations for successor collective bargaining agreements with our labor unions well prior to expiration. We cannot predict the outcome of these negotiations at this time. See "Item 1A. Risk Factors-A significant portion of our workforce is represented by labor unions and therefore subject to collective bargaining agreements, two of which, covering approximately 1,800 employees, expire in August 2014. If we are unable to renegotiate these agreements prior to expiration, employees could engage in strikes or other collective behaviors, which could materially adversely impact our business, financial condition, results of operations, liquidity and/or the market price of our outstanding securities." February 2013 Refinancing On the Refinancing Closing Date, we completed the Refinancing of the Old Credit Agreement Loans. In connection with the Refinancing, we (i) issued $300.0 million of Notes in a private offering exempt from registration under the Securities Act pursuant to the Indenture that we entered into on the Refinancing Closing Date and (ii) entered into the New Credit Agreement, dated as of the Refinancing Closing Date. The New Credit Agreement provides for the $75.0 million New Revolving Facility, including a sub-facility for the issuance of up to $40.0 million in letters of credit and the $640.0 million New Term Loan. On the Refinancing Closing Date, we used the proceeds of the Notes offering, together with $640.0 million of borrowings under the New Term Loan and cash on hand to (i) repay principal of $946.5 million outstanding on the Old Term Loan, plus $7.7 million of 36-------------------------------------------------------------------------------- Table of Contents accrued interest and (ii) pay $32.6 million of fees, expenses and other costs related to the Refinancing. For further information regarding the New Credit Agreement, the Notes and our repayment of the Old Credit Agreement Loans, see "-Liquidity and Capital Resources" herein and note (8) "Long-term Debt" to our consolidated financial statements in "Item 8. Financial Statements and Supplementary Data" included elsewhere in this Annual Report. Regulatory and Legislative We are generally subject to common carrier regulation primarily by federal and state governmental agencies. At the federal level, the FCC generally exercises jurisdiction over communications common carriers, such as FairPoint, to the extent those carriers provide, originate or terminate interstate or international communications. State regulatory commissions generally exercise jurisdiction over common carriers to the extent those carriers provide, originate or terminate intrastate communications. In addition, pursuant to the Communications Act, state and federal regulators share responsibility for implementing and enforcing the domestic pro-competitive policies introduced by that legislation. We are required to comply with the Communications Act which requires, among other things, that telecommunication carriers offer telecommunication services at just and reasonable rates and on terms and conditions that are not unreasonably discriminatory. The Communications Act also contains requirements intended to promote competition in the provision of local services and lead to deregulation as markets become more competitive. For a detailed description of the federal and state regulatory environment in which we operate and the FCC's recently promulgated CAF/ICC Order and other recent regulatory changes, as well as the effects and potential effects of such regulation on us, see "Item 1. Business-Regulatory Environment" included elsewhere in this Annual Report. We anticipate that the significant changes in both federal and state regulation described therein will not have a material impact in 2014. However, in the long run, we are uncertain of the ultimate impact as federal and state regulation continues to evolve. Fresh Start Accounting On October 26, 2009, we filed the Chapter 11 Cases. On January 13, 2011, the Bankruptcy Court entered the Confirmation Order, which confirmed the Plan. On the Effective Date, we substantially consummated our reorganization through a series of transactions contemplated by the Plan and the Plan became effective pursuant to its terms. As of the Effective Date, we were required to adopt fresh start accounting in accordance with guidance under the applicable reorganization accounting rules, pursuant to which our reorganization value, which represents the fair value of an entity before considering liabilities and approximates the amount a willing buyer would pay for the assets of the entity immediately after the reorganization, was allocated to the fair value of assets in conformity with guidance under the applicable accounting rules for business combinations, using the purchase method of accounting for business combinations. The amount remaining after allocation of the reorganization value to the fair value of identified tangible and intangible assets was reflected as goodwill, which was subject to periodic evaluation for impairment and was later determined to be completely impaired at September 30, 2011. In addition to fresh start accounting, our consolidated financial statements after the Effective Date reflect all effects of the transactions contemplated by the Plan. Therefore, our consolidated statements of financial position and consolidated statements of operations subsequent to the Effective Date are not comparable in many respects to our consolidated statements of financial position and consolidated statements of operations for periods prior to the Effective Date. Basis of Presentation We view our business of providing data, voice and communications services to business, wholesale and residential customers as one reportable segment as defined in the Segment Reporting Topic of the Accounting Standards Codification ("ASC"). Beginning in the second quarter of 2012, we reclassified certain revenues from voice services revenues to data and Internet services revenues to more accurately reflect the underlying services provided. In addition, certain computer and customer service expenses have been reclassified from selling, general and administrative expense, excluding depreciation and amortization, to cost of services and sales, excluding depreciation and amortization, for the years ended December 31, 2012 and December 31, 2011 to be consistent with the current period presentation. Results of Operations The following table sets forth our consolidated operating results reflected in our consolidated statements of operations for the year ended December 31, 2013, the year ended December 31, 2012 and the combined results of the twenty-four days ended January 24, 2011 and the three hundred forty-one days ended December 31, 2011. We believe the comparison of combined results of the year ended December 31, 2011 provides the best analysis of our results of operations. While the adoption of fresh start 37-------------------------------------------------------------------------------- Table of Contents accounting presents the results of operations of a new reporting entity, the only consolidated statement of operations items impacted by the reorganization under Chapter 11 are depreciation and amortization expense, interest expense and reorganization items. Those effects of fresh start accounting are discussed in more detail in the respective sections below. The year-to-year comparisons of financial results are not necessarily indicative of future results (in thousands, except for access line equivalents): Predecessor Combined Company Three Hundred Forty-One Twenty-Four Year Ended Year Ended Year Ended Days Ended Days Ended December 31, December 31, December 31, December 31, January 24, 2013 2012 2011 2011 2011 Revenues: Voice services $ 405,159 $ 446,126 $ 483,766 $ 451,212 $ 32,554 Access 321,812 336,000 369,336 346,313 23,023 Data and Internet services 161,423 142,911 127,323 119,363 7,960 Other 50,960 48,612 49,065 46,224 2,841 Total revenues 939,354 973,649 1,029,490 963,112 66,378 Operating expenses: Cost of services and sales, excluding depreciation and amortization 439,217 450,441 493,499 453,673 39,826 Selling, general and administrative expense, excluding depreciation and amortization 331,656 332,243 343,067 316,966 26,101 Depreciation and amortization 282,438 376,614 358,406 336,891 21,515 Reorganization related income (771 ) (3,666 ) (232 ) (232 ) - Impairment of intangible assets and goodwill - - 262,019 262,019 - Total operating expenses 1,052,540 1,155,632 1,456,759 1,369,317 87,442 Loss from operations (113,186 ) (181,983 ) (427,269 ) (406,205 ) (21,064 ) Other income (expense): Interest expense (78,675 ) (67,610 ) (73,128 ) (63,807 ) (9,321 ) Loss on debt refinancing (6,787 ) - - - - Other 4,863 739 1,659 1,791 (132 ) Total other expense (80,599 ) (66,871 ) (71,469 ) (62,016 ) (9,453 ) Loss before reorganization items and income taxes (193,785 ) (248,854 ) (498,738 ) (468,221 ) (30,517 ) Reorganization items - - 897,313 - 897,313 (Loss) income before income taxes (193,785 ) (248,854 ) 398,575 (468,221 ) 866,796 Income tax benefit (expense) 90,291 95,560 (226,613 ) 53,276 (279,889 ) (Loss) income before discontinued operations (103,494 ) (153,294 ) 171,962 (414,945 ) 586,907 Gain on sale of discontinued operations, net of taxes 10,044 - - - - Net (loss) income $ (93,450 ) $ (153,294 ) $ 171,962 $ (414,945 ) $ 586,907 Access line equivalents: Residential 527,890 586,725 645,453 Business 291,417 299,701 311,241 Wholesale 59,859 65,641 76,065 Total voice access lines 879,166 952,067 1,032,759 Broadband subscribers 329,766 326,367 314,135 Total access line equivalents (1) 1,208,932 1,278,434 1,346,894 38-------------------------------------------------------------------------------- Table of Contents (1) On January 31, 2013, we completed the sale of our operations in Idaho which accounted for 5,604 and 5,536 access line equivalents as of December 31, 2012 and 2011, respectively. Voice Services Revenues We receive revenues through the provision of local calling services to business and residential customers, generally for a fixed monthly charge and service charges for special calling features. We also generate revenue through long distance services within our service areas on our network and through resale agreements with national interexchange carriers. In addition, through our wholly-owned subsidiary, FairPoint Carrier Services, Inc., we provide wholesale long distance services to communications providers that are not affiliated with us. For the years ended December 31, 2013 and 2012, voice access lines in service decreased 7.7% and 7.8% year-over-year, respectively, which directly impacts local voice services revenues and our opportunity to provide long distance services to our customers, resulting in a decrease of minutes of use. Excluding divestitures, on a pro forma basis, voice access lines in service for the years ended December 31, 2013 and 2012 would have declined 7.1% and 7.7% year-over-year, respectively. We expect the trend of decline in voice access lines in service, and thereby a decline in aggregate voice services revenue, to continue as customers are turning to the use of alternative communication services as a result of ever-increasing competition. We were subject to retail service quality plans in the states of Maine, New Hampshire and Vermont for the years ended December 31, 2012 and 2011, pursuant to which we incurred SQI penalties resulting from any failure to meet the requirements of the respective plans. In New Hampshire, the retail service quality plan was eliminated by SB 48, which was effective August 10, 2012, thereby extinguishing our exposure to SQI penalties in that state. In Vermont, effective March 31, 2013 we were no longer subject to the retail service quality plan based on our achievement of certain retail service quality metrics. We were still subject to the retail service quality plan in Maine through July 31, 2013; however, under the Maine Deregulation Legislation enacted in August 2012, SQI penalties were eliminated starting in August 2013. We adopted a separate performance assurance plan ("PAP") for certain services provided on a wholesale basis to CLECs in each of the states of Maine, New Hampshire and Vermont, pursuant to which we are required to issue performance credits in the event we are unable to meet the provisions of the respective PAP. Our maximum exposure to penalties under the PAPs has not been reduced by deregulation legislation in Maine and New Hampshire or by the IRP adopted in Vermont. We receive support to supplement the amount of local service revenue received by us to ensure that basic local service rates for customers in high-cost areas are consistent with rates charged in lower cost areas. Prior to 2012, these subsidies were provided through the USF high-cost support program. Beginning in 2012, all forms of support under the USF were replaced with CAF Phase I frozen support. A portion of the CAF Phase I frozen support represents high-cost loop funding and is recorded as voice services revenue. We expect to receive the same level of CAF Phase I frozen support revenue in 2014, plus or minus small adjustments recorded during the respective quarters and adjusted for the divestiture of the Idaho operations, until the FCC completes its proceedings to adopt a CAF cost model and develop CAF Phase II for our operating areas. The FCC has announced its expectation to complete its CAF II model development, establish all obligations associated with the CAF II program, and offer support to price cap carriers by the end of 2014. If so, CAF II funding could be implemented during 2015. We cannot determine whether we will accept or refuse any funding under the CAF Phase II support programs until all obligations associated with the funding have been determined. The following table reflects the primary drivers of year-over-year changes in voice services revenues (in millions): Year Ended Year Ended December 31, 2013 December 31, 2012 Increase (Decrease) % Increase (Decrease) % Local voice services revenues, excluding: $ (33.5 ) $ (27.5 ) Divestiture of Idaho-based operations (2.9 ) - (Increase) decrease in accrual of PAP penalties (1) 2.1 (1.3 ) Decrease in high-cost loop credits to customers (2) 0.8 2.7 (Increase) decrease in accrual of SQI penalties (3) 0.3 (3.9 ) Long distance services revenues (7.8 ) (7.6 ) Total changes in voice services revenues $ (41.0 ) (9 )% $ (37.6 ) (8 )% (1) During the years ended December 31, 2013, 2012 and 2011, local voice services revenues were reduced by $0.7 million, $2.8 million and $1.5 million, respectively, as a result of our failure to meet specified performance standards as defined by the provisions of the separate PAPs in Maine, New Hampshire and Vermont. In fiscal years 2012 and 2011, a majority of the penalty credits resulting from these commitments were recorded as a reduction to local voice services revenues 39-------------------------------------------------------------------------------- Table of Contents with a small portion recorded to access revenues. However, as our wholesale business shifts from unbundled network elements ("UNEs") to access-driven services, a majority of penalty credits have followed and are now being recorded to access revenues. We expect this trend to continue and the impact of penalty credits on voice services revenues to decrease. (2) In 2012, the VPSB and the MPUC each approved a tariff change whereby we are no longer required to provide high-cost loop credits to customers. For the years ended December 31, 2012 and 2011, we recognized a reduction to local voice services revenues related to high-cost loop credits remitted to customers of $0.8 million and $3.5 million, respectively. (3) During the years ended December 31, 2013, 2012 and 2011, voice services revenues were increased by $0.1 million, reduced by $0.2 million and increased by $3.7 million, respectively, by SQI penalties. In fiscal year 2011, our continued performance improvement, certain legislative and regulatory changes and the additional reversal of 2008 and 2009 SQI penalties resulted in a net increase to local voice services revenues. Access Revenues We receive revenues for the provision of network access through carrier Ethernet based products and legacy access products to end user customers and long distance and other competing carriers who use our local exchange facilities to provide interexchange services to their customers. Network access can be provided to carriers and end users that buy dedicated local and interexchange capacity to support their private networks (i.e. special access) or it can be derived from fixed and usage-based charges paid by carriers for access to our local network (i.e. switched access). Carriers are migrating from legacy access products, such as DS1, DS3, frame relay, ATM and private line, to carrier Ethernet based products. These carrier Ethernet based products are more sustainable, but generally, at the outset, have lower average revenue per user than the legacy products they are replacing, resulting in a decline in access revenues. We expect the decline in access revenues to continue with customer migration; however, with the increasing need for bandwidth, including cellular backhaul, demand for carrier Ethernet based products is expected to increase over time. Our extensive fiber network with over 16,000 miles of fiber optic cable, including over 1,000 cellular telecommunications towers currently served with fiber, puts us in a position to grow our revenue base as demand for cellular backhaul and other Ethernet services expands. We expect to see demand increase on existing fiber-connected towers where we would provision or expand mobile Ethernet backhaul connections. We also construct new fiber routes to cellular telecommunications towers when the business case presents itself. As described above, we adopted a separate PAP for certain services provided on a wholesale basis to CLECs in each of the states of Maine, New Hampshire and Vermont, pursuant to which we are required to issue performance credits in the event we are unable to meet the provisions of the respective PAP. As our wholesale business shifts from UNEs to access-driven services, a majority of penalty credits have transitioned in the same manner and are now being recorded to access revenues instead of voice services revenue. We expect this trend to continue and the impact of penalty credits to access revenues to increase. Our maximum exposure to penalties under the PAPs has not been reduced by the deregulation legislation in Maine and New Hampshire or by the IRP adopted in Vermont. The following table reflects the primary drivers of year-over-year changes in access revenues (in millions): Year Ended Year Ended December 31, 2013 December 31, 2012 Increase (Decrease) % Increase (Decrease) % Carrier Ethernet services (1) $ 8.3 $ 17.2 (Increase) decrease in accrual of PAP penalties (2) (3.3 ) - Divestiture of Idaho-based operations (3.4 ) - Legacy access services (3) (15.8 ) (50.5 ) Total changes in access revenues $ (14.2 ) (4 )% $ (33.3 ) (9 )% (1) We offer carrier Ethernet services throughout our market to our business and wholesale customers, which include Ethernet virtual circuit technology for cellular backhaul. As of December 31, 2013, we provide cellular transport on our Next Generation Network through over 1,300 mobile Ethernet backhaul connections, the number of which has grown significantly over the last two years. (2) During fiscal years 2013 and 2012, access services revenues were reduced by $3.6 million and $0.3 million, respectively, as a result of our failure to meet specified performance standards as defined by the provisions of the separate PAPs in Maine, New Hampshire and Vermont. In 2012 and 2011, a majority of penalty credits were recorded to voice services revenues; therefore the impact of PAP penalties on access revenues to fiscal years 2012 and 2011 was negligible. 40-------------------------------------------------------------------------------- Table of Contents (3) Legacy access services include products such as DS1, DS3, frame relay, ATM and private line. Data and Internet Services Revenues We receive revenues from monthly recurring charges for the provision of data and Internet services to residential and business customers through DSL technology, fiber-to-the-home technology, retail Ethernet, dedicated T-1 connections, Internet dial-up, high speed cable modem and wireless broadband. We have invested in our broadband network to extend the reach and capacity of the network to customers who did not previously have access to data and Internet products and to offer more competitive services to existing customers, including retail Ethernet products. During the years ended December 31, 2013 and 2012, we grew broadband subscribers by 1.0% and 3.9%, respectively, as penetration reached 37.5% of voice access lines at December 31, 2013 from 34.3% and 30.4% at December 31, 2012 and 2011, respectively. We expect to continue our investment in our broadband network to further grow data and Internet services revenues in the coming years. The following table reflects the primary drivers of year-over-year changes in data and Internet services revenues (in millions): Year Ended Year Ended December 31, 2013 December 31, 2012 Increase % Increase % Retail Ethernet services (1) $ 8.9 $ 8.7 Other data and Internet technology based services (2) 9.6 6.9 Total changes in data and Internet revenues $ 18.5 13 % $ 15.6 12 % (1) Retail Ethernet services revenue is comprised of data services provided through E-LAN, E-LINE and E-DIA technology on our Next Generation Network. In the years ended December 31, 2013, 2012 and 2011, respectively, we recognized $27.7 million, $18.8 million and $10.1 million of retail Ethernet revenues from our Next Generation Network. (2) Includes all other services such as DSL, T-1, dial-up, high speed cable modem and wireless broadband. Other Services Revenues We receive revenues from other services, including special purpose projects on behalf of third party requests, video services (including cable television and video-over-DSL), billing and collection, directory services, the sale and maintenance of customer premise equipment and certain other miscellaneous revenues. Other services revenues also include revenue we receive from late payment charges to end users and interexchange carriers. Due to the composition of other services revenues, it is difficult to predict future trends. The following table reflects the primary drivers of year-over-year changes in other services revenues (in millions): Year Ended Year Ended December 31, 2013 December 31, 2012 Increase (Decrease) % Increase (Decrease) % Special purpose projects (1) $ 2.7 $ 1.4 Late payment fees (2) (1.6 ) 1.0 Other (3) 1.2 (2.9 ) Total changes in other services revenues $ 2.3 5 % $ (0.5 ) (1 )% (1) Special purpose projects are completed on behalf of third party requests. (2) Late payment fees are related to customers who have not paid their bills in a timely manner. (3) Other revenues were primarily attributable to directory services, billing and collections and various other miscellaneous services revenues. Cost of Services and Sales Cost of services and sales includes the following costs directly attributable to a service or product: salaries and wages, benefits (including stock based compensation), materials and supplies, contracted services, network access and transport costs, customer provisioning costs, computer systems support and cost of products sold. Aggregate customer care costs, which include billing and service provisioning, are allocated between cost of services and sales and selling, general and administrative expenses. 41-------------------------------------------------------------------------------- Table of Contents We expect cost of services and sales to decrease over time as voice access lines decline and we continue to make operational improvements and align our human resources with the changing telecommunications landscape. The following table reflects the primary drivers of year-over-year changes in cost of services and sales (in millions): Year Ended Year Ended December 31, 2013 December 31, 2012 Increase (Decrease) % Increase (Decrease) % Access expense (1) $ (7.9 ) $ (14.0 ) Severance expense (2) 3.4 (4.2 ) Employee expense (3) 0.2 (13.0 ) Other (4) (6.9 ) (11.9 ) Total changes in cost of services and sales $ (11.2 ) (2 )% $ (43.1 ) (9 )% (1) Access expense continues to decrease primarily due to increased usage of our IP infrastructure, which has enabled us to significantly reduce the associated costs of utilizing other carriers. (2) For the years ended December 31, 2013, 2012 and 2011, we recognized $5.9 million, $2.5 million and $6.7 million of severance expense, respectively, attributed to the reduction in our workforce. (3) For the years ended December 31, 2013, 2012 and 2011, we recognized $187.3 million, $187.1 million and $200.1 million, respectively, of employee expense as cost of services and sales. Although we reduced our workforce in 2013 by approximately 120 positions, an increase in overtime expenses and a decrease in capitalized labor, associated with a reduction in labor intensive capital projects in fiscal 2013, have combined to slightly increase employee expense for fiscal 2013 compared to fiscal 2012. The decrease in employee expense for fiscal year 2012 compared to fiscal year 2011 was due to a reduction in our workforce of approximately 400 positions, many of which impacted cost of services and sales, beginning in September 2011 and continuing through the end of 2011. (4) Other cost of services and sales has decreased primarily due to lower network expenses. Selling, General and Administrative Expense Selling, general and administrative ("SG&A") expense includes salaries and wages and benefits (including stock based compensation, pension and post-retirement healthcare) not directly attributable to a service or product, bad debt charges, taxes other than income, advertising and sales commission costs, customer billing, call center and information technology costs, professional service fees and rent for administrative space. We expect our SG&A expense to decrease primarily as a result of lower discount rates on our qualified pension and post-retirement healthcare obligations. The following table reflects the primary drivers of year-over-year changes in SG&A expense (in millions): Year Ended Year Ended December 31, 2013 December 31, 2012 Increase (Decrease) % Increase (Decrease) % Pension expense (1) 8.4 5.6 Post-retirement healthcare expense (2) 3.6 11.3 Bad debt expense (3) 2.3 (14.3 ) Severance expense (4) (1.7 ) 2.6 Employee expense (5) 1.4 (11.4 ) Other (6) (14.6 ) (4.6 ) Total changes in SG&A expense $ (0.6 ) - % $ (10.8 ) (3 )% (1) Increases in 2013 and 2012 net periodic benefit costs for our qualified pension plans are primarily attributable to an increase in the projected benefit obligation from reductions of approximately 55 and 93 basis points in the weighted average discount rate used to value the qualified pension obligations at December 31, 2012 and December 31, 2011, respectively. The larger projected benefit obligation served to increase service cost and interest cost recognized in 2013 and 2012, respectively, when compared to the prior year. In addition, in connection with our adoption of fresh start accounting on the Effective Date, we recognized all prior unamortized gains and losses. At December 31, 2012 and 2011, we recognized actuarial losses of $49.3 million and $64.8 million, respectively which have resulted in an increase in the amount of actuarial losses being amortized in 2013 and 2012, respectively, compared to the prior year. The actuarial losses can be attributed to the decrease in discount rates and the losses incurred on payment of significant lump sums in each of those years. See note (11) "Employee Benefit Plans" to our consolidated financial statements in "Item 42-------------------------------------------------------------------------------- Table of Contents 8. Financial Statements and Supplementary Data" included elsewhere in this Annual Report for further information on our company-sponsored qualified pension plans. (2) Increases in 2013 and 2012 net periodic benefit costs for our post-retirement healthcare plans are primarily attributable to an increase in the projected benefit obligation from reductions of approximately 46 and 99 basis points in the weighted average discount rate used to value the post-retirement healthcare obligations at December 31, 2012 and December 31, 2011, respectively. The larger projected benefit obligation served to increase service cost and interest cost recognized in 2013 and 2012, respectively, when compared to the prior year. In addition, in connection with our adoption of fresh start accounting on the Effective Date, we recognized all prior unamortized gains and losses. At December 31, 2012 and 2011, we recognized actuarial losses of $42.3 million and $164.7 million, respectively which have resulted in an increase in the amount of actuarial losses being amortized in 2013 and 2012, respectively, compared to the prior year. The actuarial losses can be attributed to the decrease in discount rates. See note (11) "Employee Benefit Plans" to our consolidated financial statements in "Item 8. Financial Statements and Supplementary Data" included elsewhere in this Annual Report for further information on our post-retirement healthcare plans. (3) For the years ended December 31, 2013, 2012 and 2011, we recognized $9.8 million, $7.5 million and $21.8 million of bad debt expense, respectively. In 2012, bad debt expense reflected settlements with wholesale carriers and an improvement in accounts receivable aging. (4) For the years ended December 31, 2013, 2012 and 2011, we recognized $2.2 million, $3.9 million and $1.3 million of severance expense, respectively. In 2013 and 2012, we worked to consolidate operational functions and realign our human resources with the changing telecommunications landscape. (5) For the years ended December 31, 2013, 2012 and 2011, we recognized $123.1 million, $122.3 million and $133.7 million, respectively, of employee expense in SG&A expense. Wages and benefits per employee were slightly higher in 2013. During the fiscal year 2012, we realized cost reductions in employee benefits and a decline in employee wages associated with our effort to consolidate operational functions and realign our human resources with the changing telecommunications landscape. (6) Decreases in other expenses is primarily due to contracted services and operating taxes. Depreciation and Amortization Depreciation and amortization includes depreciation of our communications network and equipment and amortization of intangible assets. We require significant capital expenditures to maintain, upgrade and enhance our network facilities and operations. We expect to reduce our capital expenditures in the upcoming years, which will likely reduce or stabilize our depreciation expense. We expect amortization expense to remain consistent throughout the remainder of our intangible assets' useful lives. For the years ended December 31, 2013, 2012 and 2011, we recognized $271.3 million, $365.5 million and $346.6 million of depreciation expense, respectively. We recognized $11.1 million, $11.2 million and $11.9 million of amortization expense in the years ended December 31, 2013, 2012 and 2011, respectively. In connection with our adoption of fresh start accounting on the Effective Date, property, plant and equipment assets were revalued to their fair value, generally their appraised value after considering economic obsolescence. New remaining useful lives were established and accumulated depreciation was reset to zero. Periodically, we review the estimated remaining useful lives of our group asset categories to address continuing changes in technology, competition and our overall reduction in capital spending and increased focus on more efficient utilization of our existing assets. In the third quarter of 2013, we conducted this review and determined that changes to the estimated remaining useful lives for certain of our asset categories were appropriate. Accordingly, as a result of the changes applied to the remaining useful lives, our depreciation expense in 2013 was approximately $37.0 million less than it would have been absent the changes. The decrease in depreciation expense from 2012 to 2013 is due to the $37.0 million described above, as well as certain asset classes becoming fully depreciated as remaining useful lives, established with the adoption of fresh start accounting, became exhausted. Reorganization Related Income Reorganization related income represents income or expense amounts that have been recognized as a direct result of the Chapter 11 Cases, occurring after the Effective Date. We will continue to incur expenses associated with the Chapter 11 Cases until all such cases have been closed with the Bankruptcy Court. In addition, income may be recognized to the extent that we favorably settle outstanding claims in the claims reserve established to pay outstanding bankruptcy claims and various other bankruptcy related fees (the "Claims Reserve"). As of December 31, 2013, the Claims Reserve has a balance of $0.3 million. 43-------------------------------------------------------------------------------- Table of Contents Impairment of Intangible Assets and Goodwill At September 30, 2011, as a result of the significant sustained decline in our stock price since the Effective Date, our market capitalization dropped below our book value. Signaling a possible impairment, we performed interim impairment tests on our goodwill and non-amortizable trade name. Results of these interim impairment tests required us to write off the entire balance of goodwill and write down the carrying value of the non-amortizable trade name to $39.2 million. There were no subsequent impairments. The following table reflects the impairment charges recorded during the year ended December 31, 2011 (in millions): Year Ended December 31, 2011 Goodwill $ 243.2 Non-amortizable trade name 18.8 Total impairment of intangible assets and goodwill $ 262.0 Interest Expense The following table reflects a summary of interest expense recorded during the years ended December 31, 2013, 2012 and 2011, respectively (in millions): Year Ended Year Ended Year Ended December 31, 2013 December 31, 2012 December 31, 2011 New Credit Agreement Loans $ 44.1 $ - $ - Notes 23.0 - - Old Credit Agreement Loans 7.7 66.6 63.0 Pre-Petition Credit Facility - - 9.1 Amortization of debt issue costs 0.9 0.7 0.7 Amortization of debt discount 2.3 - - Other interest expense 0.7 0.3 0.3 Total interest expense $ 78.7 $ 67.6 $ 73.1 Interest expense increased $11.1 million (16%) in the year ended December 31, 2013 as compared to the year ended December 31, 2012. The increase in interest expense is primarily attributable to the increase in interest rates and amortization of the debt discount and debt issuance fees related to the New Credit Agreement Loans as a result of the Refinancing, partially offset by lower weighted average long-term debt outstanding during fiscal year 2013 as compared to fiscal year 2012. Interest on borrowings under the Old Credit Agreement Loans accrued at an annual rate equal to either LIBOR or the base rate, in each case plus an applicable margin. Generally, the Old Credit Agreement Loans accrued interest at 6.50%. During the year ended December 31, 2012, the Old Credit Agreement Loans had an outstanding weighted average balance of $987.3 million, taking into consideration $43.0 million of principal payments made on our Old Term Loan in 2012, of which $33.0 million exceeded the scheduled payments and was allocated to the final payment due at maturity. During the first half of the first quarter of 2013, the Old Credit Agreement Loans had an outstanding weighted average balance of $952.3 million, taking into consideration $10.5 million of prepayments made during that period. On February 14, 2013, in connection with the Refinancing, we repaid the entire outstanding balance of the Old Credit Agreement Loans, issued $300.0 million aggregate principal amount of the Notes and entered into the New Credit Agreement Loans, which include the $640.0 million New Term Loan outstanding and the $75.0 million New Revolving Facility. The Notes accrue interest at a rate of 8.75% per annum. Interest on borrowings under the New Credit Agreement Loans accrues at an annual rate equal to either LIBOR or the base rate, in each case plus an applicable margin. Generally, the New Term Loan accrued interest at 7.50% during 2013. Regularly scheduled amortization payments of $1.6 million were made on the New Term Loan at the end of the second, third and fourth quarters of 2013. In addition, the New Term Loan was issued at a $19.4 million discount, which is being amortized using the effective interest method. As of December 31, 2013, we were party to interest rate swap agreements; however, since the agreements are not effective until September 30, 2015, they will have no impact on interest expense in 2013 or 2014. Interest expense decreased $5.5 million (8%) in the year ended December 31, 2012 as compared to the year ended December 31, 2011. The decrease in 2012 interest expense is primarily attributable to the 24 days ended January 24, 2011, whereby we were subject to interest charges under the Pre-Petition Credit Facility. During the 24 days ended January 24, 2011, the Pre-Petition 44-------------------------------------------------------------------------------- Table of Contents Credit Facility had an outstanding balance of $2.0 billion with a weighted average interest rate of 6.94%. The Old Credit Agreement Loans during the same period of 2012 had an outstanding balance of $1.0 billion with a weighted average interest rate of 6.5%. As stated above, we paid down $43.0 million of principal payments on our Old Term Loan in 2012, of which $33.0 million exceeded the scheduled payments and was allocated to the final payment due at maturity. For further information regarding the New Credit Agreement Loans and the Notes, see "-Liquidity and Capital Resources-Debt" herein and note (8) "Long-term Debt" to our consolidated financial statements in "Item 8. Financial Statements and Supplementary Data" included elsewhere in this Annual Report. Loss on Debt Refinancing On February 14, 2013, we completed the Refinancing and paid all amounts outstanding under the Old Credit Agreement. In connection with this Refinancing, we incurred $5.6 million in related fees and wrote off $1.2 million of debt issue costs and other prepayments related to the Old Credit Agreement. Other Income Other income generally includes non-operating gains and losses such as those incurred on the sale or disposal of assets. During the years ended December 31, 2013, 2012 and 2011, we recognized other income, net of other expenses, of $4.9 million, $0.7 million and $1.7 million, respectively. The increase in fiscal 2013 compared to fiscal 2012 is due to a one-time settlement. Reorganization Items Reorganization items represent income or expense amounts that have been recognized as a direct result of the Chapter 11 Cases, prior to the Effective Date. For details of items within Reorganization items, see note (4) "Reorganization Under Chapter 11-Financial Reporting in Reorganization-Reorganization Items" to our consolidated financial statements in "Item 8. Financial Statement and Supplementary Data" included elsewhere in this Annual Report. Income Taxes The effective income tax rate for the years ended December 31, 2013, 2012 and 2011 was 46.6% benefit, 38.4% benefit and 56.9% expense, respectively. The effective tax rate for 2013 was primarily impacted by state taxes, as well as a decrease to the valuation allowance. The effective tax rate for 2012 was primarily impacted by state taxes, as well as a favorable provision to return permanent adjustments, partially offset by an increase to the valuation allowance for deferred tax assets. The effective tax rate for 2011 was primarily impacted by the impairment charge to reduce our goodwill to zero and from certain non-taxable cancellation of indebtedness income resulting from our emergence from Chapter 11 bankruptcy protection. For 2014, our annualized effective income tax benefit rate is expected to range from 39% to 41%, excluding one-time discrete items. Changes in the relative profitability of our business, as well as recent and proposed changes to federal and state tax laws, may cause the rate to change from historical rates. See note (12) "Income Taxes" to our consolidated financial statements in "Item 8. Financial Statements and Supplementary Data" included elsewhere in this Annual Report for further discussion on income taxes. Gain on Sale of Discontinued Operations, Net of Tax On January 31, 2013, we completed the sale of our capital stock in our Idaho-based operations to Blackfoot Telecommunications Group for $30.5 million in cash. The operating results of these Idaho-based operations are immaterial and, accordingly, have not been segregated as discontinued operations for reporting purposes. A gain, before $6.7 million of income taxes, of $16.7 million was recorded upon the closing of the transaction, which is reported within discontinued operations in the consolidated statement of operations for the year ended December 31, 2013. For details of our Idaho-based operations' operating results, see note (19) "Assets Held for Sale and Discontinued Operations" to our consolidated financial statements in "Item 8. Financial Statements and Supplementary Data" included elsewhere in this Annual Report. Non-GAAP Financial Measures We report our financial results in accordance with accounting principles generally accepted in the United States ("U.S. GAAP" or "GAAP"). The table below includes certain non-GAAP financial measures and the adjustments to the most directly comparable U.S. GAAP measure used to determine the non-GAAP measures. Management believes that the non-GAAP measures, 45-------------------------------------------------------------------------------- Table of Contents which also exclude the effect of special items, may be useful to investors in understanding period-to-period operating performance and in identifying historical and prospective trends that may not otherwise be apparent when relying solely on U.S. GAAP financial measures. In addition, the non-GAAP measure is useful for investors because it enables them to view performance in a manner similar to the method used by the Company's management. Adjusted earnings before interest, taxes, depreciation and amortization ("EBITDA") also removes variability related to pension and post-retirement healthcare expenses. The maintenance covenants contained in the Company's credit facility are based on Consolidated EBITDA, which is consistent with the calculation of Adjusted EBITDA below. However, the non-GAAP financial measures, as used herein, are not necessarily comparable to similarly titled measures of other companies. Furthermore, Adjusted EBITDA has limitations as an analytical tool and should not be considered in isolation from, or as an alternative to, net income or loss, operating income, cash flow or other combined income or cash flow data prepared in accordance with U.S. GAAP. Because of these limitations, Adjusted EBITDA and related ratios should not be considered as measures of discretionary cash available to invest in business growth or reduce indebtedness. The Company compensates for these limitations by relying primarily on its U.S. GAAP results and using Adjusted EBITDA only supplementally. A reconciliation of Adjusted EBITDA to net (loss) income is provided in the table below (in thousands): Year Ended December Year Ended December Year Ended December 31, 2013 31, 2012 31, 2011 Net (loss) income $ (93,450 ) $ (153,294 ) $ 171,962 Income tax expense (benefit) (90,291 ) (95,560 ) 226,613 Interest expense 78,675 67,610 73,128 Depreciation and amortization 282,438 376,614 358,406 Pension expense (1a) 26,221 17,809 12,185 Post-retirement healthcare expense (1a) 54,469 50,875 39,601 Compensated absences (1b) 431 329 (462 ) Severance 8,150 6,380 8,006 Reorganization costs (1c) 207 1,335 21,053 Storm expenses (1d) 2,598 3,000 4,040 Other non-cash items (1e) 1,902 3,518 (651,943 ) Gain on sale of discontinued operations (10,757 ) - - Loss on debt refinancing 6,787 - - All other allowed adjustments, net (1f) (2,350 ) (675 ) (1,055 ) Adjusted EBITDA $ 265,030 $ 277,941 $ 261,534 (1) For purposes of calculating Adjusted EBITDA (in accordance with the definition of Consolidated EBITDA in the Company's credit agreement), the Company adjusts net (loss) income for interest, income taxes, depreciation and amortization, in addition to: a) the add-back of aggregate pension and post-retirement healthcare expense, b) the add-back (or subtraction) of the adjustment to the compensated absences accrual to eliminate the impact of changes in the accrual, c) the add-back of costs related to the reorganization, including professional fees for advisors and consultants. See note (4) "Reorganization Under Chapter 11-Financial Reporting in Reorganization-Reorganization Items" to our consolidated financial statements in "Item 8. Financial Statement and Supplementary Data" included elsewhere in this Annual Report, d) the add-back of costs and expenses, including those imposed by regulatory authorities, with respect to casualty events, acts of God or force majeure to the extent they are not reimbursed from proceeds of insurance, e) the add-back of other non-cash items, except to the extent they will require a cash payment in a future period, including impairment charges, and f) the add-back (or subtraction) of other items, including facility and office closures, labor negotiation expenses, non-cash gains/losses, non-operating dividend and interest income and other extraordinary gains/losses. 46-------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources Overview Our current and future liquidity is greatly dependent upon our operating results. We expect that our primary sources of liquidity will be cash flow from operations, cash on hand and funds available under the New Revolving Facility. Our short-term and long-term liquidity needs arise primarily from: (i) interest and principal payments on our indebtedness; (ii) capital expenditures; (iii) working capital requirements as may be needed to support and grow our business; and (iv) contributions to our qualified pension plan and payments under our post-retirement healthcare plans. Based on our current and anticipated levels of operations and conditions in our markets, we believe that cash on hand (including amounts available under the New Revolving Facility) as well as cash flow from operations will enable us to meet our working capital, capital expenditure, debt service and other funding requirements for at least the next 12 months. We were in compliance with the maintenance covenants contained in the Old Credit Agreement through the Refinancing Closing Date and the maintenance covenants contained in the New Credit Agreement through the end of 2013. We expect to be in compliance with the maintenance covenants contained in the New Credit Agreement for 2014. Cash Flows Cash and cash equivalents at December 31, 2013 totaled $42.7 million, compared to $23.2 million at December 31, 2012, excluding restricted cash of $1.2 million and $7.5 million, respectively. During fiscal 2013, cash inflows were largely associated with $30.5 million of proceeds from the sale of our Idaho-based operations and cash flows from operations of $171.1 million, a majority of which was offset by the Refinancing and $128.3 million of capital expenditures. The following table sets forth our consolidated cash flow results reflected in our consolidated statements of cash flows (in millions): Predecessor Combined Company Three Hundred Forty-One Twenty-Four Year Ended Year Ended Year Ended Days Ended Days Ended Net cash flows provided by December 31, December 31, December 31, December 31, January 24, (used in): 2013 2012 2011 2011 2011 Operating activities $ 171.1 $ 192.8 $ 89.0 $ 170.1 $ (81.1 ) Investing activities (96.0 ) (144.3 ) (175.3 ) (162.9 ) (12.5 ) Financing activities (55.6 ) (42.6 ) (1.8 ) (0.2 ) (1.7 ) Net increase (decrease) in cash $ 19.5 $ 5.9 $ (88.1 ) $ 7.1 $ (95.2 ) Operating activities. Net cash provided by operating activities is our primary source of funds. Net cash provided by operating activities for fiscal 2013 decreased by $21.7 million compared to fiscal 2012, primarily because reduced revenue and related collections were not sufficiently offset by lower expenses. Net cash provided by operating activities for 2012 includes payment of $8.8 million in claims of the Predecessor Company, of which $3.8 million of these claims were paid using funds of the Cash Claims Reserve (as defined herein) established on January 24, 2011. Accordingly, $5.0 million of cash on hand was used to pay claims of the Predecessor Company during 2012. During 2013, only $0.2 million of cash on hand was used to pay claims. During 2013 and 2012, $0.6 million and $10.8 million of the Cash Claims Reserve was reclaimed by the Company as a source of cash on hand, respectively. Net cash provided by operating activities for fiscal 2012 increased $103.8 million compared to fiscal 2011. The increase is primarily driven by the establishment of an $82.8 million reserve for payment of outstanding bankruptcy claims (the "Cash Claims Reserve") on the Effective Date. Net cash provided by operating activities for the year ended December 31, 2012 and the 341 days ended December 31, 2011 represent the operating activities after the Effective Date; however, they include payment of $8.8 million and $66.7 million, respectively, in claims of the Predecessor Company, of which $3.8 million and $59.9 million, respectively, of these claims were paid using funds of the Cash Claims Reserve established on the Effective Date. Accordingly, $5.0 million and $6.8 million of cash on hand was used to pay claims of the Predecessor Company during the year ended December 31, 2012 and the 341 days ended December 31, 2011, respectively. 47-------------------------------------------------------------------------------- Table of Contents Investing activities. Net cash used in investing activities for fiscal 2013 decreased $48.3 million compared to fiscal 2012 primarily driven by the sale of our Idaho-based operations during fiscal 2013 for $30.5 million in cash proceeds and a decrease in capital expenditures. Capital expenditures were $128.3 million, $145.1 million and $163.6 million for the years ended December 31, 2013, 2012 and 2011, respectively. Financing activities. Net cash used in financing activities in fiscal 2013 increased $13.0 million compared to fiscal 2012 primarily attributable to the Refinancing, whereby we issued $300.0 million aggregate principal amount of the Notes, entered into the New Credit Agreement including the $640.0 million New Term Loan and used the proceeds, along with cash on hand, to repay principal of $946.5 million outstanding on the Old Term Loan and approximately $32.6 million of fees, expenses and other costs related to the Refinancing. For further information regarding the New Credit Agreement, the Notes and our repayment of the Old Credit Agreement Loan, see "-Debt" herein and note (8) "Long-Term Debt" to our consolidated financial statements in "Item 8. Financial Statements and Supplementary Data" included elsewhere in this Annual Report. Net cash used in financing activities in fiscal 2012 increased $40.8 million compared to fiscal 2011 largely due to the $43.0 million of principal payments on the Old Term Loan, of which $33.0 million exceeded the scheduled payments and was allocated to the final payment due at maturity. Pension Contributions and Post-Retirement Healthcare Plan Expenditures During the year ended December 31, 2013, we contributed $21.8 million to our Company sponsored qualified defined benefit pension plans and funded benefit payments of $3.7 million under our post-retirement healthcare plans. Contributions to our qualified defined benefit pension plans in 2013 met the minimum funding requirements under the Pension Protection Act of 2006. Legislation enacted in 2012 changed the method for determining the discount rate used for calculating a qualified pension plan's unfunded liability for ERISA and Code purposes. This legislation included a pension funding stabilization provision which allowed pension plan sponsors to use higher interest rate assumptions when determining funded status and funding obligations. As a result, our near-term minimum required pension plan contributions have been lower than they would have been in the absence of this stabilization provision. On September 25, 2012, we elected to defer use of the higher segment rates under this legislation until the plan year beginning on January 1, 2013 solely for purposes of determining the adjusted funding target attainment percentage ("AFTAP") used to determine benefit restrictions under Section 436 of the Code. In 2014, aggregate cash pension contributions and cash post-retirement healthcare payments are expected to be approximately $35.0 million. Capital Expenditures We require significant capital expenditures to maintain, upgrade and enhance our network facilities and operations. In 2013, our net capital expenditures totaled $128.3 million, compared to $145.1 million in 2012. We anticipate that we will fund future capital expenditures through cash flows from operations and cash on hand (including amounts available under the New Revolving Facility). In 2014, capital expenditures are expected to be approximately $125.0 million. Debt The New Credit Agreement. In connection with the Refinancing, we entered into the New Credit Agreement, which provides for the $75.0 million New Revolving Facility, including a sub-facility for the issuance of up to $40.0 million in letters of credit, and the $640.0 million New Term Loan. The New Credit Agreement Loans replace the Old Credit Agreement Loans, which were terminated on the Refinancing Closing Date. The principal amount of the New Term Loan and commitments under the New Revolving Facility may be increased by an aggregate amount up to $200.0 million, subject to certain terms and conditions specified in the New Credit Agreement. The New Term Loan will mature on February 14, 2019 and the New Revolving Facility will mature on February 14, 2018, subject in each case to extensions pursuant to the terms of the New Credit Agreement. As of December 31, 2013, the Company had $59.1 million, net of $15.9 million of outstanding letters of credit, available for borrowing under the New Revolving Facility. Interest Rates and Fees. Interest on borrowings under the New Credit Agreement Loans accrue at an annual rate equal to either LIBOR or the base rate, in each case plus an applicable margin. LIBOR is the per annum rate for an interest period of one, two, three or six months (at our election), with a minimum LIBOR floor of 1.25% for the New Term Loan. The base rate for any date is the per annum rate equal to the greatest of (x) the federal funds effective rate plus 0.50%, (y) the rate of interest publicly quoted from time to time by The Wall Street Journal as the United States ''Prime Rate'' and (z) LIBOR with an interest period of one month plus 1.00%. The applicable margin for the New Term Loan is (a) 6.25% per annum with respect to term loans bearing interest based on LIBOR or (b) 5.25% per annum with respect to term loans bearing interest based on the base rate. The applicable rate for the New Revolving Facility is, initially, (a) 5.50% with respect to revolving loans bearing interest based on LIBOR or (b) 48-------------------------------------------------------------------------------- Table of Contents 4.50% per annum with respect to revolving loans bearing interest based on the base rate, in each case subject to adjustment based on our consolidated total leverage ratio, as defined in the New Credit Agreement. We are required to pay a quarterly letter of credit fee on the average daily amount available to be drawn under letters of credit issued under the New Revolving Facility equal to the applicable rate for revolving loans bearing interest based on LIBOR plus a fronting fee of 0.125% per annum on the average daily amount available to be drawn under such letters of credit. In addition, we are required to pay a quarterly commitment fee on the average daily unused portion of the New Revolving Facility, which is 0.50% initially, subject to reduction to 0.375% based on our consolidated total leverage ratio. In the third quarter of 2013, we entered into interest rate swap agreements with a combined notional amount of $170.0 million with three counterparties that are effective for a two year period beginning on September 30, 2015 and maturing on September 30, 2017. Each respective swap agreement requires us to pay a fixed rate of 2.665% and provides that we will receive a variable rate based on the three month LIBOR rate, subject to a minimum LIBOR floor of 1.25%. Amounts payable by or due to us will be net settled with the respective counterparties on the last business day of each fiscal quarter, commencing December 31, 2015. For further information regarding these agreements, see note (9) "Interest Rate Swap Agreements" to our consolidated financial statements in "Item 8. Financial Statements and Supplementary Data" included elsewhere in this Annual Report. Security/Guarantors. All obligations under the New Credit Agreement, together with certain designated hedging obligations and cash management obligations, are unconditionally guaranteed on a senior secured basis by each of the Subsidiary Guarantors and secured by a first-priority lien on substantially all personal property of FairPoint Communications and the Subsidiary Guarantors, subject to certain exclusions set forth in the related security documents, pari passu with the lien securing the obligations under the Notes. Mandatory Repayments. Commencing in the second quarter of 2013, we are required to make quarterly repayments of the New Term Loan in a principal amount equal to $1.6 million during the term of the New Credit Agreement, with such repayments being reduced based on the application of mandatory and optional prepayments of the New Term Loan made from time to time. In addition, mandatory repayments are due under the New Credit Agreement with (i) a percentage, initially equal to 50% and subject to reduction to 25% in subsequent fiscal years based on our consolidated total leverage ratio, of our excess cash flow, as defined in the New Credit Agreement, beginning with the fiscal year ending December 31, 2013, (ii) the net cash proceeds of certain asset dispositions, insurance proceeds and condemnation awards and (iii) issuances of debt not permitted to be incurred under the New Credit Agreement. Optional prepayments and mandatory prepayments resulting from the incurrence of debt not permitted to be incurred under the New Credit Agreement are required to be made at (i) 103.0% of the aggregate principal amount prepaid if such prepayment is made on or prior to February 14, 2014, (ii) 102.0% of the aggregate principal amount of the New Term Loan so prepaid if such prepayment is made after February 14, 2014, but on or prior to February 14, 2015 and (iii) 101.0% of the aggregate principal amount prepaid if such prepayment is made after February 14, 2015 and on or prior to February 14, 2016. No premium is required to be paid for prepayments made after February 14, 2016. We did not make any optional or mandatory prepayments under the New Credit Agreement, excluding mandatory quarterly repayments discussed above, during the year ended December 31, 2013. In addition, we will not be required to make an excess cash flow payment for fiscal year 2013. Covenants. The New Credit Agreement contains customary representations and warranties and affirmative and negative covenants for a transaction of this type, including two financial maintenance covenants: (i) a consolidated interest coverage ratio and (ii) a consolidated total leverage ratio. The New Credit Agreement also contains a covenant limiting the maximum amount of capital expenditures that we and our subsidiaries may make in any fiscal year. Events of Default. The New Credit Agreement also contains customary events of default for a transaction of this type. The Notes. On the Refinancing Closing Date, we issued $300.0 million in aggregate principal amount of the Notes pursuant to the Indenture in a private offering exempt from registration under the Securities Act. The terms of the Notes are governed by the Indenture. The Notes are senior secured obligations of FairPoint Communications and are guaranteed by the Subsidiary Guarantors. The Notes and the guarantees thereof are secured by a first-priority lien on substantially all personal property of FairPoint Communications and the Subsidiary Guarantors, subject to certain exclusions set forth in the related security documents, pari passu with the lien securing the obligations under the New Credit Agreement. The Notes will mature on August 15, 2019 and accrue interest at a rate of 8.75% per annum, which is payable semi-annually in arrears on February 15 and August 15 of each year. On or after February 15, 2016, we may redeem all or part of the Notes at the redemption prices set forth in the Indenture, plus accrued and unpaid interest thereon, to the applicable redemption date. At any time prior to February 15, 2016, we may redeem all or part of the Notes at a redemption price equal to 100% of the principal amount of the Notes redeemed, plus a "make-whole" premium as of, and accrued and unpaid interest to, the applicable redemption date. In addition, at any time prior to February 15, 2016, we may, on one or more occasions, redeem up to 35% of the original aggregate principal amount of the Notes, using net cash proceeds of certain qualified equity offerings, at a redemption price of 108.75% of the principal amount of Notes redeemed, plus accrued and unpaid interest to the applicable redemption date. 49-------------------------------------------------------------------------------- Table of Contents The holders of the Notes have the ability to require us to repurchase all or any part of the Notes if we experience certain kinds of changes in control or engage in certain asset sales, in each case at the repurchase prices and subject to the terms and conditions set forth in the Indenture. The Indenture contains certain covenants which are customary with respect to non-investment grade debt securities, including limitations on our ability to incur additional indebtedness, pay dividends on or make other distributions or repurchase our capital stock, make certain investments, enter into certain types of transactions with affiliates, create liens and sell certain assets or merge with or into other companies. These covenants are subject to a number of important limitations and exceptions. The Indenture also provides for customary events of default, including cross defaults to other specified debt of FairPoint Communications and certain of its subsidiaries. The Old Credit Agreement. On January 24, 2011, the Old Credit Agreement Borrowers entered into the Old Credit Agreement. The Old Credit Agreement was comprised of the Old Revolving Facility, which had a sub-facility providing for the issuance of up to $30.0 million of letters of credit, and the Old Term Loan. The entire outstanding principal amount of the Old Credit Agreement Loans was due and payable five years after January 24, 2011, subject to certain conditions. On February 14, 2013, we entered into the New Credit Agreement and repaid all outstanding amounts under the Old Credit Agreement, which was subsequently terminated. In addition, the following agreements relating to the Old Credit Agreement Loans were terminated on the Refinancing Closing Date: (i) the Security Agreement, dated as of January 24, 2011, among FairPoint Communications, the subsidiaries of FairPoint Communications party thereto and Bank of America, N.A., as administrative agent, (ii) the Pledge Agreement, dated as of January 24, 2011, made by FairPoint Communications and the subsidiaries of FairPoint Communications party thereto in favor of Bank of America, N.A., as administrative agent, and (iii) the Continuing Guaranty, dated as of January 24, 2011, made by the subsidiaries of FairPoint Communications party thereto in favor of Bank of America, N.A., as administrative agent. Merger Orders. As a condition to the approval of the Merger and related transactions by state regulatory authorities we agreed to make certain capital expenditures following the completion of the Merger, which were modified by regulatory settlements agreed to with representatives for each of Maine, New Hampshire and Vermont and approved by the applicable regulatory authorities in Maine, New Hampshire and Vermont and approved by the Bankruptcy Court as part of the Plan. For further information on these capital expenditure requirements, see "Item 1. Business-Regulatory Environment-State Regulation-Regulatory Conditions to the Merger, as Modified in Connection with the Plan" included elsewhere in this Annual Report. Off-Balance Sheet Arrangements As of December 31, 2013, we had approximately $15.9 million outstanding letters of credit under the New Revolving Facility and $1.7 million of surety bonds. As of December 31, 2012, we had approximately $12.0 million in outstanding standby letters of credit under the Old Revolving Facility and $1.8 million of surety bonds. We do not have any other off-balance sheet arrangements other than our operating lease obligations, which are not reflected on our balance sheet. See "-Summary of Contractual Obligations" for further detail. Summary of Contractual Obligations The table set forth below contains information with regard to disclosures about contractual obligations and commercial commitments. The following table discloses aggregate information about our contractual obligations as of December 31, 2013 and the periods in which payments are due (in thousands): Payments due by period Less More than 1-3 3-5 than Contractual Obligations Total 1 year years years 5 years Long-term debt obligations, including current maturities (a) $ 935,200 $ 6,400 $ 12,800 $ 12,800 $ 903,200 Interest payments on long-term debt obligations (b) 401,229 76,165 154,519 148,484 22,061 Capital lease obligations, including current maturities 2,170 1,625 369 176 - Operating lease obligations 26,616 9,144 11,348 5,514 610 Other long-term liabilities (c) 849,911 37,029 66,905 61,291 684,686 Total contractual obligations $ 2,215,126 $ 130,363 $ 245,941 $ 228,265 $ 1,610,557 50-------------------------------------------------------------------------------- Table of Contents (a) Long-term debt obligations exclude outstanding letters of credit totaling $15.9 million under the New Revolving Facility at December 31, 2013. For more information, see note (8) "Long-term Debt" to our consolidated financial statements in "Item 8. Financial Statements and Supplementary Data" included elsewhere in this Annual Report. (b) Interest payments represent cash payments on the long-term debt, including payments associated with interest rate swaps, while excluding amortization of capitalized debt issuance costs. (c) Other long-term liabilities primarily include our qualified pension and post-retirement healthcare obligations, and deferred tax liabilities. For more information, see notes (11) "Employee Benefit Plans" and (12) "Income Taxes" to our consolidated financial statements in "Item 8. Financial Statements and Supplementary Data" included elsewhere in this Annual Report. In addition, (i) The balance excludes $3.8 million of reserves for uncertain tax positions, including interest and penalties, that were included in deferred tax liabilities at December 31, 2013 for which we are unable to make a reasonably reliable estimate as to when cash settlements with taxing authorities will occur; (ii) The balance excludes $2.1 million of non-cash unfavorable union contracts, which were recorded upon the adoption of fresh start accounting and are included in other long-term liabilities at December 31, 2013. For further information, see note (2) "Significant Accounting Policies-(o) Other Liabilities" to our consolidated financial statements in "Item 8. Financial Statements and Supplementary Data" included elsewhere in this Annual Report; (iii) The balance includes the current portion of our post-retirement healthcare obligations of $5.7 million presented in the current portion of other accrued liabilities at December 31, 2013; and (iv) Our 2014 pension contribution is expected to be $30.0 million, which includes our minimum required contribution and an additional discretionary contribution, and has been reflected as due in less than one year. Our actual contribution could differ from thisestimation. Due to uncertainties in the pension funding calculation, the amount and timing of any other pension contributions are unknown and therefore the remaining accrued pension obligation has been reflected as due in more than 5 years. Critical Accounting Policies and Estimates As disclosed in note (2) "Significant Accounting Policies" to our consolidated financial statements in "Item 8. Financial Statements and Supplementary Data" included elsewhere in this Annual Report, the preparation of our financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions about future events that affect the amounts reported in our consolidated financial statements and accompanying notes. Actual results could differ significantly from those estimates. We believe that the following discussion addresses our most critical accounting policies, which are those that are most important to the portrayal of our financial condition and results of operations and require management's most difficult, subjective and complex judgments. Our critical accounting policies as of December 31, 2013 are as follows: • Revenue recognition; • Allowance for doubtful accounts; • Accounting for qualified pension and other post-retirement healthcare benefits; • Accounting for income taxes; • Depreciation of property, plant and equipment; • Stock-based compensation; and • Valuation of long-lived assets and indefinite-lived intangible assets. Revenue Recognition. We recognize service revenues based upon usage of our local exchange network and facilities and contract fees. Fixed fees for voice services, Internet services and certain other services are recognized in the month the service is provided. Revenue from other services that are not fixed fee or that exceed contracted amounts is recognized when those services are provided. Non-recurring customer activation fees, along with the related costs up to, but not exceeding, the activation fees, are deferred and amortized over the customer relationship period. SQI penalties and certain PAP penalties are recorded as a reduction to revenue. We recognize certain revenues pursuant to various cost recovery programs from state and federal USF, CAF/ICC and from revenue sharing agreements with other LECs administered by the National Exchange Carrier Association ("NECA"). Revenues are calculated based on our investment in our network and other network operations and support costs. We have historically collected revenues recognized through this program; however, adjustments to estimated revenues in future periods are possible. These adjustments could be necessitated by adverse regulatory developments with respect to these subsidies and revenue sharing 51-------------------------------------------------------------------------------- Table of Contents arrangements, changes in the allowable rates of return, the determination of recoverable costs and/or decreases in the availability of funds in the programs due to increased participation by other carriers. We make estimated adjustments, as necessary, to revenue and accounts receivable for billing errors, including certain disputed amounts. If circumstances related to these adjustments change or our knowledge evolves, our estimate of the recoverability of our accounts receivable could be further reduced from the levels provided in our consolidated financial statements. Allowance for Doubtful Accounts. In evaluating the collectability of our accounts receivable, we assess a number of factors, including a specific customer's or carrier's ability to meet its financial obligations to us, the length of time the receivable has been past due and historical collection experience. Based on these assessments, we record both specific and general reserves for uncollectible accounts receivable to reduce the related accounts receivable to the amount we ultimately expect to collect from customers and carriers. If circumstances change or economic conditions worsen such that our past collection experience is no longer relevant, our estimate of the recoverability of our accounts receivable could be further reduced from the levels reflected in our accompanying consolidated balance sheet. On the Effective Date, the accounts receivable balances were valued at fair value using the net realizable value approach. The net realizable value approach was determined by reducing the gross receivable balance by our allowance for doubtful accounts. Due to the relatively short collection period, the net realizable value approach was determined to result in a reasonable indication of fair value of the assets. Accounting for Pension and Other Post-retirement Healthcare Benefits. Certain of our employees participate in our qualified pension plans and other post-retirement healthcare plans. In the aggregate, the projected benefit obligations of the qualified pension plans exceed the fair value of their respective assets and the post-retirement healthcare plans do not have plan assets, resulting in expense. Significant qualified pension and other post-retirement healthcare plan assumptions, including the discount rate used, the long-term rate-of-return on plan assets, and medical cost trend rates are periodically updated and impact the amount of benefit plan income, expense, assets and obligations reflected in our consolidated financial statements. The actuarial assumptions we used in determining our qualified pension and post-retirement healthcare plans obligations may differ materially from actual results due to changing market and economic conditions, higher or lower withdrawal rates or longer or shorter life spans of participants. While we believe that the assumptions used are appropriate, differences in actual experience or changes in assumptions might materially affect our financial position or results of operations. Our qualified pension and post-retirement liabilities are highly sensitive to changes in the discount rate. We currently estimate that a movement of 1% in the discount rate would change our December 31, 2013 qualified pension plan benefit obligations by approximately 18%. We currently estimate that a 1% fluctuation in the discount rate would change our December 31, 2013 post-retirement healthcare benefit obligations by approximately 21%. The post-retirement healthcare benefit obligations are also highly sensitive to the medical trend rate assumption. A 1% increase in the medical trend rate assumed for post-retirement healthcare benefits at December 31, 2013 would result in an increase in the post-retirement healthcare benefit obligations of approximately $139.3 million and a 1% decrease in the medical trend rate assumed at December 31, 2013 would result in a decrease in the post-retirement healthcare benefit obligations of approximately $106.6 million. For additional information on our qualified pension and post-retirement healthcare plans, see note (11) "Employee Benefit Plans" to our consolidated financial statements in "Item 8. Financial Statements and Supplementary Data" included elsewhere in this Annual Report. Accounting for Income Taxes. Our current and deferred income taxes are affected by events and transactions arising in the normal course of business, as well as in connection with the adoption of new accounting standards and non-recurring items. Assessment of the appropriate amount and classification of income taxes is dependent on several factors, including estimates of the timing and realization of deferred income tax assets and the timing of income tax payments. Actual payments may differ from these estimates as a result of changes in tax laws, as well as unanticipated future transactions affecting related income tax balances. We account for uncertain tax positions taken or expected to be taken in our tax returns utilizing a two step approach. The first step is a recognition process in which we determine whether it is more-likely-than-not that a tax position will be sustained upon examination based on the technical merits of the position. The second step is a measurement process in which a tax position that meets the more-likely-than-not recognition threshold is measured to determine the amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement. For additional information on income taxes, see note (12) "Income Taxes" to our consolidated financial statements in "Item 8. Financial Statements and Supplementary Data" included elsewhere in this Annual Report. Depreciation of Property, Plant and Equipment. We recognize depreciation on property, plant and equipment principally on the composite group remaining life method and straight-line composite rates. This method provides for the recognition of the cost of the remaining net investment in telephone plant, less anticipated net salvage value (if any), over the remaining asset lives. 52-------------------------------------------------------------------------------- Table of Contents When an asset is retired, the original cost, net of salvage value, is charged against accumulated depreciation and no immediate gain or loss is recognized on the disposition of the asset. Under this method, we review depreciable lives periodically and may revise depreciation rates when appropriate. The Company utilizes straight-line depreciation for its non-telephone property, plant and equipment. Periodically, the Company reviews the estimated remaining useful lives of its group asset categories to address continuing changes in technology, competition and the Company's overall reduction in capital spending and increased focus on more efficient utilization of its existing assets. In the third quarter of 2013, the Company conducted this review and determined that changes to the estimated remaining useful lives for certain asset categories were appropriate. Accordingly, as a result of the changes to the remaining useful lives, depreciation expense in 2013 was approximately $37.0 million less than it would have been absent the changes, resulting in a reduction in net loss of approximately $39.0 million, or a benefit of $1.49 per share. This change in non-cash expense had no impact on our compliance with the covenants contained in the New Credit Agreement. Stock-based Compensation. Compensation expense for share-based awards made to employees and directors are recognized based on the estimated fair value of each award over the award's vesting period. We estimate the fair value of share-based payment awards on the date of grant using either an option-pricing model for stock options or the closing market value of our stock for restricted stock and expense the value of the portion of the award that is ultimately expected to vest over the requisite service period in the statement of operations. We utilize the Black-Scholes option pricing model to calculate the fair value of our stock option grants. The key assumptions used in the Black-Scholes option pricing model are the expected life of the stock option, the expected dividend rate, the risk-free interest rate and expected volatility. The expected life of the stock options granted represents the period of time that the options are expected to be outstanding. The risk-free interest rates are based on United States Treasury yields in effect at the date of grant consistent with the expected exercise timeframes. The expected volatility reflects the historical volatility for a duration consistent with the contractual life of the options. Our assumptions of these key inputs, in addition to our assumption made about the portion of the awards that will ultimately vest, requires subjective judgment. For additional information on share-based awards, including key assumptions used in calculating the grant date fair values, see note (16) "Stock-Based Compensation" to our consolidated financial statements in "Item 8. Financial Statements and Supplementary Data" included elsewhere in this Annual Report. Valuation of Long-lived Assets and Indefinite-lived Intangible Assets. We review our long-lived assets, which include our amortizable intangible assets, for impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. In addition, we review non-amortizable intangible assets for impairment on at least an annual basis as of the first day of the fourth quarter of each year, or more frequently whenever indicators of impairment exist. Indicators of impairment could include, but are not limited to: • an inability to perform at levels that were forecasted; • a permanent decline in market capitalization; • implementation of restructuring plans; • changes in industry trends; and/or • unfavorable changes in our capital structure, cost of debt, interest rates or capital expenditures levels. No factors signaling a potential impairment were identified during the year ended December 31, 2013. Accordingly, no impairment review of our long-lived assets was required in 2013. Our only non-amortizable intangible asset is the FairPoint trade name. As previously discussed, no factors signaling a potential impairment were identified during the year ended December 31, 2013. As a result, no interim impairment review of our trade name was necessary. An annual impairment review was performed on October 1, 2013. We assess the fair value of our trade name utilizing the relief from royalty method. If the carrying amount of our trade name exceeds its estimated fair value, the asset is considered impaired. For this annual impairment review, we made certain assumptions including an estimated royalty rate, long-term growth rate, effective tax rate and discount rate and applied these assumptions to projected future cash flows, exclusive of cash flows associated with wholesale and others revenues not generated through brand recognition. Results of the assessment indicated that an impairment was not necessary; however, future changes in one or more of these assumptions could result in the recognition of an impairment loss. For additional information on our FairPoint trade name, including the impairment charges recorded in the year ended December 31, 2011 on goodwill and our trade name, see note (6) "Goodwill and Other Intangible Assets" to our consolidated financial statements in "Item 8. Financial Statements and Supplementary Data" included elsewhere in this Annual Report. 53-------------------------------------------------------------------------------- Table of Contents New Accounting Standards For details of recent Accounting Standards Updates and our evaluation of their adoption on our consolidated financial statements, see note (3) "Recent Accounting Pronouncements" to our consolidated financial statements in "Item 8. Financial Statements and Supplementary Data" included elsewhere in this Annual Report. Inflation There are cost of living adjustment clauses in certain of the collective bargaining agreements covering our labor union employees. Considerable fluctuations in cost of living due to inflation could result in an adverse effect on our operations. |