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UNITED STATES CELLULAR CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) United States Cellular Corporation ("U.S. Cellular") owns, operates and invests in wireless markets throughout the United States. U.S. Cellular is an 84%-owned subsidiary of Telephone and Data Systems, Inc. ("TDS") as of June 30, 2014. U.S. Cellular provides wireless telecommunications services to approximately 4.7 million customers in 23 states. As of June 30, 2014, U.S. Cellular's average penetration rate in its consolidated operating markets was 14.7%. U.S. Cellular operates on a customer satisfaction strategy, striving to meet or exceed customer needs by providing a comprehensive range of wireless products and services, excellent customer support, and a high-quality network. The following discussion and analysis should be read in conjunction with U.S. Cellular's interim consolidated financial statements and notes included in Item 1 above, and with the description of U.S. Cellular's business, its audited consolidated financial statements and Management's Discussion and Analysis of Financial Condition and Results of Operations included in U.S. Cellular's Annual Report on Form 10-K ("Form 10-K") for the year ended December 31, 2013. OVERVIEW The following is a summary of certain selected information contained in the comprehensive Management's Discussion and Analysis of Financial Condition and Results of Operations that follows. The overview does not contain all of the information that may be important. You should carefully read the entire Management's Discussion and Analysis of Financial Condition and Results of Operations and not rely solely on the overview. Financial and operating highlights in the six months ended June 30, 2014 included the following: † In March 2014, U.S. Cellular sold the majority of its St. Louis area non-operating market license for $92.3 million. As a result of this sale, a gain of $75.8 million was recorded in (Gain) loss on license sales and exchanges in the Consolidated Statement of Operations. † In February 2014, U.S. Cellular completed a license exchange in Milwaukee. As a result of this transaction, a gain of $15.7 million was recorded in (Gain) loss on license sales and exchanges in the Consolidated Statement of Operations. The following operating information is presented for Core Markets. As used here, Core Markets is defined as all consolidated markets in which U.S. Cellular currently conducts business and, therefore, excludes the Divestiture Markets and the NY1 & NY2 Partnerships. Core Markets as defined also includes any other income or expenses due to U.S. Cellular's direct or indirect ownership interests in other spectrum in the Divestiture Markets which was not included in the Divestiture Transaction and other retained assets from the Divestiture Markets. See Note 5 - Acquisitions, Divestitures and Exchanges and Note 7 - Investments in Unconsolidated Entities in the Notes to Consolidated Financial Statements for additional information. † Total customers were 4,653,000 at June 30, 2014, including 4,500,000 retail customers (97% of total). † Retail customer net losses were 110,000 in the first six months of 2014 compared to net losses of 47,000 in 2013. In the postpaid category, there were net losses of 119,000 in 2014, compared to net losses of 86,000 in 2013. Postpaid defections increased due to billing system conversion issues and aggressive promotions by other carriers. Prepaid net additions were 9,000 in 2014 compared to net additions of 39,000 in 2013. The decline resulted from lower net additions in the national retail channel. † Postpaid customers comprised approximately 92% of U.S. Cellular's retail customers as of June 30, 2014. The postpaid churn rate was 2.0% in 2014 compared to 1.6% in 2013. Billing system conversion issues and aggressive competitive offerings contributed to the increase in postpaid churn. The prepaid churn rate was 6.7% in 2014 compared to 5.8% in 2013. † Billed average revenue per user ("ARPU") increased to $53.62 in 2014 from $50.97 in 2013 reflecting an increase in postpaid ARPU due to increases in smartphone adoption and corresponding revenues from data products and services. Service revenue ARPU increased to $60.23 in 2014 from $57.52 in 2013 due primarily to an increase in postpaid ARPU, offset by a decrease in inbound roaming revenue. † Postpaid customers on smartphone service plans increased to 55% as of June 30, 2014 compared to 46% as of June 30, 2013. In addition, smartphones represented 73% of all devices sold in 2014 compared to 64% in 2013. † Beginning in the second quarter of 2014, U.S. Cellular expanded its offerings for equipment installment plans. For the three months ended June 30, 2014, 15% of total smartphone sales to customers were made under an equipment installment plan. 16 -------------------------------------------------------------------------------- Table of Contents The following financial information is presented for U.S. Cellular consolidated results: † Retail service revenues of $1,510.9 million decreased $175.5 million, or 10%, in 2014 due to a decrease of 799,000 in the average number of customers (including approximately 500,000 due to the reductions caused by the Divestiture Transaction and NY1 & NY2 Deconsolidation) partially offset by an increase in billed ARPU. † Cash flows from operating activities were $212.9 million. At June 30, 2014, Cash and cash equivalents and Short-term investments totaled $444.1 million and there were no outstanding borrowings under the revolving credit facility. † Total additions to Property, plant and equipment were $233.5 million, including expenditures to deploy fourth generation Long-term Evolution ("4G LTE") equipment, construct cell sites, increase capacity in existing cell sites and switches, outfit new and remodel existing retail stores, and enhance billing and other customer management related systems and platforms. Total cell sites in service decreased 20% year-over-year to 6,183 primarily as a result of the NY1 & NY2 Deconsolidation and the deactivation of certain cell sites in the Divestiture Markets. † Operating income (loss) decreased $263.0 million, to a loss of $42.5 million in 2014. The (Gain) loss on license sales and exchanges and the (Gain) loss on sale of business and other exit costs contributed $108.9 million and $242.1 million to operating income in 2014 and 2013, respectively. Without these items, operating income decreased $129.8 million due to lower service revenues and higher equipment subsidies, which were partially offset by lower system operations, selling, general and administrative, and depreciation, amortization and accretion expense. † Net income (loss) attributable to U.S. Cellular shareholders decreased $147.6 million to $0.7 million in 2014 compared to $148.3 million in 2013, due primarily to the net impact of lower operating income and a decrease in Gain (loss) on investments. Basic earnings (loss) per share and Diluted earnings (loss) per share were $0.01 in 2014, which was $1.76 and $1.74 lower, respectively, than in 2013. U.S. Cellular anticipates that its future results may be affected by the following factors: † Effects of industry competition on service and equipment pricing; † U.S. Cellular completed the migration of its customers to a new Billing and Operational Support System ("B/OSS") in the third quarter of 2013. Intermittent system outages and delayed system response times negatively impacted customer service and sales operations at certain times. System enhancements continue to be implemented to address these issues, and customer service and sales operations response times have improved. However, any future operational problems associated with the new billing system could have adverse effects on U.S. Cellular's business (in areas such as overall customer satisfaction, customer attrition, uncollectible accounts receivable, gross customer additions, or operating expenses). All of these factors could have a material adverse effect on U.S. Cellular's results of operations or cash flows; † Impacts of selling Apple iPhone products; † Impacts of selling devices under equipment installment plans; † Relative ability to attract and retain customers in a competitive marketplace in a cost effective manner; † Expanded distribution of products and services in third-party national retailers; † Potential increases in prepaid customers, who generally generate lower ARPU and higher churn, as a percentage of U.S. Cellular's customer base in response to changes in customer preferences and industry dynamics; † The nature and rate of growth in the wireless industry, requiring U.S. Cellular to grow revenues primarily from selling additional products and services to its existing customers, increasing the number of multi-device users among its existing customers, increasing data products and services and attracting wireless customers switching from other wireless carriers; † Continued growth in revenues and costs related to data products and services and declines in revenues from voice services; † Rapid growth in the demand for new data devices and services which may result in increased cost of equipment sold and other operating expenses and the need for additional investment in network capacity and enhancements; † Further consolidation among carriers in the wireless industry, which could result in increased competition for customers and/or cause roaming revenues to decline; 17 -------------------------------------------------------------------------------- Table of Contents † Uncertainty related to various rulemaking proceedings underway at the Federal Communications Commission ("FCC"); † The ability to negotiate satisfactory 4G LTE data roaming agreements with other wireless operators. Pro Forma Financial Information Refer to U.S. Cellular's Form 8-K filed on August 2, 2013 for pro forma financial information related to the Divestiture Transaction and the NY1 & NY2 Deconsolidation for the three and six months ended June 30, 2013, as if the transactions had occurred at the beginning of the period. REGULATORY DEVELOPMENTS FCC Interoperability Order On October 25, 2013, the FCC adopted a Report and Order and Order of Proposed Modification confirming a voluntary industry agreement on interoperability in the Lower 700 MHz spectrum band. The FCC's Report and Order laid out a roadmap for the voluntary commitments of AT&T and DISH Network Corporation ("DISH") to become fully binding. The FCC implemented the AT&T commitments in an Order adopted in the first quarter of 2014 that modified AT&T's Lower 700 MHz licenses. Pursuant to these commitments, AT&T will begin incorporating changes in its network and devices that will foster interoperability across all paired spectrum blocks in the Lower 700 MHz Band and support LTE roaming on AT&T networks for carriers with compatible Band 12 devices, consistent with the FCC's rules on roaming. AT&T will be implementing the foregoing changes in phases starting with network software enhancement taking place possibly through the third quarter of 2015 with the AT&T Band 12 device roll-out to follow. In addition, the FCC has adopted changes in its technical rules for certain unpaired spectrum licensed to AT&T and DISH in the Lower 700 MHz band to enhance prospects for Lower 700 MHz interoperability. AT&T's network and devices currently interoperate across only two of the three paired blocks in the Lower 700 MHz band. U.S. Cellular's LTE deployment, carried out in conjunction with its partner, King Street Wireless, utilizes spectrum in all three of these blocks and, consequently, was not interoperable with the AT&T configuration. U.S. Cellular believes that the FCC action will broaden the ecosystem of devices available to U.S. Cellular's customers over time. FCC Net Neutrality Proposal In May 2014, the FCC issued a notice of proposed rulemaking seeking comments on revised net neutrality rules. The revised proposed rules are substantially similar to rules adopted in 2010 that were vacated by a U.S. Court of Appeals in January 2014 (as described in our Form 10-K for the year ended December 31, 2013), except that they include certain changes intended to allow the revised proposed rules to be sustained considering the Court's decision. In particular, whereas the vacated rules prohibited fixed (i.e., cable and telephone) Internet Service Providers from engaging in "unreasonable discrimination" in transmitting internet traffic, the revised proposed rules would prohibit those carriers from engaging in "commercially unreasonable practices." The FCC is also considering applying that standard to wireless Internet Service Providers, which were not subject to the former "unreasonable discrimination" standard. All types of Internet Service Providers previously were and would again be prohibited from "blocking" access to lawful Internet services, and remain subject to "transparency" requirements which were not vacated by the Court of Appeals. The FCC also now proposes to "enhance" those transparency requirements to provide for greater disclosure of network management practices. The FCC proceeding is currently pending, and we cannot predict the outcome of the proceeding. FCC Spectrum Auction 97 The FCC has scheduled an auction of AWS-3 spectrum licenses, referred to as Auction 97, to begin on November 13, 2014. U.S. Cellular evaluates opportunities to acquire additional spectrum in FCC auctions and may participate as a bidder or member of a bidding group. If U.S. Cellular participates, information relating to this will be disclosed at a later time, subject to FCC rules. In such event, applicable FCC anti-collusion rules will place certain restrictions on public disclosures and business communications with other companies relating to U.S. Cellular's participation, commencing on the application deadline of September 12, 2014 until the down payment deadline for Auction 97, which will be the later of January 7, 2015 or ten business days after release of the auction closing public notice. These anti-collusion rules, which could last three to four months or more, may restrict the normal conduct of U.S. Cellular's disclosures and/or business communications by U.S. Cellular relating to the auction. The restrictions could have an adverse effect on U.S. Cellular's business, financial condition or results of operations. 18 -------------------------------------------------------------------------------- Table of Contents RESULTS OF OPERATIONS Summary Operating Data for U.S. Cellular Consolidated Markets Following is a table of summarized operating data for U.S. Cellular's Consolidated Markets. Consolidated Markets herein refers to markets which U.S. Cellular currently consolidates, or previously consolidated in the periods presented, and is not adjusted in prior periods for subsequent divestitures or deconsolidations. Unless otherwise noted, figures reported in Results of Operations are representative of consolidated results. As of or for Six Months Ended June 30, 2014 2013 Retail Customers Postpaid Total at end of period 4,148,000 4,412,000 Gross additions 387,000 356,000 Net additions (losses) (119,000) (194,000) ARPU(1) $ 57.18 $ 54.80 Churn rate(2) 2.0 % 1.9 % Smartphone penetration(3) 55.3 % 45.5 % Prepaid Total at end of period 352,000 381,000 Gross additions 150,000 181,000 Net additions (losses) 9,000 16,000 ARPU(1) $ 33.18 $ 32.76 Churn rate(2) 6.7 % 6.6 % Total customers at end of period 4,653,000 4,968,000 Billed ARPU(1) $ 53.62 $ 51.15 Service revenue ARPU(1) $ 60.23 $ 57.85 Smartphones sold as a percent of total devices sold 72.8 % 63.7 % Total Population Consolidated markets(4) 54,817,000 84,025,000 Consolidated operating markets(4) 31,729,000 31,822,000 Market penetration at end of period Consolidated markets(5) 8.5 % 5.9 % Consolidated operating markets(5) 14.7 % 15.6 % Capital expenditures (000s) $ 233,508 $ 286,907 Total cell sites in service 6,183 7,748 Owned towers 4,457 4,411 Summary Operating Data for U.S. Cellular Core Markets Following is a table of summarized operating data for U.S. Cellular's Core Markets. For comparability, Core Markets as presented here excludes the results of the Divestiture Markets and NY1 and NY2 Partnerships as of or for the six months ended June 30, 2013. As of or for Six Months Ended June 30, 2014 2013 Retail Customers Postpaid Total at end of period 4,148,000 4,412,000 Gross additions 387,000 341,000 Net additions (losses) (119,000) (86,000) ARPU(1) $ 57.18 $ 54.34 Churn rate(2) 2.0 % 1.6 % Smartphone penetration(3) 55.3 % 45.5 % Prepaid Total at end of period 352,000 381,000 Gross additions 150,000 167,000 Net additions (losses) 9,000 39,000 ARPU(1) $ 33.18 $ 32.36 Churn rate(2) 6.7 % 5.8 % Total customers at end of period 4,653,000 4,968,000 Billed ARPU(1) $ 53.62 $ 50.97 Service revenue ARPU(1) $ 60.23 $ 57.52 Smartphones sold as a percent of total devices sold 72.8 % 64.0 % Total Population Consolidated markets(4) 54,817,000 84,025,000 Consolidated operating markets(4) 31,729,000 31,822,000 Market penetration at end of period Consolidated markets(5) 8.5 % 5.9 % Consolidated operating markets(5) 14.7 % 15.6 % Capital expenditures (000s) $ 233,508 $ 279,073 Total cell sites in service 6,183 6,113 Owned towers 3,892 3,846 19 -------------------------------------------------------------------------------- Table of Contents (1) ARPU metrics are calculated by dividing a revenue base by an average number of customers by the number of months in the period. These revenue bases and customer populations are shown below: a. Postpaid ARPU consists of total postpaid service revenues and postpaid customers. b. Prepaid ARPU consists of total prepaid service revenues and prepaid customers. c. Billed ARPU consists of total retail service or "billed" revenues (total postpaid, prepaid and reseller service revenues) and postpaid, prepaid and reseller customers. d. Service revenue ARPU consists of total retail service revenues, inbound roaming and other service revenues and postpaid, prepaid and reseller customers. (2) Churn metrics represent the percentage of the postpaid or prepaid customers that disconnect service each month. These metrics represent the average monthly postpaid or prepaid churn rate for each respective period. (3) Smartphones represent wireless devices which run on an Android, Apple, BlackBerry or Windows Mobile operating system, excluding tablets. Smartphone penetration is calculated by dividing postpaid smartphone customers by total postpaid customers. (4) The decrease in the population of Consolidated markets is due primarily to the divestiture of the Mississippi Valley non-operating license in October 2013 and the majority of the St. Louis area non-operating market license in March 2014. Total Population is used only to calculate market penetration of consolidated markets and consolidated operating markets, respectively. See footnote (5) below. (5) Market penetration is calculated by dividing the number of wireless customers at the end of the period by the total population of consolidated markets and consolidated operating markets, respectively, as estimated by Claritas. The increase in penetration is due primarily to a lower denominator as a result of the license divestitures described in footnote (4) above. 20 -------------------------------------------------------------------------------- Table of Contents Components of Operating Income Percentage Six Months Ended June 30, 2014 2013 Change Change (Dollars in thousands) Retail service $ 1,510,918 $ 1,686,399 $ (175,481) (10) % Inbound roaming 107,706 130,907 (23,201) (18) % Other 78,462 90,009 (11,547) (13) % Service revenues 1,697,086 1,907,315 (210,229) (11) % Equipment sales 186,498 169,561 16,937 10 % Total operating revenues 1,883,584 2,076,876 (193,292) (9) % System operations (excluding Depreciation, amortization and accretion reported below) 367,738 408,566 (40,828) (10) % Cost of equipment sold 542,452 458,761 83,691 18 % Selling, general and administrative 799,816 824,207 (24,391) (3) % Depreciation, amortization and accretion 316,090 392,425 (76,335) (19) % (Gain) loss on asset disposals, net 8,827 14,452 (5,625) (39) % (Gain) loss on sale of business and other exit costs, net (17,411) (242,093) 224,682 93 % (Gain) loss on license sales and exchanges (91,446) - (91,446) N/M Total operating expenses 1,926,066 1,856,318 69,748 4 % Operating income (loss) $ (42,482) $ 220,558 $ (263,040) >(100) % N/M - Not meaningful Operating Revenues Service revenues Service revenues consist primarily of: (i) charges for access, airtime, roaming, recovery of regulatory costs and value added services, including data products and services, provided to U.S. Cellular's retail customers and to end users through third party resellers ("retail service"); (ii) charges to other wireless carriers whose customers use U.S. Cellular's wireless systems when roaming; and (iii) amounts received from the Federal Universal Service Fund ("USF"). Retail service revenues Retail service revenues decreased by $175.5 million, or 10%, in 2014 to $1,510.9 million due to a decrease in U.S. Cellular's average customer base (including the reductions caused by the Divestiture Transaction and NY1 & NY2 Deconsolidation) partially offset by an increase in billed ARPU. Billed ARPU increased to $53.62 in 2014 from $51.15 in 2013. This overall increase is due primarily to an increase in postpaid ARPU to $57.18 in 2014 from $54.80 in 2013, reflecting increases in smartphone adoption and corresponding revenues from data products and services. U.S. Cellular expects continued pressure on retail service revenues in the foreseeable future due to industry competition for customers and related effects on pricing of service plan offerings offset to some degree by continued adoption of smartphones and data usage. In addition, beginning in the second quarter of 2014, U.S. Cellular expanded its offerings of equipment installment plans. To the extent that customers adopt these plans, U.S. Cellular expects an increase in equipment sales revenues. In addition, certain of the equipment installment plans provide the customer with a reduction in the monthly access charge for the device; thus, to the extent that existing customers adopt such plans, U.S. Cellular expects a reduction in retail service revenues and ARPU. Inbound roaming revenues Inbound roaming revenues decreased by $23.2 million, or 18%, in 2014 to $107.7 million. The decrease was due primarily to a $17.6 million impact related to the Divestiture Transaction and NY1 & NY2 Deconsolidation. The remaining decrease in the Core Markets was due to a decrease in rates and a decline in voice volume, partially offset by higher data usage. 21 -------------------------------------------------------------------------------- Table of Contents Other revenues Other revenues decreased by $11.5 million, or 13%, in 2014 compared to 2013, due primarily to a $14.2 million decrease in eligible telecommunications carriers ("ETC") support. Pursuant to the FCC's Reform Order ("Reform Order"), U.S. Cellular's current ETC support is being phased down at the rate of 20% per year beginning July 1, 2012. The Phase II Mobility Fund was not operational by July 2014. Therefore, as provided by the Reform Order, the phase down is currently suspended and U.S. Cellular will continue to receive 60% of its baseline support until the Phase II Mobility Fund is operational. At this time, U.S. Cellular cannot predict the net effect of the FCC's changes to the USF high cost support program in the Reform Order. Accordingly, U.S. Cellular cannot predict whether such changes will have a material adverse effect on U.S. Cellular's business, financial condition or results of operations. Equipment sales revenues Equipment sales revenues include revenues from sales of wireless devices and related accessories to both new and existing customers, as well as revenues from sales of devices and accessories to agents. All Equipment sales revenues are recorded net of rebates. U.S. Cellular offers a competitive line of quality wireless devices to both new and existing customers. U.S. Cellular's customer acquisition and retention efforts include offering new wireless devices to customers at discounted prices; in addition, customers on currently offered rate plans receive loyalty reward points that may be used to purchase a new wireless device or accelerate the timing of a customer's eligibility for a wireless device upgrade at promotional pricing. U.S. Cellular also continues to sell wireless devices to agents including national retailers; this practice enables U.S. Cellular to provide better control over the quality of wireless devices sold to its customers, establish roaming preferences and earn quantity discounts from wireless device manufacturers which are passed along to agents and other retailers. Beginning in the second quarter of 2014, U.S. Cellular expanded its offerings of equipment installment plans. To the extent that customers adopt these plans, U.S. Cellular expects an increase in equipment sales revenues. In addition, certain of the equipment installment plans provide the customer with a reduction in the monthly access charge for the device; thus, to the extent that existing customers adopt such plans, U.S. Cellular expects a reduction in retail service revenues and ARPU. Equipment sales revenues increased $16.9 million, or 10%, in 2014 to $186.5 million. In the Core Markets, equipment sales revenues increased by $24.6 million due primarily to an increase in average revenue per device sold (including the impact of sales under equipment installment plans), partially offset by the sale of fewer devices, primarily in the feature phone category. The increase in equipment sales revenues in the Core Markets was partially offset by the effects of the Divestiture Transaction and the NY1 & NY2 Deconsolidation. Operating Expenses System operations expenses (excluding Depreciation, amortization and accretion) System operations expenses (excluding Depreciation, amortization, and accretion) include charges from telecommunications service providers for U.S. Cellular's customers' use of their facilities, costs related to local interconnection to the wireline network, charges for cell site rent and maintenance of U.S. Cellular's network, long-distance charges, outbound roaming expenses and payments to thirdparty data product and platform developers. System operations expenses decreased $40.8 million, or 10%, to $367.7 million. Key components of the net changes in System operations expense were as follows: † Customer usage expenses decreased by $24.4 million, or 19%, driven by impacts of the Divestiture Transaction and NY1 & NY2 Deconsolidation and decreases in network costs due to lower rates for long distance usage and lower fees for platform and content providers. † Maintenance, utility and cell site expenses decreased $13.2 million, or 7%, driven primarily by impacts of the Divestiture Transaction and NY1 & NY2 Deconsolidation and lower headcount, partially offset by costs related to 4G LTE support. † Expenses incurred when U.S. Cellular's customers used other carriers' networks while roaming decreased $3.2 million, or 4%, due primarily to the Divestiture Transaction and NY1 & NY2 Deconsolidation, lower voice usage and lower rates, offset by higher data roaming usage in the Core Markets. 22 -------------------------------------------------------------------------------- Table of Contents U.S. Cellular expects system operations expenses to increase in the future to support the continued growth in cell sites and other network facilities as it continues to add capacity, enhance quality and deploy new technologies as well as to support increases in total customer usage, particularly data usage. However, these increases are expected to be offset to some extent by cost savings generated by shifting data traffic to the more efficient 4G LTE network from the 3G network. Cost of equipment sold Cost of equipment sold increased by $83.7 million, or 18%, in 2014 to $542.5 million. The increase was driven by a 36% increase in the average cost per device sold, which more than offset the impact of selling fewer devices. Average cost per device sold increased due to general customer preference for higher-priced 4G LTE smartphones. Smartphones sold as a percentage of total devices sold were 73% and 64% in 2014 and 2013, respectively. The total number of devices sold decreased by 11%, partially due to the Divestiture Transaction. U.S. Cellular's loss on equipment, defined as equipment sales revenues less cost of equipment sold, was $356.0 million and $289.2 million for 2014 and 2013, respectively. U.S. Cellular expects loss on equipment to continue to be a significant cost in the foreseeable future as wireless carriers continue to use device availability and pricing as a means of competitive differentiation. In addition, U.S. Cellular expects increasing sales of data centric wireless devices to result in higher equipment subsidies over time; these devices generally have higher purchase costs which cannot be recovered through proportionately higher selling prices to customers under the standard contract/subsidy model the industry has operated with for many years. However, U.S. Cellular expects the introduction of the equipment installment plans to offset the increases in loss on equipment to some degree. Selling, general and administrative expenses Selling, general and administrative expenses include salaries, commissions and expenses of field sales and retail personnel and facilities; telesales department salaries and expenses; agent commissions and related expenses; corporate marketing and merchandise management; and advertising expenses. Selling, general and administrative expenses also include bad debts expense, costs of operating customer care centers and corporate expenses. Key components of the $24.4 million, or 3%, decrease to $799.8 million were as follows: † Selling and marketing expense decreased by $7.0 million, or 2%, due primarily to the effects of the Divestiture Transaction and NY1 & NY2 Deconsolidation, offset by increases in advertising and commissions expenses. † General and administrative expense decreased by $17.4 million, or 4%, due primarily to the Divestiture Transaction and NY1 & NY2 Deconsolidation and lower consulting expenses related to the billing system conversion in the prior year, offset by an increase in bad debts expense. Depreciation, amortization and accretion Depreciation, amortization and accretion decreased $76.3 million, or 19%, in 2014 to $316.1 million due primarily to the higher amount of accelerated depreciation, amortization and accretion in the Divestiture Markets that occurred in 2013. The impact of the acceleration was $13.1 million in 2014 compared to $88.3 million in 2013. The accelerated depreciation, amortization and accretion in the Divestiture Markets was completed in the first quarter of 2014. (Gain) loss on asset disposals, net (Gain) loss on asset disposals, net was a loss in both 2014 and 2013 due primarily to the write-off and disposals of certain network assets. (Gain) loss on sale of business and other exit costs, net The net gain in both 2014 and 2013 resulted from the Divestiture Transaction. See Note 5 - Acquisitions, Divestitures and Exchanges in the Notes to Consolidated Financial Statements for additional information. (Gain) loss on license sales and exchanges The net gain in 2014 resulted from the sale of the St. Louis area non-operating market license and the license exchange in Milwaukee. See Note 5 - Acquisitions, Divestitures and Exchanges in the Notes to Consolidated Financial Statements for additional information. 23 -------------------------------------------------------------------------------- Table of Contents Components of Other Income (Expense) Percentage Six Months Ended June 30, 2014 2013 Change Change (Dollars in thousands, except per share amounts) Operating income (loss) $ (42,482) $ 220,558 $ (263,040) >(100) % Equity in earnings of unconsolidated entities 70,195 62,437 7,758 12 % Interest and dividend income 2,457 1,872 585 31 % Gain (loss) on investments - 18,527 (18,527) N/M Interest expense (29,198) (21,064) (8,134) (39) % Other, net 186 106 80 75 % Total investment and other income 43,640 61,878 (18,238) (29) % Income before income taxes 1,158 282,436 (281,278) (100) % Income tax expense 2,205 128,051 (125,846) (98) % Net income (1,047) 154,385 (155,432) >(100) % Less: Net income (loss) attributable to noncontrolling interests, net of tax (1,740) 6,080 (7,820) >(100) % Net income attributable to U.S. Cellular shareholders $ 693 $ 148,305 $ (147,612) (100) % Basic earnings per share attributable to U.S. Cellular shareholders $ 0.01 $ 1.77 $ (1.76) (99) % Diluted earnings per share attributable to U.S. Cellular shareholders $ 0.01 $ 1.75 $ (1.74) (99) % N/M - Not meaningful Equity in earnings of unconsolidated entities U.S. Cellular's investment in the Los Angeles SMSA Limited Partnership ("LA Partnership") contributed $39.6 million and $40.4 million to Equity in earnings of unconsolidated entities in 2014 and 2013, respectively. On April 3, 2013, U.S. Cellular deconsolidated the NY1 & NY2 Partnerships and began reporting them as equity method investments in its consolidated financial statements as of that date. Equity in earnings of the NY1 & NY2 Partnerships was $13.7 million and $8.6 million in 2014 and 2013, respectively. See Note 7 - Investments in Unconsolidated Entities in the Notes to Consolidated Financial Statements for additional information. Gain (loss) on investments In 2013, in connection with the deconsolidation of the NY1 & NY2 Partnerships, U.S. Cellular recognized a non-cash pre-tax gain of $18.5 million. Interest expense The increase in interest expense was due primarily to a decrease in capitalized interest related to network and systems projects. Interest cost capitalized was $2.0 million and $10.2 million for 2014 and 2013, respectively. Income tax expense See Note 3 - Income Taxes in the Notes to Consolidated Financial Statements for a discussion of the overall effective tax rate on Income before income taxes. Net income (loss) attributable to noncontrolling interests, net of tax The decrease from 2013 to 2014 is due primarily to the elimination of the noncontrolling interest as a result of the NY1 & NY2 Deconsolidation on April 3, 2013. 24 -------------------------------------------------------------------------------- Table of Contents Three Months Ended June 30, 2014 Compared to Three Months Ended June 30, 2013 Components of Operating Income (Loss) Three Months Ended June 30, 2014 2013 Change Percentage Change (Dollars in thousands) Retail service $ 746,117 $ 802,408 $ (56,291) (7 )% Inbound roaming 57,580 65,033 (7,453) (11 )% Other 39,776 43,525 (3,749) (9 )% Service revenues 843,473 910,966 (67,493) (7 )% Equipment sales 114,300 84,164 30,136 36 % Total operating revenues 957,773 995,130 (37,357) (4 )% System operations (excluding Depreciation, amortization and accretion reported below) 187,131 192,267 (5,136) (3 )% Cost of equipment sold 271,978 217,070 54,908 25 % Selling, general and administrative 404,252 404,127 125 - Depreciation, amortization and accretion 148,337 202,580 (54,243) (27 )% (Gain) loss on asset disposals, net 6,893 9,018 (2,125) (24 )% (Gain) loss on sale of business and other exit costs, net (10,511) (249,024) 238,513 96 % Total operating expenses 1,008,080 776,038 232,042 30 % Operating income (loss) $ (50,307) $ 219,092 $ (269,399) >(100 )% Operating Revenues Retail service revenues Retail service revenues decreased $56.3 million, or 7%, to $746.1 million in 2014 due primarily to a decrease in U.S. Cellular's average customer base (including the reductions caused by the Divestiture Transaction) partially offset by an increase in billed ARPU. Billed ARPU increased to $53.36 in 2014 compared to $50.60 in 2013. The overall increase is due primarily to an increase in postpaid ARPU to $56.82 in 2014 from $54.18 in 2013, reflecting increases in smartphone adoption and corresponding revenues from data products and services. Inbound roaming revenues Inbound roaming revenues decreased by $7.5 million, or 11%, to $57.6 million in 2014 compared to 2013. The decrease was due in part to a $3.4 million impact related to the Divestiture Transaction. The remaining decrease in the Core Markets was due to a decrease in rates and a decline in voice volume, partially offset by higher data usage. Other revenues Other revenues decreased by $3.7 million, or 9%, to $39.8 million, due primarily to a $6.4 million decrease in ETC revenues. ETC revenues decreased due to the phase down of USF support as described in Results of Operations - U.S. Cellular for the six months ended June 30, 2014. Equipment sales revenues Equipment sales revenues increased by $30.1 million, or 36%, in 2014 to $114.3 million. The increase was due primarily to activity in the Core Markets, which reflected an increase in the average revenue per device sold (including the impact of sales under equipment installment plans), partially offset by the sale of fewer devices, primarily in the feature phone category. The increase in equipment sales revenues in the Core Markets was partially offset by the effects of the Divestiture Transaction. 25 -------------------------------------------------------------------------------- Table of Contents Operating Expenses System operations expenses (excluding Depreciation, amortization and accretion) Key components of the $5.1 million, or 3%, decrease to $187.1 million were as follows: † Customer usage expense decreased $6.8 million, or 11%, driven by the impacts of the Divestiture Transaction and lower fees for platform and content providers. † Maintenance, utility and cell site expenses decreased $1.1 million, or 1%, due primarily to the impacts of the Divestiture Transaction and lower headcount, partially offset by costs related to 4G LTE support. † Expenses incurred when U.S. Cellular's customers used other carriers' networks while roaming increased $2.7 million, or 7%, due primarily to an increase in data usage, partially offset by a decrease in voice usage, lower rates, and the impacts of the Divestiture Transaction. Cost of equipment sold Cost of equipment sold increased by $54.9 million, or 25%, to $272.0 million in 2014 due primarily to an increase of 34% in the average cost per device sold due to general customer preference for higher-priced 4G LTE smartphones. The increase in average cost per device sold was partially offset by fewer device sales in the Core Markets and impacts of the Divestiture Transaction. Selling, general and administrative expenses Selling, general and administrative expenses were essentially flat year over year. Key components of Selling, general and administrative expenses were as follows: † Selling and marketing expense increased by $2.5 million, or 1%, due primarily to an increase in commission and personnel expenses, partially offset by the effects of the Divestiture Transaction. † General and administrative expense decreased by $2.4 million, or 1%, due primarily to the Divestiture Transaction and lower consulting expenses related to the billing system conversion in the prior year, offset by an increase in bad debts expense. Depreciation, amortization and accretion Depreciation, amortization and accretion decreased $54.2 million, or 27%, in 2014 to $148.3 million due primarily to the higher amount of accelerated depreciation, amortization and accretion in the Divestiture Markets that occurred in 2013. The impact of the acceleration was $50.3 million in 2013. (Gain) loss on asset disposals, net (Gain) loss on asset disposals, net was a loss in both 2014 and 2013 due primarily to the write-off and disposals of certain network assets. (Gain) loss on sale of business and other exit costs, net The net gain in both 2014 and 2013 resulted from the Divestiture Transaction. See Note 5 - Acquisitions, Divestitures and Exchanges in the Notes to Consolidated Financial Statements for additional information. 26 -------------------------------------------------------------------------------- Table of Contents Components of Other Income (Expense) Percentage Three Months Ended June 30, 2014 2013 Change Change (Dollars in thousands, except per share amounts) Operating income (loss) $ (50,307) $ 219,092 $ (269,399) >(100 )% Equity in earnings from unconsolidated entities 33,120 35,602 (2,482) (7 )% Interest and dividend income 1,573 969 604 62 % Gain (loss) on investments - 18,527 (18,527) N/M Interest expense (14,336) (10,154) (4,182) 41 % Other, net 100 321 (221) (69 )% Total investment and other income 20,457 45,265 (24,808) (55 )% Income (loss) before income taxes (29,850) 264,357 (294,207) >(100 )% Income tax expense (benefit) (10,399) 120,682 (131,081) >(100 )% Net income (loss) (19,451) 143,675 (163,126) >(100 )% Less: Net income (loss) attributable to noncontrolling interests, net of tax (662) 284 (946) >(100 )% Net income (loss) attributable to U.S. Cellular $ (18,789) $ 143,391 $ (162,180) >(100 )% Basic earnings (loss) per share attributable to U.S. Cellular shareholders $ (0.22) $ 1.71 $ (1.93) >(100 )% Diluted earnings (loss) per share attributable to U.S. Cellular shareholders $ (0.22) $ 1.69 $ (1.91) >(100 )% N/M - Not meaningful Equity in earnings of unconsolidated entities U.S. Cellular's investment in the LA Partnership contributed $18.4 million and $19.8 million to Equity in earnings of unconsolidated entities in 2014 and 2013, respectively. Interest expense The increase in interest expense was due primarily to a decrease in capitalized interest related to network and systems projects. Capitalized interest was $1.1 million and $5.5 million for 2014 and 2013, respectively. Net income (loss) attributable to noncontrolling interests, net of tax The decrease from 2013 to 2014 is due primarily to lower income in certain partnerships in 2014. Income tax expense (benefit) See Note 3 - Income Taxes in the Notes to Consolidated Financial Statements for a discussion of the change in income tax expense (benefit) and the overall effective tax rate on Income (loss) before income taxes. 27 -------------------------------------------------------------------------------- Table of Contents RECENT ACCOUNTING PRONOUNCEMENTS See Note 1 - Basis of Presentation in the Notes to Consolidated Financial Statements for information on recent accounting pronouncements. FINANCIAL RESOURCES U.S. Cellular operates a capital- and marketing-intensive business. U.S. Cellular utilizes cash on hand, cash from operating activities, cash proceeds from divestitures and disposition of investments, short-term credit facilities and long-term debt financing to fund its acquisitions (including licenses), construction costs, operating expenses and share repurchases. Cash flows may fluctuate from quarter to quarter and year to year due to seasonality, the timing of acquisitions, capital expenditures and other factors. The table below and the following discussion in this Financial Resources section summarize U.S. Cellular's cash flow activities for the six months ended June 30, 2014 and 2013. |