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ALASKA COMMUNICATIONS SYSTEMS GROUP INC - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis should be read in conjunction with the Consolidated Financial Statements and related notes and the other financial information included elsewhere in this Form 10-K. OVERVIEW We provide leading integrated communications services to consumer, business and wholesale customers in and out of Alaska. Our facilities based 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. 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 and price trends of bandwidth • the growth in demand for bandwidth • decline in demand for voice and other legacy services local customer preferences • unemployment levels • housing activity and development patterns 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. Two significant events were expected to impact this overall revenue stability. The first is Verizon's entry into the Alaska market, and the second, is declines in wireless CETC Revenue and other wireline high cost loop support revenue as a result of changes enacted by the FCC. Foreign roaming revenue, CETC Revenue and high cost loop support revenues represented approximately 23% and 26% of our total revenue in 2013 and 2012, respectively, and profit margins on these revenues streams are relatively high. As a result of these adverse events, management in 2012 implemented a business plan that focused on driving sustained growth in retail broadband revenue across multiple market segments: business, wholesale, and consumer; wireline and wireless. Previously, the Company had focused on select market segments, primarily wireless and enterprise, with the intent to maximize returns. These adverse external events necessitated a broader view of all market segments, and a move away from reliance on certain high cost support and roaming revenues. Management's assessment of the telecom market in Alaska indicated an estimated $1.0 billion market growing approximately five percent annually. To generate sustained growth in this market, our business plan requires investments in sales, service, marketing and product development and other initiatives, such as incorporating Lean methods to eliminate waste and simplify our business. In conjunction with the commencement of this long-term plan and these future adverse impacts, management and the Board of Directors recognized that the Company needed to reduce its outstanding debt to sustainable levels. Consequently, in the fourth quarter of 2012 our Board of Directors completely suspended the common stock cash dividend. This long-term plan is resulting in improved financial results. Broadband revenue growth has accelerated, the Company is adding customers across many different market segments, and the Company has reduced debt through cash and convertible buybacks totaling $125.0 million since January 1, 2012. 30-------------------------------------------------------------------------------- Table of Contents In addition to this plan, on July 22, 2013, the Company announced the closing of the AWN Transaction, allowing us to combine our wireless network with that of GCI. ACS is a one-third owner of AWN, while GCI owns the remaining two-thirds. GCI and ACS are leading wireless providers in Alaska, and in forming AWN, they both have each contributed their respective wireless assets, including spectrum licenses, cell sites, backhaul facility usage rights, and other assets necessary for AWN to operate an infrastructure company that designs, builds, and operates a statewide wireless network. AWN's network will cover more of Alaska's population than the network of any other wireless provider, and will provide the latest wireless services, including LTE, to its owners. GCI and ACS will independently sell these services to their respective retail customers and continue to operate as competitors in Alaska. Under the AWN structure, AWN will generate earnings based upon: • wholesale revenues it will receive from its two retail owners, which are impacted by the number of connections and the wholesale rates established by AWN for these connections, which are anticipated to be about 70% of our retail wireless revenues, • service charges to ACS and GCI for an amount equal to 100% of the CETC Revenues received by each respective company, • roaming revenues from other wireless carriers, and • revenues by selling backhaul to other wireless carriers (note that this does not preclude the Company from selling backhaul directly to other wireless carriers in competition with both GCI and AWN). AWN will incur all costs associated with operation of the wireless network, and will provide a mechanism to support its owners for their wireless equipment subsidies. AWN has no debt, other than a working capital revolver, and the governance of AWN is designed to maximize the agreed-upon financial objectives of its owners- to maximize its free cash flow ("FCF") and to distribute this FCF to its owners. As an owner, ACS will profit from AWN in three ways: • GCI paid ACS $100.0 million at closing, and we used $65.0 million of these proceeds to pay down our senior term loan facility. Of the remaining $35.0 million of liquidity, $4.1 million was used to unwind interest rate swaps, and $8.5 million to fund fees and expenses due at closing. • AWN will pay ACS a preferred distribution over the first four years, after formation, totaling up to $190.0 million, subject to criteria set forth in the Operating Agreement as outlined in Note 3 in our audited financial statements for the period ended December 31, 2013. • After four years, we will receive future distribution of FCF in proportion to our interest. ACS will continue to provide wireless services to its retail wireless customers and our margins on wireless services will now be based on the wholesale charges paid to AWN as well as any other direct costs we incur to support our retail wireless customers. Historical costs, such as roaming COGS and wireless equipment subsidies, are now primarily the responsibility of AWN. Our go forward wireless performance is now affected by our ability to operate within the margins we generate under the AWN structure. These margins, on average, are estimated to be 30% of our wireless retail revenue (margins being our retail revenue less the wholesale charges we pay AWN). These margins are intended to recover our fixed costs of operating our retail and indirect sales channels, our costs to support our customers including customer care, billing and collection, and other general and administrative costs. During the fourth quarter we began to implement actions to address how we operate within this operating margin, including reducing our employee levels in retail stores and our contact centers, and we expect further actions throughout 2014 to reduce our overall costs to provide wireless services. This retail services business is not anticipated to generate significant FCF for ACS, and our profits from wireless are intended to be generated through the AWN distribution. We believe that AWN's future financial performance, and the preferred distribution structure will result in a higher degree of certainty for our future FCF performance than we otherwise would have expected to generate as a standalone wireless operator, in particular with the entry of Verizon into our market. Finally, our business plan called for systematic expense management to ensure we operate efficiently and deliver the highest level of customer service. In 2013, the company formally adopted Lean as a framework to eliminate waste and simplify how we do business. We have established a team of process 31-------------------------------------------------------------------------------- Table of Contents improvement experts who have adopted LEAN and we are implementing LEAN, with a particular area of focus in 2014 being supply chain management and certain corporate functions. We expect that LEAN will empower our employees to eliminate waste which will improve our customer experience. We will spend less over time and this is expected to improve our profitability and improve service levels to our customers. 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 • Consumer • Other Services (including access services and high cost support) • Wireless • AWN Related Business and Wholesale Providing services to Business and Wholesale customers is our primary focus. Business services have experienced significant growth since January of 2012 and we believe the economics of businesses services are attractive. Given the demand from our customers for more bandwidth and services, we expect growth from these customers to continue for the foreseeable future. We provide communications services such as voice and broadband, and managed services including data network hosting, IT management, cloud-based services, billing and collection, and long distance services to these customers primarily over our own network. Our business customers include small and medium businesses, larger enterprises and government customers which include municipal, local, state and federal government entities, school districts, libraries and rural health care hospitals. Our acquisition of Tekmate, discussed in Item 7 Management's Discussion and Analysis of Financial Condition and Results of Operations under the heading Other initiatives, is an example of our strategy to provide increasing levels of managed services to business customers, such as monitoring and maintaining our customers information technology infrastructures. Our wholesale customers are other telecommunications carriers, including our primary competitor, GCI, who rely on us to provide connectivity for voice, long distance and broadband needs, to access their customers over all or portions of our network. The wholesale market is characterized as larger transactions that can create variability in our operating performance. Overall we expect wholesale revenue to grow modestly. Consumer We primarily provide voice and broadband services to residential customers. Given that our primary competitor has extensive triple play offerings (video, voice and broadband) we are selective in how we offer products and services to this customer segment, to maximize our returns. We expect revenue growth from these customers will be more modest than our revenue growth from business customers. In 2013 our primary focus was to offer higher bandwidth speeds to these customers, leveraging the capabilities of our existing network, a process which will continue into 2014. Our primary competitive advantage is we offer bandwidth without data caps, while our primary competitor charges customers for exceeding certain levels of data usage. Other Services Including Access Services and High Cost Support We provide voice and broadband termination services to inter and intrastate carriers who provide services to our retail customers. We are compensated for these services, primarily by charging terminating and originating per minute rates to these carriers. These revenue streams have been in decline and we expect them to continue to decline. 32-------------------------------------------------------------------------------- Table of Contents We also receive inter and intrastate high cost universal support funds and similar revenue streams structured by state and federal regulatory agencies that allow us to recover our costs of providing universal service in Alaska. These revenue streams have experienced some erosion in 2013 due to changes in funding qualification by the relevant regulatory authority. As further discussed under "Regulation," as a result of substantial changes enacted by the Federal Communications Commission ("FCC"), certain of these revenue streams, are undergoing significant reform and until this reform process is complete it is difficult to predict the positive or negative growth in these revenue streams in the future and the obligations we must inherit should we qualify for future funding. Wireless We provide wireless voice and broadband services, and other value-added wireless products and services, such as wireless devices, across Alaska with roaming coverage available in the contiguous states, Hawaii and Canada by utilizing the AWN network. Prior to the AWN structure, we provided these services utilizing our own wireless network. Under the AWN structure, we continue to provide these services to our retail wireless customers by utilizing the AWN network. We believe that the network owned by AWN has the most extensive statewide coverage of any wireless carrier and also has a significant Wi-Fi network in the urban corridors. The AWN spectrum licenses are the 800-900 MHz (for digital cellular voice and broadband services), 1800-1900 MHz (all digital PCS voice and broadband services) , 3650-3700 MHz and AWS 1710-1735 MHL (for 4G LTE cellular service) The ACS and GCI contributed spectrum have similar characteristics which combined cover virtually all of Alaska. While a unique structure, because we are a minority owner of AWN, our future performance in wireless is affected by the following factors related to AWN: • First, AWN's ability to integrate the ACS and GCI networks in a way that does not hinder the service experience for our customers. • Second, AWN's ability to offer wireless products and services, including handsets in a competitively neutral manner to GCI and ACS. • Third, AWN's ability to establish wholesale rates for wireless services that allow us to earn a reasonable profit for our provision of retail wireless services. Our performance in wireless is also impacted by the following market based events: • First, continued changes to the lifeline program (as discussed in our regulatory section under the headers Federal Universal Service Support, Lifeline Reform, Alaska Universal Service Fund and Other RCA proceedings), which has undergone substantial new rules which make it more difficult for us to maintain our wireless lifeline customer base (in 2012 and 2013 we lost approximately 9,500 lifeline customers due to these new rules). • Second, the timing and pace of Verizon's entry into the wireless retail market in Alaska. In 2013, Verizon turned up its wireless data network in the major urban markets of Alaska. The impact of this turn was deminimus because the AWN transaction mitigated the impact from lower roaming revenue as roaming is now earned by AWN. The Verizon market entry is expected to have the most material impact to us when Verizon enters the retail market and competes with us and the other wireless carriers in Alaska for subscribers. Although it is difficult to predict, we expect that in 2014 Verizon will open retail stores in the state and begin to provide retail wireless services. • Finally, our performance in wireless is affected by our ability to operate within the expected margins we generate under the AWN structure. These margins, on average, are estimated to be 30% of our wireless retail revenue. These margins are intended to recover our fixed costs of operating our retail and indirect sales channels, our costs to support our customers including customer care, billing and collection, and other general and administrative costs. During the fourth quarter we began to implement actions to address how we operate within this operating margin, including reducing our employee levels in retail stores and our contact centers, and we expect further actions throughout 2014 to reduce our overall costs to provide wireless services. 33 -------------------------------------------------------------------------------- Table of Contents AWN Related We report revenues that are related to our ownership position in AWN. Because our network provides access to the retail marketplace, and as a result of the cost of providing service to high cost areas, we generate CETC Revenues established by either state or federal regulatory agencies. As part of the AWN transaction we have agreed to pay a service charge to AWN for an amount equal to our CETC Revenue, and therefore CETC Revenue has no impact on our net income or EBITDA calculations. Prior to the formation of AWN, we also served as a roaming partner for many national wireless carriers, which resulted in us generating roaming revenue. Because AWN now operates the network, all roaming revenue is, and is expected to continue to be, generated by AWN. Prior to the formation of AWN, we also provided significant backhaul services to other wireless carriers. Backhaul services are broadband connections between a wireless carrier's cell site, their central office switch and connectivity to the Internet. Upon the closing of AWN, all backhaul contracts were transferred to AWN, which results in our loss of revenue. However, we are not excluded from providing backhaul services in the future, and will compete with AWN and GCI for these services and expect to grow these revenues going forward. Executive Summary The following summary should be read in conjunction with "Non-GAAP Financial Measures" included in this Managements' Discussion and Analysis of Financial Condition and Results of Operations. Operating Revenues Consolidated operating revenue of $348.9 million decreased $18.8 million, or 5.1%, in 2013. We believe consolidated revenue should be evaluated in three categories: i) Retail service revenue which is intended to represent recurring voice, broadband and other revenue generated from business, wholesale and consumer customers. Revenue of $141.3 million increased $4.0 million, or 2.9% in 2013. Growth in broadband revenue, caused by existing customers consuming more bandwidth and increasing our market share for broadband service was the primary factor for revenue growth in this category. ii) Other revenue, which primarily consists of access and high cost support revenue, decreased $5.6 million, or 8.8% to $57.9 million. Access revenue declined as a result of declining voice traffic with long distance carriers, and high cost support was impacted by lower revenue associated with changes to this funding program. Decline in other revenue was caused by lower equipment sales revenue, mainly due to a large contract with a federal customer in 2012 that did not reoccur. iii) Wireless and AWN related, which includes service and equipment sales revenue from our wireless customers, and roaming, and backhaul revenue which we transferred to AWN at closing, and CETC Revenue, which we continue to generate following the AWN close, but which we will pay a service charge to AWN for the amount of revenue we receive. Revenue of $149.7 million declined $17.2 million, or 10.3%. A decline in foreign roaming revenue of $15.1 million was the primary driver as this revenue moved to AWN. Lower retail wireless customer base also contributed to the decline. Adjusted EBITDA Adjusted EBITDA, as defined in "Non-GAAP Financial Measures" ("Adjusted EBITDA") of $106.5 million decreased $15.3 million from 2012 due largely to $18.8 million lower revenue, $18.6 million of higher operating expenses, offset by $22.0 million in preferred distributions from AWN. Higher operating expenses were due to $3.7 million increase in selling, general & administrative expense and an increase of $14.9 million in Cost of services and sales including the new wholesale charges from AWN. Operating Metrics Operating metrics are essential to understand the characteristics of our revenues and drivers of our key areas of growth or decline. Business broadband connections of 19,285 and average monthly revenue per user ("ARPU") of $175.34 at December 31, 2013, were up from connections of 18,718 and ARPU of 34-------------------------------------------------------------------------------- Table of Contents $152.09 in 2012. 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, therefore, is an important metric to indicate the increasing amounts of bandwidth that we provide to our customers, and it is expected to grow at a faster rate than connections. Wireless connections of 108,848 at December 31, 2013 decreased 5.4% from 115,017 at December 31, 2012. Postpaid wireless connections (including life-line) experienced the most significant decline and fell to 93,127 at December 31, 2013 from 100,910 at December 31, 2012. Weakness in postpaid is due to many factors, including dissatisfaction from our customers who are moving to the AWN network which, in particular markets, has weaker coverage characteristics from our legacy CDMA network, and customers moving to national carriers with better device availability and nationwide coverage. Partially offsetting this decline was growth in prepaid wireless connections which increased to 15,721 from 14,107 year over year. This growth in prepaid connections fell short of our expectations as we were delayed in moving to AWN's new prepaid platform to support LTE prepaid products, until the latter half of 2013. Consumer broadband connections of 38,677 at December 31, 2013 increased for the seventh consecutive quarter and were up 5.7% year over year. Consumer broadband ARPU also improved to $48.92 in 2013 compared with $42.46 in 2012 as the result of customers taking our higher bandwidth products. Prior to the AWN transaction, our wireless equipment subsidy was a significant part of our operating performance and represented $9.2 million for the twelve months ended December 31, 2013. Under AWN, we receive certain support payments on a per handset basis from AWN, which substantially reduces our overall cost of equipment. We expect the wireless equipment subsidy to not be a significant part of our operating performance in future years. 35-------------------------------------------------------------------------------- Table of Contents The table below provides connection levels, ARPU, churn and Wireless equipment subsidies as of, or for, the periods indicated: 2013 2012 Voice At December 31: Consumer access lines 49,297 55,823 Business access lines 79,816 80,852 For the year ended December 31: Voice ARPU consumer $ 26.71 $ 26.64 Voice ARPU business $ 23.78 $ 24.25 Broadband At December 31: Consumer connections 38,677 36,576 Business connections 19,285 18,718 For the year ended December 31: ARPU consumer $ 48.92 $ 42.46 ARPU business $ 175.34 $ 152.09 Wireless At December 31: Postpaid connections 85,982 91,804 Lifeline connections 7,145 9,106 Prepaid connections 15,721 14,107 Total 108,848 115,017 For the year ended December 31: Retail wireless ARPU $ 52.63 $ 52.16 Churn For the quarters ended December 31: Voice access lines 1.3 % 1.4 % Broadband connections 2.1 % 2.1 % Wireless connections 3.4 % 3.7 % Wireless equipment subsidy (in thousands): For the year ended December 31 $ 9,151 $ 14,391 Liquidity We generated $67.7 million of cash from operating activities in 2013 compared with $84.4 million in 2012. This cash flow along with the $100.0 million received as part of the AWN transactions was utilized for the repayment of debt of $99.6 million and total capital expenditures of $48.2 million. As of December 31, we had a $30.0 million undrawn revolving credit facility. Outstanding letters of credit commit $1.9 million of the available revolving credit facility at December 31, 2013. Other Initiatives A key focus in 2013 was to close the AWN Transaction and provide wireless services over the AWN network. Our other key area of focus was to work with the FCC to establish a stable and predictable funding mechanism for high cost funding. Additionally, we continued to advance our offerings of new products and services to our customers including increased bandwidth speeds, hosted VOIP products, and cloud based products such as Microsoft 365 and managed services. 36 -------------------------------------------------------------------------------- Table of Contents To further accelerate our offerings for managed services, in January 2014 we announced the acquisition of our remaining ownership position, or 51% in Tekmate. Tekmate is one of Alaska's leading IT services firm which provides services such as 24x7 network monitoring and support primarily for business customers. Tekmate generated over $9.1 million in revenue in 2013 and has 58 skilled employees. We look to combine the services of Tekmate with our own broadband services to move toward more managed service offerings with our customers. 37 -------------------------------------------------------------------------------- Table of Contents RESULTS OF OPERATIONS The following tables summarize our results of operations for the years ended December 31, 2013, 2012 and 2011. Net income for the year ended December 31, 2013 was affected by the gain on the AWN transaction of $207.3 million, $18.1 million in equity from affiliates and costs incurred for the AWN Transaction of $6.4 million all before tax. Net income for the year ended December 31, 2012 was affected by costs incurred for the AWN Transaction of $6.1 million before tax. Net income for the year ended December 31, 2011 was affected by $13.4 million in extinguishment of debt expenses before tax arising from the repurchase of $98.3 million principal amount of our 5.75% Notes utilizing proceeds from the sale of our 6.25% Notes. (in thousands) 2013 2012 2011 Service Revenue: Business and Wholesale Customers Voice $ 22,947 $ 23,842 $ 25,613 Broadband 40,027 33,972 30,658 Other 7,659 7,385 6,668 Wholesale 30,047 33,393 33,001 Business and Wholesale service revenue 100,680 98,592 95,940 Consumer Customers Voice 16,818 18,968 21,001 Broadband 22,108 18,398 17,011 Other 1,739 1,386 1,062 Consumer service revenue 40,665 38,752 39,074 Total Service Revenue 141,345 137,344 135,014 Growth in Service Revenue 2.9 % 1.7 % Growth in Broadband Service Revenue 18.6 % 9.9 % Other Revenue: Equipment Sales 2,083 3,021 1,458 Access 37,033 40,250 38,321 High Cost Support 18,776 20,223 21,103 Total Service and Other Revenue 199,237 200,838 195,896 Growth in Service and Other Revenue -0.8 % 2.5 % Growth excluding equipment sales -0.3 % 1.7 % Wireless Revenue: Business and Consumer retail service revenue 71,197 73,845 74,481 Equipment sales 4,847 6,015 5,665 Other 5,049 4,281 4,257 AWN Related: Foreign Roaming 40,029 55,105 38,934 Wireless Backhaul 6,035 6,897 3,210 CETC 21,018 20,733 26,871 Amortization of deferred AWN capacity revenue 1,512 - - Total AWN Related 68,594 82,735 69,015 Total Wireless Revenue 149,687 166,876 153,418 Total Revenue $ 348,924 $ 367,714 $ 349,314 38 -------------------------------------------------------------------------------- Table of Contents Operating expenses: Cost of services and sales, non-affiliates 138,124 148,125 135,732 Cost of services and sales, affiliates 25,158 275 - Selling, general and administrative 111,034 107,316 91,962 Depreciation and amortization 42,191 51,487 58,559 Gain on disposal of assets, net (204,200 ) (2,668 ) (565 ) Loss on impairment of equity investment 1,267 - - Earnings from equity method investments (18,056 ) (115 ) - Total operating expenses 95,518 304,420 285,688 Operating income 253,406 63,294 63,626 Other income and (expense): Interest expense (39,790 ) (39,570 ) (38,271 ) Loss on extinguishment of debt (2,370 ) (575 ) (13,445 ) Interest income 53 43 34 Other (13 ) - 174 Total other income and (expense) (42,120 ) (40,102 ) (51,508 ) Income before income tax expense 211,286 23,192 12,118 Income tax expense (54,905 ) (5,783 ) (11,646 ) Net income $ 156,381 $ 17,409 $ 472 Year Ended December 31, 2013 Compared to the Year Ended December 31, 2012 Operating Revenue Business and Wholesale Retail Service Revenue Business and Wholesale revenue of $100.7 million increased $2.1 million, or 2.1%, in 2013 from $98.6 million in 2012. This improvement was primarily driven by $6.1 million increase from new and existing customers buying or increasing their consumption of bandwidth using our advanced network services such as MPLS, dedicated Internet and Enhanced Metro Ethernet. Although broadband connections have grown modestly, growth of broadband ARPU drove overall revenue growth and reflects customer demand for increasing amounts of bandwidth. Broadband ARPU increased to $175.34 in 2013 from $152.09 in 2012, an increase of 15.3%. These increases were partially offset by a $0.9 million decrease in traditional voice revenue due to 1,036 fewer connections year-over-year and lower ARPU of $23.78 from $24.25 in the prior year due to price compression. We also benefited from a $1.5 million non-recurring transaction from a wholesale carrier in 2012 that impacted year over year performance. Consumer Retail Service Revenue Consumer revenue of $40.7 million increased $1.9 million, or 4.9%, in 2013 from $38.7 million in 2012. Broadband revenue increased $3.7 million to $22.1 million in 2013 from $18.4 million in 2012. Broadband connections increased 2,101 year over year and customers are subscribing to higher levels of bandwidth speeds, which resulted in an increase in ARPU of $48.92 from $42.46 in the prior year, an increase of 15.2%. Partially offsetting this increase in broadband, voice revenue decreased $2.2 million primarily due to 6,526 fewer connections offset by marginally higher ARPU of $26.71 from $26.64 in the prior year. This trend is expected to continue as more customers discontinue using their fixed landline voice service and move to wireless alternatives. Other Revenue Other revenue was impacted as follows: • $3.2 million in lower access revenue, caused by lower minutes of use from long distance carriers that use our network to originate and terminate their calls. • $1.5 million in lower high cost support revenue. • $1.0 million in lower equipment sales revenue, primarily caused by a $1.5 million non-recurring sale in 2012. 39 -------------------------------------------------------------------------------- Table of Contents Wireless Wireless revenue of $81.1 million decreased $3.0 million or 3.6%, in 2013 from $84.1 million in 2012. Our wireless subscriber base of 108,848 connections decreased 6,169 year-over-year as discussed in the operating metrics section above. AWN Related AWN related revenues changed substantially on a year over year basis as a result of the AWN transaction which closed in July 2013. Foreign roaming revenue of $40.0 million, declined $15.1 million from $55.1 million in the prior year. Upon closing of AWN, we no longer generate foreign roaming revenue. Wireless backhaul revenue of $6.0 million, declined $0.9 million from $6.9 million in the previous year. All existing backhaul contracts with wireless carriers transferred to AWN at closing, resulting in this year over year decrease. We intend to enter into new backhaul agreements in the future and expect this revenue stream to grow in the future. CETC Revenue increased slightly on a year over year basis to $21.0 million. Under the AWN structure, we will pay a service charge to AWN for an amount equal to our CETC revenue so it does not contribute to our overall net income or cash from operations. Operating Expenses Cost of Services and Sales, Non-Affiliates Cost of services and sales, non-affiliates of $138.2 million decreased $9.9 million, or 6.7%, in 2013 from $148.1 million in 2012. This decrease was due to certain operating expenses that have moved to AWN such as $6.0 million in roaming costs and $2.1 lower leased circuit expense. We also experienced $1.8 million lower USF contribution costs as a result of the Transformation Order, data usage no longer subject to USF contributions, and a reduction in the USF contribution interstate rate throughout 2013. Partially offsetting these costs are an increase of $0.4 million in wireless device and accessory costs. Cost of Services and Sales, Affiliates Cost of services and sales, affiliates of $25.2 million increased $24.9 million in 2013 from $0.3 million in 2012. This increase was primarily due to the consummation of the AWN transaction. These costs include $20.4 million in AWN wholesale costs, representing a new cost for us purchasing wholesale wireless plans from AWN, $10.1 million representing a contractual obligation to pass an amount equal to our CETC Revenue to AWN, and an increase of $0.6 million in TekMate equipment and services. These higher costs were partially offset by $6.8 million in handset subsidy support received from AWN which serves to lower our overall operating expenses. Selling, General and Administrative Selling, general and administrative expenses of $111.0 million increased $3.7 million, or 3.5%, in 2013 from $107.3 million in 2012. This increase was due primarily to higher labor costs of $2.8 million related to management and sales incentives, a $1.4 million increase in service expenses such as advertising, consulting, legal and other. AWN transaction costs increased $0.2 million. These were partially offset by a $0.7 million decrease in bad debt costs primarily due to the settlement of specific reserved accounts with a large customer. Depreciation and Amortization Depreciation and amortization expense of $42.2 million decreased $9.3 million, or 18.1%, in 2013 from $51.5 million in 2012 due primarily to the sale of assets to GCI and the contribution of assets with a book value of $63.4 million to AWN in late July 2013. Gain on Disposal of Assets, Net The $204.2 million gain on the disposal assets recorded in 2013 was primarily associated with the $207.3 million gain on the sale/contribution of wireless assets in connection with the formation of AWN offset by $3.1 million of losses on the disposal of other equipment during the year. 40-------------------------------------------------------------------------------- Table of Contents Earnings on Equity Method Investments Earnings on equity method investments income of $18.1 million increased $18.0 million in 2013 from $0.1 million due to the new equity investment in AWN. Other Income and Expense Interest expense of $39.8 million in 2013 decreased $0.2 million, or 0.6%, compared with $39.6 million in 2012 due to a higher weighted-average interest rate, partially offset by lower average borrowings. Interest expense was impacted by the following: (i) a $4.9 million decrease due to overall lower debt balances, (ii) a $0.9 million increase from floating-to-fixed interest rate swap agreements, which became effective in the third quarter of 2012, (iii) a $2.3 million increase associated with an amendment to our Senior Loan Facility which took place November 1, 2012, and increased our cost of borrowing by 75 basis points. Under the amendment, our stated cost of borrowing increased from LIBOR plus 400 basis points to LIBOR plus 475 basis points, and (iv) a $0.8 million charge to interest expense related to an unfavorable legal settlement with a IT vendor on a claim originating in 2009. 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 2013, the $0.8 million favorable change in the fair value of this swap was credited to interest expense and $1.6 million of unrealized losses previously recorded to accumulated other comprehensive loss was charged to interest expense. Loss on extinguishment of debt of $2.4 million in 2013 relates to $1.6 million pay-downs on our Senior Loan Facility and $0.7 million representing the portion of the interest rate swap that was over-hedged and moved from accumulated other comprehensive income when the $65.0 million debt payment was made at AWN closing. A $0.6 million loss on extinguishment of debt was recorded in 2012 in connection with the repurchase of a portion of the 5.75% Notes. Income Taxes Income tax expense and the effective tax rate in 2013 were $54.9 million and 26.0%, respectively. In 2013, the Company reversed previously recorded amounts related to the favorable Crest, Inc. Internal Revenue Service examination. In addition, in 2013, the Company reversed deferred tax valuation allowances in the amount of $1.9 million. Excluding these reversals, the effective income tax rate was 41.2%. Income tax expense and the effective tax rate in 2012 were $5.8 million and 24.9%, respectively. In 2012, the Company reversed deferred tax valuation allowances in the amount of $3.6 million. Excluding this reversal, the effective income tax was 40.4%. Net Income Net income was $156.4 million in 2013 compared to $17.4 million in 2012. The year-over-year improvement reflects the gains related to the AWN transaction, as well as the operating revenue, operating expense, and income tax items discussed above. Year Ended December 31, 2012 Compared to the Year Ended December 31, 2011 Operating Revenues Business and Wholesale Retail Service Revenue Business and Wholesale revenue of $98.6 million increased $2.7 million, or 2.8%, in 2012 from $95.9 million in 2011. This improvement was primarily driven by a $3.3 million increase from commercial customers using advanced network services such as MPLS, dedicated Internet and Enhanced Metro Ethernet. Although broadband connections have remained relatively flat in total, growth in broadband ARPU reflected customer demand for increasing amounts of bandwidth. Broadband ARPU increased to $152.09 in 2012 from $135.61 in 2011. This increase was partially offset by a $1.8 million decrease in retail voice revenue due to 2,203 fewer connections year over year and lower ARPU of $24.25 from $25.16 in the prior year due to price compression. We also benefited from a $1.5 million non-recurring transaction from a wholesale carrier in 2012. 41-------------------------------------------------------------------------------- Table of Contents Consumer Retail Service Revenue Consumer revenue of $38.8 million decreased $0.3 million, or .8%, in 2012 from $39.1 million in 2011. Voice revenue decreased $2.0 million primarily due to 6,684 fewer connections, even though ARPU of $26.64 increased slightly from $26.85 in the prior year. This trend reflects more customers cutting their fixed landline voice service and moving to wireless alternatives. Offsetting the decrease in voice, broadband revenue increased $1.4 million. Broadband connections increased 81 year-over-year, as customers are subscribing to higher levels of bandwidth speeds, which resulted in an increase in ARPU to $42.46 from $38.41 in the prior year. Other Other revenue was impacted as follows: • $1.6 million in increased equipment sales revenue primarily caused by a non-recurring sale in 2012 • $1.9 million in increased access revenue primarily due to changes in intrastate access funding reform • $.9 million in decreased high cost support revenue related to interstate support associated with access line losses Wireless Wireless revenue of $84.1 million decreased $.3 million, or .3%, in 2012 from $84.4 million in 2011. Our wireless subscriber base of 115,017 decreased 2,542 in 2012, from 117,559 in 2011, reflecting a decrease of 4,028 in postpaid connections. This decline was partially offset by an increase of 4,078 in prepaid connections. AWN Related Foreign roaming revenue increased $16.2 million, or 41.5%, due to the large number of customers from other carriers roaming on our network. CETC Revenue of $20.7 million decreased $6.1 million, or 22.8%, in 2012 from $26.9 million in 2011. Wireless backhaul revenue of $6.9 million, increased $3.7 million from $3.2 million in the previous year. Operating Expense Cost of Services and Sales, Non-Affiliates Cost of services and sales, non-affiliates of $148.1 million increased $12.4 million, or 9.1%, in 2012 from $135.7 million in 2011. This increase was driven by increases of $3.6 million in Home Internet and advanced network service 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, $3.2 million in USF contribution expense associated with Intrastate access reform which is driving down the cost of intrastate rates to be more in line with interstate rates, $3.0 million in roaming COGS due to our customers consuming higher amounts of bandwidth on other carrier's networks when they travel outside of Alaska, $2.8 million in device and accessory expenses primarily driven by our customers purchasing higher cost wireless devices, $1.3 million in land and building costs associated with new cell site leases and collocation agreements with other carriers, and $0.6 million in circuit costs. Offsetting these increases was a decrease of $2.8 million in Interstate and Intrastate access COGS associated with a decline in access lines. Cost of Services and Sales, Affiliates Cost of services and sales, affiliates totaled $0.3 million in 2012 and zero in 2011. The increase of $0.3 million is due to TekMate equipment and services. Selling, General Administrative Selling, general and administrative expenses of $107.3 million increased $15.3 million, or 16.7%, in 2012 from $92.0 million in 2011. This growth was due to increases of $7.8 million in labor reflecting $2.4 million of incentive compensation, $1.9 million in higher health and welfare costs, $1.7 million in annual wage increases and $1.5 million for increased staffing in sales and customer service functions associated with 42-------------------------------------------------------------------------------- Table of Contents improving performance to our customer promises. In addition, we incurred $6.1 million in transaction costs and other administrative expenses associated with the AWN Transaction, and $0.6 million in bad debt expense due in part to specific accounts for which funding from outside agencies is currently uncertain. These items were partially offset by a $0.5 million reduction in advertising, consulting, legal and other outside services expense. In addition, selling, general and administrative expenses in 2011 were favorably affected by a $1.4 million settlement of a contract dispute with a bankrupt vendor. Depreciation and Amortization Depreciation and amortization expense of $51.5 million decreased $7.1 million, or 12.1%, in 2012 from $58.6 million in 2011 due primarily to a number of pooled asset classes reaching their maximum depreciable lives. These decreases were partially offset by depreciation on additions to our IT asset base during 2012. Gain on Disposal of Assets The $2.7 million gain on the disposal assets recorded in 2012 was primarily associated with the sale of excess property. Other Income and Expense Interest expense of $39.6 million in 2012 increased $1.3 million compared with $38.3 million in 2011 due to a marginally higher weighted average interest rate. The higher interest rate reflects $1.9 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 sale of our 6.25% Notes in the second quarter of 2011 and subsequent repurchase of a portion of our 5.75% Notes, which carry a higher effective rate. 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 fourth quarter, the $0.2 million favorable change in the fair value of this swap was credited to interest expense and $0.3 million of unrealized losses previously recorded to accumulated other comprehensive loss was charged to interest expense. A $0.6 million loss on extinguishment of debt was recorded in 2012 in connection with the repurchase of $13.7 million aggregate principal amount of our 5.75% Notes. A $13.4 million loss on extinguishment of debt was recorded in the second quarter of 2011 in connection with the repurchase of a portion of the 5.75% Notes. Income Taxes Income tax expense and the effective tax rate in 2012 were $5.8 million and 24.9%, respectively. In 2012, the Company reversed deferred tax valuation allowances in the amount of $3.6 million as a result of utilizing bonus depreciation which will allow it to utilize additional amounts of its NOL carry forwards. Excluding this reversal, the effective income tax rate was 40.4%. Income tax expense of $11.6 million in 2011 reflects the $5.5 million deferred tax valuation allowance recorded during the third quarter discussed below, partially offset by tax benefits from certain discreet items. Excluding the valuation allowance, but including permanent differences and other adjustments, the effective tax rate was 50.7% in 2011. Income tax expense will not involve significant cash outflows until these NOLs are exhausted. Net Income Net income was $17.4 million in 2012 compared to $0.5 million in 2011. The year over year change primarily reflects the operating revenue and operating expense items discussed above, the $13.4 million loss on the extinguishment of debt recorded in 2011 in connection with the repurchase of a portion of our 5.75% Notes and the year over year reduction in income tax expense. FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES Cash Flows We satisfied our cash requirements for operations, capital expenditures, and debt service in 2013, 2012 and 2011 primarily through internally generated funds and the $100.0 million in cash received as part of the AWN transaction. At December 31, 2013, we had $43.0 million in cash and cash equivalents and $0.5 million in restricted cash. As of December 31, 2013, we also had a $30.0 million undrawn revolving credit facility. Outstanding standby letters of credit commit $1.9 million of the available revolving credit facility at December 31, 2013. 43 -------------------------------------------------------------------------------- Table of Contents A summary of significant sources and use of funds for the years ended December 31, 2013, 2012 and 2011 is as follows: (in thousands) 2013 2012 2011 Net cash provided by operating activities $ 67,707 $ 84,356 $ 79,081 Capital expenditures $ (47,738 ) $ (54,206 ) $ (50,179 ) Capitalized interest $ (1,926 ) $ (1,961 ) $ (1,982 ) Change in unsettled capital expenditures $ 1,492 $ (2,726 ) $ 4,425 Proceeds on sale of assets $ 4,747 $ 3,616 $ 2,665 Proceeds on sale/contribution of asset to AWN $ 100,000 $ - $ - Return of capital from equity investment $ - $ 32 $ - Change in unsettled acquisition costs $ (3,345 ) $ - $ - Net change in short-term investment $ 2,037 $ (2,050 ) $ - Net change in restricted accounts $ 3,408 $ 1,081 $ (44 ) Net debt (repayments) borrowings $ (99,565 ) $ (19,477 ) $ 15,854 Debt issuance costs $ (206 ) $ (3,167 ) $ (4,448 ) Payment of cash dividend on common stock $ - $ (9,117 ) $ (38,818 ) Net stock issuance (payment of withholding taxes) $ (411 ) $ 58 $ (1,685 ) Interest paid $ (35,187 ) $ (36,155 ) $ (34,367 ) Cash paid on extinguishment of hedge instruments $ (4,073 ) $ - $ - Cash Flows from Operating Activities Cash provided by operating activities of $67.7 million in 2013 reflected net income excluding non-cash items of $57.5 million, a $2.1 million decrease in accounts payable excluding capital items and a $1.0 million increase in accrued payroll and benefits. These items were partially offset by a $0.7 million increase in materials and supplies and a $5.5 million increase in accounts receivable. Payment of AWN Transaction related costs totaled $8.3 million. The Company incurred AWN Transaction costs up to and following the consummation of the transaction. The Company has funded these costs primarily through a combination of internally generated funds and proceeds from the transaction. Cash provided by operating activities of $84.4 million in 2012 reflected net income excluding non-cash items of $84.5 million, a $5.1 million increase in accounts payable excluding capital items and a $2.5 million increase in accrued payroll and benefits. These items were partially offset by a $4.0 million increase in materials and supplies and a $2.7 million increase in accounts receivable. Payment of AWN Transaction related costs totaled $4.2 million. Cash provided by operating activities of $79.1 million in 2011 reflected net income excluding non-cash items of $89.7 million offset by the release of revenue reserves of approximately $7.6 million and cash payments of approximately $1.5 million associated with various federal funding programs. Interest payments, net of cash interest income and including capitalized interest, were $35.2 million, $36.2 million and $34.4 million in 2013, 2012 and 2011, respectively. Through a series of interest rate swap transactions, interest on 56% of our term loan at December 31, 2013 is effectively fixed at an annual rate of 6.47% for the period January 2013 through March 2013, 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% and a current outstanding balance of $114.0. Cash Flows from Investing Activities Cash provided by investing activities of $58.7 million in 2013 increased $115.0 million from cash used in investing activities of $56.3 million in 2012. This increase primarily reflects the receipt of $100 million from the sale of wireless assets to GCI and a $10.7 million decrease in capital expenditures, inclusive of capitalized interest and the settlement of capital expenditure payables. 44 -------------------------------------------------------------------------------- Table of Contents Cash used in investing activities of $56.3 million in 2012 increased $11.5 million from $44.8 million in 2011. This increase reflects an $11.2 million increase in capital expenditures, inclusive of capitalized interest and the settlement of capital expenditure payables, due primarily to the construction of our 4G LTE wireless network. Our historical capital expenditures have been significant, but we expect them to be reduced from levels incurred in 2013. 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 was $100.2 million in 2013 relating almost exclusively to the pay-down of $99.6 million in debt. Payments included (a) scheduled principal payments of $7.3 million on the term loan component of our Senior Credit Facility, (b) principal prepayments on the term loan component of our Senior Credit Facility totaling $78.0 million and (c) the full redemption of our 5.75% Notes totaling $13.0 million. Cash used in financing activities was $31.7 million in 2012. Payments on debt of $19.5 million included principal payments on our 5.75% Notes totaling $13.7 million and scheduled payments on the term loan component of our Senior Credit Facility totaling $4.4 million. Reducing the outstanding balance of the 5.75% Notes to $25.0 million or lower precluded an acceleration of the maturity date on the term loan component of the Senior Credit Facility from October 21, 2016 to December 19, 2012. Cash used in financing activities was $29.1 million in 2011. Net proceeds of $115.6 million from the issuance of our 6.25% Notes were used to repurchase $98.3 million principal amount of our 5.75% Notes at a premium of $6.9 million. Debt issuance costs associated with the transaction totaled $4.4 million. Cash dividends of $38.8 million were paid in 2011. 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. 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) 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; (ii) the entrance of Verizon into the Alaska wireless market and the potential negative impact on our retail service revenues beginning in 2014; (iii) servicing our substantial debt and funding principal payments; (iv) the funding of other obligations, including our pension plans and lease commitments; (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; and (viii) our ability to obtain adequate financing to support our business and pursue growth opportunities. We are responding to these challenges by (i) driving growth in broadband service revenues with a particular focus on business and wholesale customers; (ii) and maintaining our wireless customers to support AWN and maximize our preferred distributions in the future, and (iii) managing our cost structure to deliver consistent free cash flow performance. We also anticipate dedicating a significant portion of our free cash flow to pay down debt and reduce our interest expense over time. 45 -------------------------------------------------------------------------------- Table of Contents As of December 31, 2013, total long-term obligations outstanding, including current portion, were $456.3 million consisting of a $344.2 million draw from our Senior Credit Facility, net of a $1.7 million debt discount, $104.8 million of convertible notes, net of $9.2 million in debt discounts, and $7.3 million in capital lease and other obligations. As of December 31, 2013, we had $43.0 million in cash and access to $28.1 million of our $30.0 million revolver. On January 2, 2014, we made $13.2 in principal payments on our long-term debt representing 100% of the required payments for 2014. We believe that we will have sufficient cash on hand, cash provided by operations and available borrowing capacity under our revolving credit facility to service our debt, and fund our operations, capital expenditures and other obligations over the next twelve months. Our ability to meet such obligations will be dependent upon our future financial performance, which is, in turn, subject to future economic conditions and to financial, business, regulatory and other factors, many of which are beyond our control. Senior Credit Facility On October 21, 2010, we entered into a $470.0 million Senior Credit Facility which consists of a drawn term loan of $440.0 million and an undrawn revolving loan of $30.0 million (the "revolver"). At December 31, 2013, we had access to $28.1 million under the revolving credit facility, representing 94% of available capacity. Outstanding standby letters of credit totaled $1.9 million at December 31, 2013. The term loan component of the 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 payment of dividends. The Senior Credit Facility also has a requirement that 25% - 75% of certain cash flow generated by our business be used to pay down outstanding principal. The Senior Credit Facility also requires that we achieve certain financial ratios quarterly including a total leverage ratio, senior secured leverage ratio and a fixed charges coverage ratio. As of December 31, 2013, we were in compliance with these ratios. These measures are defined more specifically below. The AWN transaction required numerous conditions to close, one of which was an amendment to our Senior Credit Facility. On November 1, 2012, an amendment was entered into allowing for the sale to GCI and transfer directly to AWN of certain wireless assets. 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. Therefore, additional term modifications were required to provide the flexibility necessary to address the resulting lower Adjusted EBITDA, as defined in our senior credit facility, from the AWN Transaction. 46-------------------------------------------------------------------------------- Table of Contents A comparison of certain original terms of our Senior Credit Facility with the corresponding amended terms is summarized as follows: Senior Credit Facility Terms Original As Amended Interest rate: Margin over LIBOR 4.00 % 4.75 % LIBOR floor 1.50 % 1.50 % Quarterly principal payments (in thousands): * Through quarter ended December 31, 2012 $ 1,100 $ 1,100 Effective quarter beginning January 1, 2013 $ 1,100 $ 1,825 Effective quarter beginning January 1, 2014 $ 1,100 $ 3,300 Effective quarter beginning January 1, 2015 $ 1,100 $ 3,675 Effective quarter beginning January 1, 2016 $ 1,100 $ 3,300 Total Leverage to Adjusted EBITDA Ratio Limit: Through June 30, 2014 5.25 6.00 Through December 31, 2014 5.25 5.50 Thereafter 5.25 5.25 Senior Secured Leverage to Adjusted EBITDA Ratio Limit: Through June 30, 2014 4.40 4.75 Through December 31, 2014 4.40 4.50 Thereafter 4.40 4.25 Adjusted EBITDA to Fixed Charges Coverage Ratio Minimum: Through June 30, 2014 2.75 2.25 Through September 30, 2015 2.75 2.50 Thereafter 2.75 2.75 Total Leverage Ratio limit on which cash dividends on common stock may be paid * 5.00 3.50 * Term modification effective November 1, 2012. Total Leverage Ratio: Our "total leverage ratio" may not exceed 6.00 to 1.00. "Total leverage ratio" means, generally, as at the last day of any fiscal quarter, the ratio of our (a) adjusted total debt to (b) Adjusted EBITDA (as defined in our Senior Credit Facility more specifically below) for the period of four of our consecutive fiscal quarters ended on such date, all determined on a consolidated basis in accordance with Generally Accepted Accounting Principles. Payment of cash dividends on common stock is not permitted until such time that the Company's Total Leverage Ratio is not more than 3.50 to 1.00. The total leverage ratio was 3.94 to 1.00 as of December 31, 2013. Senior Secured Leverage Ratio: Our "senior secured leverage ratio" may not exceed 4.75 to 1.00. "Senior secured leverage ratio" means, as of the last day of any fiscal quarter, the ratio of our (a) senior secured debt to (b) Adjusted EBITDA, as defined in our Senior Credit Facility. The senior secured leverage ratio was 3.33 to 1.00 as of December 31, 2013. Fixed Charges Coverage Ratio: Our "fixed charges coverage ratio" may not be less than 2.25 to 1.00. The ratio of (a) Adjusted EBITDA, as defined in our Senior Credit Facility, to (b) "Fixed Charges" is defined specifically in our Senior Credit Facility, and more generally, below. The fixed charges coverage ratio was 3.02 to 1.00 as of December 31, 2013. Adjusted EBITDA, as defined in our Senior Credit Facility, means consolidated net income, plus the sum of: • consolidated interest expense; • provision for income taxes based on income; 47 -------------------------------------------------------------------------------- Table of Contents • depreciation and amortization expense; • certain specified expenses incurred in connection with the AWN Transaction, including charges associated with the potential termination of hedging agreements; • unrealized losses on financial derivatives; • non-cash, stock-based compensation expense; • extraordinary, non-recurring or unusual losses; • cash dividends or distributions from AWN; • the cumulative effect of a change in accounting principles; and • all other non-cash charges that represent an accrual for which no cash is expected to be paid in the next twelve months; minus (to the extent included in determining consolidated net income) the sum of: • unrealized gains on financial derivatives; • extraordinary, non-recurring or unusual gains; • gains on sales of assets other than in the ordinary course of business; and • all other non-cash income. "Fixed charges" means (a) cash interest expense plus (b) cash income tax. The above definition of Adjusted EBITDA is not necessarily consistent with the Non-GAAP measure of Adjusted EBITDA presented elsewhere in this "Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations." Principal payments totaling $85.3 and $4.4 million were made on the term loan during the years ended December 31, 2013 and 2012 respectively. Substantially all of our assets, including those of our subsidiaries, have been pledged as collateral for our Senior Credit Facility. In connection with the Senior Credit Facility, the Company entered into forward floating-to-fixed interest rate swaps and a buy back of the 1.5% LIBOR floor, as a component of its cash flow hedging strategy. The notional amounts of the swaps were $192.5 million, $115.5 million and $77.0 million with interest rates of 6.463%, 6.470% and 6.475%, respectively, inclusive of a 4.0% LIBOR spread. The swaps began on June 30, 2012 and were expected to continue through September 30, 2015. To protect against movements in LIBOR prior to the start of the swaps, the Company acquired an interest rate cap at a cost of $0.1 million for the period between December 31, 2010 and June 30, 2012, capping LIBOR at 3.0% on a notional principal amount of $385.0 million. On November 1, 2012, the effective date of the amendment to the Company's Senior Credit Facility, and as a result of the incremental $65.0 million AWN transaction principal payment on the term loan required by this amendment, it was determined that the swap in the notional amount of $192.5 million no longer met the hedge effectiveness criteria. The $192.5 million swap was extinguished and settled on August 1, 2013 for $4.1 million in cash. The portion of unrealized losses on this swap was recorded to accumulated other comprehensive loss, from the swap's inception through the date hedge accounting treatment was discontinued (November 1, 2012), and amounts associated with the variable rate interest payments underlying the accelerated $65.0 million principal payment, were reclassified to loss on extinguishment of debt. The amount of this reclassification was $0.7 million. The remaining balance of amounts recorded to accumulated other comprehensive loss associated with this hedge will be amortized to interest expense over the period of the remaining originally designated hedged variable rate interest payments. The notional amount of the two remaining swaps are $115.5 million and $77.0 million with interest rates of 7.220% and 7.225%, respectively, inclusive of a 4.75% LIBOR spread. Other Debt Instruments The balance of our 6.25% Notes due in 2016 was $114.0 million as of December 31, 2013. We may periodically consider repurchasing outstanding convertible notes, for cash or shares of the Company's common stock, or a combination thereof. The amount of any convertible notes to be repurchased, as well as the timing of any repurchases, will be based on business, market and other conditions and factors, including price, regulatory matters, contractual requirements or consents, and capital availability. Any repurchases might be made using a variety of methods, which may include open 48 -------------------------------------------------------------------------------- Table of Contents market purchases, privately negotiated transactions, or by any combination of those methods, in compliance with applicable securities laws and regulations. There can be no assurance that we will be able to successfully repurchase any convertible notes on terms acceptable to the Company. Contractual Obligations Our contractual obligations as of December 31, 2013, are presented in the following table. Generally, long-term liabilities are included in the table based on the year of required payment or an estimate of the year of payment. Such estimates of payment are based on a review of past trends for these items as well as a forecast of future activities. As described below, certain items were excluded from the following table where the year of payment is unknown and could not be reasonably estimated. (in thousands) Total 2014 2015-2016 2017-2018 Thereafter Long-term debt $ 467,157 $ 14,310 $ 334,220 $ 114,727 $ 3,900 Interest on long-term debt 98,667 31,503 53,757 10,323 3,084 Capital leases 7,257 1,110 1,520 727 3,900 Operating leases 66,732 6,553 12,156 9,956 38,067 Unconditional purchase obligations 5,732 3,780 1,493 387 72 Total contractual cash obligations $ 645,545 $ 57,256 $ 403,146 $ 136,120 $ 49,023 Total pension benefit liabilities associated with the ACS Retirement Plan recognized on the consolidated balance sheet as of December 31, 2013 and December 31, 2012 were $3.7 million and $5.5 million, respectively, and is included in "Other long-term liabilities-non affiliate" on our consolidated balance sheet. Because this liability is impacted by, among other items, plan funding levels, changes in plan demographics and assumptions, and investment return on plans assets, it does not represent expected liquidity needs. Accordingly, we did not include this liability in the "Contractual Obligations" table. We made cash contributions of $0.4 million in 2013 and $0.5 million in 2012. No cash contributions were made in 2011. This plan is not fully funded. We also participate in the Alaska Electrical Pension Fund, a multi-employer defined benefit plan, to which we pay a contractual hourly amount based on employee classification or base compensation. We contributed $9.2 million, $9.6 million and $9.1 million to this plan in 2013, 2012 and 2011, respectively. Minimum required future contributions to this plan are subject to the number of employees in each classification and/or base compensation of employees in future years and, therefore, are not included in the "Contractual Obligations" table. This plan is not fully funded. As of December 31, 2013 and December 31, 2012, the Company had an accumulated asset retirement obligation of $3.7 million and $6.9 million. This liability was not included in the "Contractual Obligations" table due primarily to the uncertainty as to the timing of future payments. As of December 31, 2013 and December 31, 2012, the Company had deferred tax liabilities totaling $95.0 million and $27.5 million, exclusive of deferred tax assets. This amount is not included in the "Contractual Obligations" table because the Company believes this presentation would not be meaningful. Deferred income tax liabilities are calculated based on temporary differences between the tax basis of assets and liabilities and their book basis, which will result in taxable amounts in future years when the book basis is settled. The results of these calculations do not have a direct connection with the amount of cash taxes to be paid in any future periods. In addition, funding obligation associated with our self insurance programs have been excluded from the table due primarily to the uncertainty as to the timing of future payments. 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, gain on sale of long-term investments, gain and loss on disposal of assets, gift of services, AWN transaction related costs, income taxes and stock-based compensation, and 49 -------------------------------------------------------------------------------- Table of Contents including return of capital from equity investment, as defined and reconciled below ("Adjusted EBITDA"), and Adjusted EBITDA Margin, defined as Adjusted EBITDA divided by operating revenues, because we believe they 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. 50 -------------------------------------------------------------------------------- Table of Contents The following table provides the computation of Adjusted EBITDA and Free Cash Flow for the years ended December 31, 2013, 2012 and 2011: (in thousands) 2013 2012 2011 Net income $ 156,381 17,409 472 Add (subtract): Interest expense 39,790 39,570 38,271 Loss on extinguishment of debt 2,370 575 13,445 Interest income (53 ) (43 ) (34 ) Depreciation and amortization 42,191 51,487 58,559 Loss on impairment of equity investment 1,267 - - Loss on sale of short-term investments 13 - - Gain on sale of long-term investments - - (174 ) (Gain) loss on disposal of assets 3,118 (2,668 ) (565 ) Earnings from equity method investment in Tekmate (93 ) (115 ) - Earnings from equity method investment in AWN (17,963 ) - - Gain on sale/contribution of asset to AWN (207,318 ) - - Tekmate distribution received - 147 - AWN distributions received 17,844 - - AWN distributions receivable within 12 days 4,167 - - Income tax expense 54,905 5,783 11,646 Stock-based compensation and long-term cash incentives 3,491 3,550 3,888 Gift of services - - (51 ) AWN transaction-related costs 6,382 6,126 500 Adjusted EBITDA $ 106,492 $ 121,821 $ 125,957 Less: Incurred capital expenditures * (47,738 ) (54,206 ) (50,179 ) Amortization of deferred AWN capacity revenue (1,512 ) - - AWN transaction-related capital costs, net change (41 ) 1,580 - Cash interest expense (35,187 ) (36,155 ) (34,367 ) Free Cash Flow $ 22,014 $ 33,040 $ 41,411 Operating revenues $ 348,924 $ 367,714 $ 349,314 Adjusted EBITDA Margin 30.5 % 33.1 % 36.1 % * Excludes capitalized interest (included in "Cash interest expense") and the change in unsettled capital expenditures. OUTLOOK Operating Results, Liquidity and Capital Resources We expect to see continued strength in business and wholesale and consumer customer service revenues, led by broadband revenue growth across all customer groups. These revenue increases are driven by new broadband products and services and increasing demand for broadband. We also believe we will generate revenue growth by growing market share. Our acquisition of TekMate in January 2014 will also contribute to our operating results in 2014. 51-------------------------------------------------------------------------------- Table of Contents Other revenue categories are expected to see mixed results. We expect equipment sales to be a variable revenue stream and will be impacted by large non-recurring events. We expect access revenues to continue to decline as voice traffic experiences decline with long distance carriers. It is uncertain the direction of high cost support revenue. As discussed in Item 1. Business and Item 1A. Risk Factors, this revenue stream is undergoing significant reform. It is difficult to predict the future direction of this source or revenue as well as the future obligations we will inherit to sustain this revenue stream. Wireless service, equipment sales and other revenue is expected to see continued declines, due to Verizon's anticipated retail entry into the Alaska marketplace. Regarding our cost structure, as we move into 2014, we took certain actions to continue to manage our cost structure, primarily related to our cost of supporting wireless services to ensure we generate consistent cash flow from operations, Adjusted EBITDA and Free Cash Flow, the latter of which will be dedicated to further debt pay downs. These actions include selective reduction of approximately 5% of our workforce in the fourth quarter of 2013, reduction in elevated promotional activity for consumer broadband, and reduced sales and incentive compensation expense through better alignment of our retail, direct and indirect sales channels with the market opportunity and lower anticipated year over year management incentive compensation payouts. We expect to make continued adjustments to our cost structure in 2014, as we re-position our wireless offerings in the face of the entry of Verizon wireless in the market. This re-positioning will improve our competitiveness and cost of delivery of our service offerings. We believe that through continued top line revenue growth in service revenue, and expense management we should continue to generate sufficient Free Cash Flow to further reduce our indebtedness. We believe that, we will have sufficient cash on hand, cash provided by operations and available borrowing capacity under our revolving credit facility to service our debt and fund our operations, capital expenditures and other obligations over the next twelve months. ADDITIONAL INFORMATION Off-Balance Sheet Arrangements We have no special purpose or limited purpose entities that provide off-balance sheet financing, liquidity or market or credit risk support and we do not engage in leasing, hedging, research and development services or other relationships that expose us to any material liabilities that are not reflected on our balance sheet or included in "Contractual Obligations" above. Critical Accounting Policies and Estimates The preparation of our consolidated financial statements, in conformity with accounting principles generally accepted in the United States of America, requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and 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. We have identified certain policies and estimates as critical to our business operations and the understanding of our past or present results of operations. We consider these policies and estimates critical because they had a material impact, or they have the potential to have a material impact, on our financial statements and they require significant judgments, assumptions or estimates. Revenue Recognition Policies We recognize revenue for recurring services when earned, which is usually on a month-to-month basis. We also recognize non-recurring revenues, including activation fees and usage sensitive charges, when earned. Where we have determined that certain bundled products, including coupled wireline and wireless services, constitute arrangements with multiple deliverables, we allocate and measure using units of accounting and our judgment within the arrangement based on relative fair values. We recognize access revenue when we earn it. We participate in access revenue pools with other telephone companies. Such pools are funded by toll revenue and/or access charges regulated by the FCC within the interstate jurisdiction. Much of the interstate access revenue is initially recorded based on 52-------------------------------------------------------------------------------- Table of Contents estimates. These estimates are derived from interim financial statements, available separations studies and the most recent information available about achieved rates of return. These estimates are subject to adjustment in future accounting periods as additional operational information becomes available for us and the other telephone companies. To the extent that disputes arise over revenue settlements, we defer revenue collected until settlement methodologies are resolved and finalized. Although we have withdrawn from interstate access pools, we have a remaining liability for certain periods prior to July 1, 2009. Income Taxes We use the asset-liability method of accounting for income taxes and account for income tax uncertainties using the "more-likely-than-not" threshold. Under the asset-liability method, deferred taxes reflect the temporary differences between the financial and tax bases of assets and liabilities using the enacted tax rates in effect in the years in which the differences are expected to reverse. Deferred tax assets are reduced by a valuation allowance to the extent management determines it is more-likely-than-not that the value of our deferred tax assets will not be fully realized. Derivative Financial Instruments We recognize all asset or liability derivatives at fair value. The accounting for changes in fair value is contingent on the intended use of the derivative and its designation as a hedge. Derivatives that are not hedges are adjusted to fair value through earnings. If a derivative is a hedge, depending on the nature of the hedge, changes in fair value either offset the change in fair value of the hedged assets, liabilities or firm commitments through earnings, or are recognized in other comprehensive income until the hedged transaction is recognized in earnings. The change in a derivative's fair value related to the ineffective portion of a hedge, if any, is immediately recognized in earnings. We do not enter into any derivative contracts for speculative purposes. On the date a derivative contract is entered into, we designate the derivative as either a fair value or cash flow hedge. We formally assess, both at the hedge's inception and on an ongoing basis, whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in fair values or cash flows of hedged items. If we determine that a derivative is not highly effective as a hedge or that it has ceased to be a highly effective hedge, we discontinue hedge accounting prospectively. The change in a derivative's fair value related to the ineffective portion of a hedge is immediately recognized in earnings. Amounts recorded to accumulated other comprehensive income (loss) from the date of the derivative's inception to the date of ineffectiveness are amortized to earnings over the remaining term of the hedged item. If the hedged item is settled prior to its originally scheduled date, any remaining accumulated comprehensive income (loss) associated with the derivative instrument is reclassified to earnings. Termination of a derivative instrument prior to its scheduled settlement date may result in charges for termination fees. Recently Issued Accounting Pronouncements The Company evaluated recently issued accounting pronouncements to determine the impact of new pronouncements on GAAP and our consolidated financial statements. There are no new accounting pronouncements that have been issued or adopted during the year ended December 31, 2013, that we expect will have a significant effect on our consolidated financial statements. |