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WINDSTREAM CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Unless the context indicates otherwise, the terms "Windstream," "we," "us" or "our" refer to Windstream Holdings, Inc. and its subsidiaries, including Windstream Corporation, and the term "Windstream Corp." refers to Windstream Corporation and its subsidiaries. The following sections provide an overview of our results of operations and highlight key trends and uncertainties in our business. Certain statements constitute forward-looking statements. See "Forward-Looking Statements" at the end of this discussion for additional factors relating to such statements, and see "Risk Factors" in Item 1A of Part I of our Annual Report on Form 10-K for the year ended December 31, 2013, filed with the Securities and Exchange Commission ("SEC") on February 27, 2014, for a discussion of certain risk factors applicable to our business, financial condition and results of operations. ORGANIZATIONAL STRUCTURE Windstream Holdings, Inc. ("Windstream Holdings") is a publicly traded holding company and the parent of Windstream Corporation ("Windstream Corp."). Windstream Holdings common stock trades on the Nasdaq Global Select Market under the ticker symbol "WIN". All shares of Windstream Corp. common stock are held by Windstream Holdings and do not trade on any stock market. Windstream Corp. and its guarantor subsidiaries are the sole obligors of all outstanding debt obligations and, as a result also file periodic reports with the SEC. Windstream Holdings is not a guarantor of nor subject to the restrictive covenants included in any of Windstream Corp.'s debt agreements. There are no significant differences between the consolidated results of operations, financial condition, and cash flows of Windstream Holdings and those of Windstream Corp. other than for certain expenses directly incurred by Windstream Holdings principally consisting of audit, legal and board of director fees, Nasdaq listing fees, other shareholder-related costs, income taxes, common stock activity, and payables from Windstream Corp. to Windstream Holdings. For the three and nine month periods ended September 30, 2014, the amount of expenses directly incurred by Windstream Holdings were approximately $0.4 million and $2.0 million, respectively, on a pretax basis, or $0.2 million and $1.2 million on an after-tax basis. Unless otherwise indicated, the following discussion of our business strategy, trends and results of operations pertain to both Windstream Holdings and Windstream Corp. PROPOSED SPIN-OFF OF CERTAIN NETWORK AND REAL ESTATE ASSETS On July 29, 2014, we announced plans to spin off certain telecommunications network assets, including our fiber and copper networks and other real estate, into Communications Sales & Leasing, Inc. ("CS&L"), an independent, publicly traded real estate investment trust ("REIT"). The REIT will lease use of the assets initially to us through an exclusive long-term triple-net lease with an initial estimated rent payment of $650.0 million per year. We will continue to operate and maintain the assets in order to deliver advanced communications and technology services to consumers and businesses. We will also continue to have sole responsibility for meeting our existing regulatory obligations following the creation of the REIT. The REIT will focus on expanding and diversifying its assets and tenants through future acquisitions. We will also contribute our consumer competitive local exchange carrier ("CLEC") business to the REIT, which will continue to operate this business. Revenues from the consumer CLEC business were approximately $27.4 million for the nine month period ended September 30, 2014. The tax-free spin-off should enable Windstream to realize significant financial flexibility by lowering long-term debt by approximately $3.2 billion and potentially allow us to accelerate broadband investments, transition faster to an IP network or pursue additional growth opportunities to better serve customers. As part of this proposed transaction, shareholders will retain their existing Windstream shares and are expected to receive one share of the REIT for every four shares of Windstream common stock held as of the record date in the form of a tax-free dividend. We plan to maintain our current dividend practice through the close of the transaction. If the closing date of the spin-off is not on the record date of Windstream's normal quarterly dividend, we intend to pay a pro rata dividend to our shareholders based on the number of days elapsed in the quarter. We anticipate that the spin-off will occur in the first quarter of 2015. 46 -------------------------------------------------------------------------------- Table of Contents Following the close of the spin-off transaction, Windstream initially expects to pay an annual dividend of $.10 per share and CS&L initially expects to pay an annual dividend of $2.40 per share (which would be equivalent to a $.60 per share Windstream dividend per annum). Completion of the proposed spin-off is contingent on receipt of regulatory approvals, final approval from our board of directors, execution of all definitive agreements, and satisfaction of other customary conditions. No assurances can be given that such conditions will be satisfied or as to the timing of any regulatory action. We may, at any time and for any reason until the proposed transaction is complete, abandon the spin-off or modify or change the terms of the spin-off. See Note 13 to the unaudited consolidated financial statements for additional information regarding the proposed spin-off. OVERVIEW Our vision is to be the premier enterprise communications and services provider in the United States while maintaining our strong, stable consumer business. We provide advanced communications and technology solutions, including managed services and cloud computing, to businesses nationwide. In addition to business services, we offer broadband, voice and video services to consumers in primarily rural markets. We have operations in 48 states and the District of Columbia, a local and long-haul fiber network spanning approximately 118,000 miles, a robust business sales division and 27 data centers. STRATEGY Our business strategy is focused on maximizing growth opportunities with our enterprise business customers while optimizing our cost structure and maintaining the stability of our consumer business with the goal of generating solid and sustainable cash flows over the long-term to build shareholder value. In implementing our strategy, we continue to invest in capital initiatives designed to drive improvements in network performance and to enhance our ability to provide advanced solutions to our business customers and increase broadband speeds and capacity in our consumer markets. We continue to transition revenue streams away from traditional consumer voice services to our strategic growth areas of business services and consumer broadband. Business service and consumer broadband revenues were 72.8 percent of total revenues for both of the three and nine month periods ended September 30, 2014, as compared to 72.2 percent and 71.7 percent for the same periods in 2013. The diversification of our revenue streams is key to our success in accelerating revenue growth opportunities as we combat the effects of revenue declines from consumer customer losses and wholesale revenue declines due to intercarrier compensation reform. The expansion of our fiber transport network through capital investment has enhanced our ability to provide wireless transport, or backhaul services. As cellular customers consume more wireless data, wireless carriers need more bandwidth on the wireline transport network. We made significant investments during 2012 and 2013 to accommodate the wireless carriers' additional bandwidth needs, including fiber-to-the-tower deployments designed to increase capacity and replace copper facilities servicing wireless towers. We expect wireless data usage to continue to increase, which will drive the need for additional wireless backhaul [[Image Removed]] capacity. On the consumer front, we are continuing to make investments to increase broadband speeds and capacity throughout our territories. Although new customer growth is slowing as the market becomes more heavily penetrated, we expect increases in real-time streaming video and traditional Internet usage to motivate customers to upgrade to faster broadband speeds with a higher price. Our consumer business remains under pressure due to competition from wireless carriers, cable television companies and other companies using emerging technologies. 47 -------------------------------------------------------------------------------- We believe that we are well positioned to grow our business by investing in our network, offering advanced products and solutions, targeting business customers and controlling costs through our disciplined approach to capital and expense management. In leveraging these strengths, we expect to continue to create significant value for both our customers and our shareholders. Dividend One way in which we create shareholder value is through the payment of dividends on our common stock. Since our formation as a public company in 2006, our current dividend practice is to pay a quarterly dividend of $0.25 per common share or $1 per common share on an annual basis. As previously discussed, in connection with the proposed spin-off and formation of the REIT, we expect to lower our annual dividend from $1 per common share to $.10 per share. If the completion of the proposed spin-off does not occur on the record date of Windstream's normal quarterly dividend, we intend to pay a pro rata dividend to our shareholders based on the number of days elapsed in the quarter. Our dividend practice can be changed at any time at the discretion of our board of directors. Accordingly, we cannot assure you we will continue paying dividends at the current rate or the post-spin adjusted rate. See "Risk Factors" in Item 1A of Part I of our Annual Report on Form 10-K for the year ended December 31, 2013, for additional information. EXECUTIVE SUMMARY Key activities during the nine month period ended September 30, 2014, included: • continued focus on revenue growth opportunities in our business service and consumer broadband areas, including implementation of targeted price increases; • implemented new initiatives to enhance business sales and productivity and launched an expanded advertising campaign to increase brand awareness and highlight our integrated solutions and customized service; and • continued focus on operational efficiency and cost management strategies. Each of these initiatives reflected our ongoing efforts to become the premier enterprise communications and services provider. BUSINESS TRENDS The following discussion highlights key trends affecting our business: Business communications services: Demand for advanced communications services is expected to drive growth in revenues from business customers. To meet this demand, we continue to expand our capabilities in integrated voice and data services, which deliver voice and broadband services over a single Internet connection. We also offer multi-site networking services which provide a fast and private connection between business locations as well as a variety of other data services. We leverage our national network to offer more complex and customized solutions to our customers. While offering sales growth opportunities, the shift to more complex solutions requiring additional customization can lead to longer installation times. We view this as a strategic growth area, but we are subject to competition from other carriers and cable companies, which could suppress growth and result in lower operating margins. Business locations decreased 31,800, or 5.2 percent, during the twelve month period ended September 30, 2014 primarily due to business closures and competition. We combat competition by offering personalized service to our business customers through advanced customized solutions, an integrated sales approach, and dedicated representatives. See "Competition" in Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2013, filed with the SEC on February 27, 2014, for more details. Data center services: Many businesses are moving towards cloud computing and managed services as an alternative to a traditional information technology ("IT") infrastructure. Our data centers are capable of delivering those services, and we are actively investing in data center expansion in order to meet the growing demand for these types of services. In addition to cloud computing and managed services, our data centers offer colocation services, in which we provide a safe, secure environment for storage of servers and networking equipment. 48 -------------------------------------------------------------------------------- Carrier access: As wireless data usage grows, wireless carriers need additional bandwidth on the wireline network to accommodate the additional wireless traffic. We have made significant success-based capital investments to provide backhaul services to wireless carriers. These investments include building out fiber to new wireless towers and replacing copper facilities with fiber facilities to wireless towers we already serve. We will continue to make success-based capital investments to offer additional wireless backhaul services to wireless carriers; however, these investments have decreased substantially during 2014 as we have reached the vast majority of existing towers within our targeted area. In the near term, carrier access revenues will be adversely impacted by declining demand for dedicated copper-based circuits, as wireless carriers continue to migrate traffic to fiber-based connections. Consumer high-speed Internet: As of September 30, 2014, we provided high-speed Internet service to approximately 74 percent of primary residential lines in service. The number of high-speed Internet customers we serve will continue to be impacted by the effects of competition from other service providers and increased penetration in the marketplace as the number of households without high-speed Internet service continues to shrink. As a result, consumer high-speed Internet connections decreased 41,400, or 3.5 percent during the twelve month period ended September 30, 2014. To offset the effects of competition, we believe growing customer demand for faster speeds and value-added services, such as online security and back-up, will drive growth in consumer high-speed Internet revenues. We continue to focus on increasing our broadband speeds available to customers. As of September 30, 2014, we could deliver speeds up to 3 Megabits per second ("Mbps") to approximately 99 percent of our addressable lines, and speeds of up to 6 Mbps, 12 Mbps, and 24 Mbps are available to approximately 79 percent, 53 percent, and 18 percent of our addressable lines, respectively. Consumer voice line losses: Voice and switched access revenues will continue to be adversely impacted by future declines in voice lines due to competition from cable companies, wireless carriers and providers using other emerging technologies. To combat competitive pressures, we continue to emphasize our bundled products and services. Our consumers can bundle voice, high-speed Internet and video services, providing one convenient billing solution and multi-service discounts. We believe that product bundles positively impact customer retention, and the associated discounts provide our customers the best value for their communications and entertainment needs. As of September 30, 2014, all of our voice lines had wireless competition and approximately 70 percent of our voice lines had fixed-line voice competition. Consumer voice lines decreased 112,200, or 6.4 percent during the twelve month period ended September 30, 2014, primarily due to the effects of competition. Synergies and operational efficiencies: To secure our bottom line against evolving revenue streams and a shift in our revenue mix that has resulted in a higher proportion of lower margin revenues, we are committed to aggressive cost management strategies that emphasize operational efficiencies. During the nine month period ended September 30, 2014, we completed a workforce reduction to increase operational efficiency by eliminating approximately 400 positions, including 175 resulting from a voluntary separation initiative. We anticipate annualized savings of approximately $20.0 million as a result. For the duration of 2014, we will remain focused on improvements in our cost structure through network grooming and continued declines in the cost of providing services resulting from operational efficiencies and billing system conversions that will further reduce costs. 49 --------------------------------------------------------------------------------ORGANIZATION AND RESULTS OF OPERATIONS We provide a wide range of telecommunication services, from advanced data solutions for businesses to basic voice services. Our sales, marketing and customer support teams are structured based upon the type of customer they serve. We deliver these services over owned or leased network facilities. Our corporate support teams, such as finance and accounting, human resources and legal, support our operations as a whole. The following table reflects the consolidated operating results of Windstream Holdings as of: Three Months Ended Nine Months Ended September 30, September 30, (Millions) (a) 2014 2013 2014 2013 Revenues and sales: Service revenues: Business $ 902.4 $ 917.6 $ 2,716.2 $ 2,747.7 Consumer 321.3 322.3 951.1 975.0 Wholesale 131.5 147.8 414.2 450.4 Other 54.4 55.1 165.5 166.4 Total service revenues 1,409.6 1,442.8 4,247.0 4,339.5 Product sales 45.9 55.7 139.4 157.2 Total revenues and sales 1,455.5 1,498.5 4,386.4 4,496.7 Costs and expenses: Cost of services (exclusive of depreciation and amortization included below) 670.9 644.8 1,967.8 1,932.6 Cost of products sold 39.0 46.2 120.1 138.2 Selling, general and administrative 231.9 243.1 734.7 717.6 Depreciation and amortization 348.5 338.2 1,031.4 999.7 Merger and integration costs 10.0 5.8 26.0 17.8 Restructuring charges 3.6 0.8 19.8 8.3 Total costs and expenses 1,303.9 1,278.9 3,899.8 3,814.2 Operating income 151.6 219.6 486.6 682.5 Other (expense) income, net (0.1 ) (5.6 ) 0.1 (5.0 ) Loss on early extinguishment of debt - (14.7 ) - (28.5 ) Interest expense (143.4 ) (148.8 ) (427.8 ) (479.7 ) Income from continuing operations before income taxes 8.1 50.5 58.9 169.3 Income taxes 0.1 19.9 20.9 47.4 Income from continuing operations 8.0 30.6 38.0 121.9 Discontinued operations - - - 0.7 Net income $ 8.0 $ 30.6 $ 38.0 $ 122.6 (a) Certain prior year amounts have been reclassified to conform to the current year financial statement presentation. These reclassifications did not impact net income or comprehensive income. 50 -------------------------------------------------------------------------------- The following table reflects the consolidated operating metrics of Windstream Holdings as of September 30: (Thousands) 2014 2013 Business Operating Metrics: Customer locations Enterprise 216.3 208.8 Small business 364.4 403.7 Total customer locations (a) 580.7 612.5 Total business customers 357.7 393.9 Carrier special access circuits 84.3 101.5 Consumer Operating Metrics: Voice lines 1,640.5 1,752.7 High-speed Internet 1,142.0 1,183.4 Digital television customers 389.9 409.5 Total consumer connections 3,172.4 3,345.6 (a) Business customer locations include each individual customer location to which we provide service and exclude carrier special access circuits. Business customer locations are segmented between Enterprise locations which represent customer relationships that generate $750 or more in revenue per month and Small business locations which represent customer relationships that generate less than $750 in revenue per month. A detailed discussion and analysis of our consolidated operating results is presented below. Business Service Revenues Business service revenues include revenues from integrated voice and data services, advanced data and traditional voice and long-distance services provided to enterprise and small business customers. Business services also include revenues from other carriers for special access circuits and fiber connections. We expect business service revenues to be favorably impacted by increasing demand for integrated data and voice services, multi-site networking and data center services. As wireless data usage grows and fourth generation ("4G") networks are expanded, we expect to provide special access services to support the capacity needs of wireless carriers. Fiber-to-the-tower initiatives are designed to accommodate network capacity requirements for wireless carriers as a result of growing wireless data usage. In the near term, carrier access revenues will be adversely impacted by declining demand for dedicated copper-based circuits, as wireless carriers continue to migrate traffic to fiber-based connections. We experience competition in the business channel primarily from other carriers, including traditional telephone companies and competitive providers. Cable companies are also a source of competition, primarily for small business customers, but have begun to compete for larger customers by expanding their product and sales capabilities. For the three and nine month periods ended September 30, 2014, business locations decreased by approximately 5,300 and 25,000, respectively, compared to decreases of 8,100 and 22,800 for the same periods in 2013. Our growth in enterprise customer locations is outpaced by losses in small business customer locations, primarily due to business closures and competition from cable companies. However, our enterprise locations are growing strategic revenue through sales of integrated voice and data services, data center and managed services, and advanced data services such as multi-site networking. While opportunities for growth from business services continue, competition as well as general economic conditions may impact future revenue growth. In addition, traditional business voice and long-distance service revenues continue to decline due to competition and migration to more advanced integrated voice and data services. 51 -------------------------------------------------------------------------------- The following table reflects the primary drivers of year-over-year changes in business service revenues: Three Months Ended Nine Months Ended September 30, 2014 September 30, 2014 Increase Increase (Millions) (Decrease) % (Decrease) % Due to increases in data and integrated services and high speed Internet revenues (a) $ 11.0 $ 26.2 Due to increases in data center and managed services revenues (b) 5.6 16.3 Due to decreases in traditional voice, long distance and miscellaneous revenues (c) (14.2 ) (40.7 ) Due to decreases in carrier revenues (d) (17.6 ) (33.3 ) Net decreases in business revenues $ (15.2 ) (2 )% $ (31.5 ) (1 )% (a) Increases in data and integrated services revenues were primarily due to continued demand for advanced data services and customer migration to our integrated voice and data services, previously discussed. (b) Increases in data center and managed services revenues; which include cloud computing, colocation, dedicated server and disaster recovery solutions for business customers; reflected increased demand and incremental sales of these services. In order to support the higher demand, we have added four data centers since the first quarter of 2013. (c) Decreases in traditional voice and long-distance service revenues were primarily attributable to lower usage, adverse effects of competition and the migration of existing customers to integrated services and bundled offerings. These declines were partially offset by incremental revenues attributable to the access recovery charge ("ARC") of $4.3 million and $14.6 million in the three and nine month periods ended September 30, 2014, respectively, primarily due to an increase in the monthly rate effective July 1st of each year. The ARC is a monthly charge established by the FCC designed to mitigate revenue reductions from intercarrier compensation reform. (d) Carrier revenues primarily consist of monthly recurring charges for dedicated circuits and fiber-to-the-tower connections. The decreases in these revenues were attributable to a decline in special access charges for dedicated copper-based circuits as carriers accelerate migration to fiber-based networks, partially offset by incremental revenues derived from our fiber-to-the-tower connections, previously discussed. Consumer Service Revenues Consumer service revenues are generated from the provision of high-speed Internet, voice and video services to consumers. We expect the trend of consumer voice line loss to continue as a result of competition from wireless carriers, cable companies and other providers using emerging technologies. For the three and nine month periods ended September 30, 2014, consumer voice lines decreased by approximately 29,800 and 81,800, respectively, compared to decreases of 30,600 and 89,200 for the same periods in 2013. Demand for faster broadband speeds and Internet-related services, such as virus protection and online data backup services, are expected to favorably impact consumer high-speed Internet revenues, offsetting some of the decline in consumer voice revenues due to competition. For the three and nine month periods ended September 30, 2014, consumer high-speed Internet customers decreased by approximately 11,800 and 28,900, respectively, compared to decreases of 11,100 and 31,200 for the same periods in 2013. As of September 30, 2014, we provided high-speed Internet service to approximately 74 percent of primary residential lines in service and approximately 77 percent of our total voice lines had high-speed Internet competition, primarily from cable service providers. We do not expect significant additional cable expansions into our service areas during 2014, but we could experience some increased competition from high-speed Internet offerings of wireless competitors. The number of high-speed Internet customers we serve will continue to be impacted by the effects of competition from other service providers and increased penetration in the marketplace as the number of households without high-speed Internet service continues to shrink. To combat competitive pressures in our markets, we emphasize our bundled service strategy and enhancements to our network to offer faster Internet speeds. Service bundles provide discounts and other incentives for customers to bundle their voice, long distance, high-speed Internet and video services. 52 -------------------------------------------------------------------------------- The following table reflects the primary drivers of year-over-year changes in consumer service revenues: Three Months Ended Nine Months Ended September 30, 2014 September 30, 2014 Increase Increase (Millions) (Decrease) % (Decrease) % Due to increases in high-speed Internet revenues (a) $ 1.7 $ 4.7 Due to decreases in voice, long distance and miscellaneous revenues (b) (2.7 ) (28.6 ) Net decreases in consumer revenues $ (1.0 ) - % $ (23.9 ) (2 )% (a) Increases in high-speed Internet revenues were primarily due to the continued migration of customers to higher speeds, increased sales of value added services and targeted price increases, partially offset by a decline in high-speed Internet customers, as previously discussed. (b) Decreases in voice service revenues were primarily attributable to the decline in voice lines, partially offset by the affects of targeted price increases. Wholesale Service Revenues Wholesale service revenues include switched access revenues, federal Universal Service Fund ("USF") revenues and voice and data services sold to other carriers on a wholesale basis. Switched access revenues include usage sensitive revenues from long distance companies and other carriers for access to our network in connection with the completion of long distance calls, as well as reciprocal compensation received from wireless and other local connecting carriers for the use of our network facilities. USF revenues are government subsidies designed to partially offset the cost of providing wireline services in high-cost areas, as further discussed in the "Regulatory Matters" section. In addition, we offer voice and data services on a wholesale basis to other carriers. Revenues from these services are expected to decline due to voice line losses and continued reductions in switched access rates. However, we expect these declines to have less of an impact in 2014 due to the previous implementation of the majority of intercarrier compensation reform rate reductions. The following table reflects the primary drivers of year-over-year changes in wholesale service revenues: Three Months Ended Nine Months Ended September 30, 2014 September 30, 2014 Increase Increase (Millions) (Decrease) % (Decrease) % Due to increases in voice, long distance and other revenues (a) $ 2.8 $ 1.1 Due to decreases in state USF revenues (0.6 ) (2.2 ) Due to changes in federal USF revenues (b) (5.5 ) 1.2 Due to decreases in switched access revenues (c) (13.0 ) (36.3 ) Net decreases in wholesale revenues $ (16.3 ) (11 )% $ (36.2 ) (8 )% (a) Increases in voice, long distance and other revenues were primarily due to increased minutes of usage. (b) Federal USF revenues primarily consist of revenues attributable to the access recovery mechanism ("ARM") and frozen USF support. The ARM is additional federal universal service support available to help mitigate revenue losses from intercarrier compensation reform not covered by the ARC, previously discussed. The decline in the three months ended September 30, 2014 is mostly attributable to a decrease in the ARM monthly rate effective July 1, 2014. (c) Decreases in switched access revenues were primarily due to the impact of intercarrier compensation reform and a continued decline in network demand. As previously discussed, the ARC and ARM are designed to help mitigate the revenue losses resulting from intercarrier compensation reform. 53 --------------------------------------------------------------------------------Other Service Revenues Other service revenues include USF surcharge revenues, revenues from other miscellaneous services and consumer revenues generated in markets where we lease the connection to the customer premise. We no longer offer new consumer service in those areas. As a result, we expect other service revenues to decline as existing customers disconnect. As previously discussed, we expect to transfer this business to the REIT in connection with the proposed spin-off of certain network and real estate assets. Other service revenues decreased $0.7 million, or 1 percent, and $0.9 million, or less than 1 percent in the three and nine month periods ended September 30, 2014, respectively, compared to the same periods in 2013. Product Sales Product sales consist of sales of various types of communications equipment to our customers. Business product sales includes high-end data and communications equipment which facilitate the delivery of advanced data and voice services to our business customers. Consumer product sales include high-speed Internet modems, home networking equipment, computers and phones. We also sell network equipment to contractors on a wholesale basis. The following table reflects the primary drivers of year-over-year changes in product sales: Three Months Ended Nine Months Ended September 30, 2014 September 30, 2014 Increase Increase (Millions) (Decrease) % (Decrease) % Due to changes in consumer product sales $ (0.2 ) $ 4.2 Due to decreases in contractor sales (1.4 ) (11.4 ) Due to decreases in business product sales (8.2 ) (10.6 ) Net decreases in product sales $ (9.8 ) (18 )% $ (17.8 ) (11 )% Cost of Services Cost of services expense primarily consists of charges incurred for network operations, interconnection, bad debt and business taxes. Network operations charges include salaries and wages, materials, contractor costs, IT support and costs to lease certain network facilities. Interconnection consists of charges incurred to access the public switched network and transport traffic to the Internet, including charges paid to other carriers for access points where we do not own the primary network infrastructure. Other expense consists of third-party costs for ancillary voice and data services, business and financial services, bad debt and business taxes. The following table reflects the primary drivers of year-over-year changes in cost of services: Three Months Ended Nine Months Ended September 30, 2014 September 30, 2014 Increase Increase (Millions) (Decrease) % (Decrease) % Due to changes in interconnection expense (a) $ 8.0 $ (1.2 ) Due to increases in network operations (b) 6.7 16.2 Due to increases in postretirement and pension (c) 5.5 22.1 Due to changes in other expense 3.2 (15.7 ) Due to increases in Federal USF expenses (d) 2.7 13.8 Net increases in cost of services $ 26.1 4 % $ 35.2 2 % (a) Increase in interconnection expense during the three month period ended September 30, 2014 was attributable to increased purchases of circuits due to the growth in data customers, as well as higher capacity circuits to service existing customers and increase the transport capacity of our network, partially offset by the favorable impact of network efficiency projects, rate reductions, and lower long distance usage by our customers. (b) Increases in network operations were primarily due to adding new data centers and increasing capacity at existing data center locations. 54 -------------------------------------------------------------------------------- (c) Increases in postretirement and pension expense primarily resulted from the difference in the amount of curtailment gains recognized during the first quarter of 2014 and the three and nine month periods ended September 30, 2013 related to the elimination of medical and prescription subsidies for certain active employees. These curtailment gains reduced cost of services by $5.1 million in the nine month period ended September 30, 2014 compared to reductions of $4.5 million and $24.1 million in the three and nine month periods ended September 30, 2013, respectively. See Note 7 for additional information. (d) Increases in federal USF contributions were driven by an increase in the average USF contribution factor for the nine month period ended September 30, 2014, compared to the same period a year ago. Cost of Products Sold Cost of products sold represents the cost of equipment sales to customers. The change in cost of products sold was consistent with the change in product sales. The following table reflects the primary drivers of year-over-year changes in cost of products sold: Three Months Ended Nine Months Ended September 30, 2014 September 30, 2014 Increase Increase (Millions) (Decrease) % (Decrease) % Due to decreases in product sales to consumers $ (0.3 ) $ (0.1 ) Due to decreases in sales to contractors (1.4 ) (11.2 ) Due to decreases in product sales to business customers (5.5 ) (6.8 ) Net decreases in cost of products sold $ (7.2 ) (16 )% $ (18.1 ) (13 )% Selling, General and Administrative ("SG&A") SG&A expenses result from sales and marketing efforts, advertising, IT support, costs associated with corporate and other support functions and professional fees. These expenses include salaries, wages and employee benefits not directly associated with the provisioning of services. The following table reflects the primary drivers of year-over-year changes in SG&A expenses: Three Months Ended Nine Months Ended September 30, 2014 September 30, 2014 Increase Increase (Millions) (Decrease) % (Decrease) % Due to increases in postretirement and pension (a) $ 2.5 $ 8.0 Due to increases in sales and marketing expenses (b) 0.6 18.5 Due to decreases in other costs (7.1 ) (4.7 ) Due to decreases in employee medical expenses (7.2 ) (4.7 ) Net changes in SG&A and other expenses $ (11.2 ) (5 )% $ 17.1 2 % (a) Increases in postretirement and pension expense primarily resulted from the difference in the amount of curtailment gains recognized during the first quarter of 2014 and the three and nine month periods ended September 30, 2013 related to the elimination of medical and prescription subsidies for certain active employees. These curtailment gains reduced SG&A expenses by $4.4 million in the nine month period ended September 30, 2014 compared to reductions of $2.0 million and $8.1 million in the three and nine month periods ended September 30, 2013, respectively. See Note 7 for additional information. (b) Increase in sales and marketing expenses in the nine month period ended September 30, 2014 was primarily due to the expansion of enterprise marketing campaigns designed to generate sales leads and promote brand awareness. 55 --------------------------------------------------------------------------------Depreciation and Amortization Expense Depreciation and amortization expense includes the depreciation of property, plant and equipment and the amortization of intangible assets. The following table reflects the primary drivers of year-over-year changes in depreciation and amortization expense: Three Months Ended Nine Months Ended September 30, 2014 September 30, 2014 Increase Increase (Millions) (Decrease) % (Decrease) % Due to increases in depreciation expense (a) $ 19.1 $ 58.1 Due to decreases in amortization expense (b) (8.8 ) (26.4 ) Net increases in depreciation and amortization expense $ 10.3 3 % $ 31.7 3 % (a) Increases in depreciation expense were primarily due to additions to property, plant and equipment. (b) Decreases in amortization expense reflected the use of the sum-of-the-years-digits method for customer lists. The effect of using an accelerated amortization method results in an incremental decline in expense each year as the intangible assets amortize. Merger, Integration and Restructuring Costs We incur a significant amount of costs to complete a merger or acquisition and integrate its operations into our business, which are presented as merger and integration expense in our consolidated results of operations. These costs primarily consist of expenses incurred for IT and network conversions, rebranding, and consulting fees. Expenses for IT conversions and other transition activities related to the 2011 acquisition of PAETEC Holding Corp ("PAETEC") and fees related to the proposed spin-off of certain network and real estate assets account for the merger and integration costs incurred for the periods presented. Restructuring charges are primarily incurred as a result of evaluations of our operating structure. Among other things, these evaluations explore opportunities to provide greater flexibility in managing and financing existing and future strategic operations, for task automation, network efficiency and the balancing of our workforce based on the current needs of our customers. Severance, lease exit costs and other related charges are included in restructuring charges. On February 21, 2014, we announced a reduction in workforce to increase operational efficiency. As a result, we eliminated approximately 400 positions on or before March 3, 2014, with about 175 of the eliminated positions resulting from a voluntary separation initiative. In connection with this workforce reduction, we incurred pre-tax restructuring charges of $12.1 million during the first quarter of 2014, primarily consisting of severance and other employee benefit costs. Set forth below is a summary of merger, integration and restructuring costs for the three and nine month periods ended September 30: Three Months Ended Nine Months Ended (Millions) 2014 2013 2014 2013 Merger and integration costs: Employee-related transition costs $ - $ 1.5 $ - $ 5.2 Information technology conversion costs (a) 4.2 2.6 15.7 7.5 Rebranding, consulting and other costs (b) 5.8 1.7 10.3 5.1 Total merger and integration costs 10.0 5.8 26.0 17.8 Restructuring charges (c) 3.6 0.8 19.8 8.3 Total merger, integration and restructuring costs $ 13.6 $ 6.6 $ 45.8 $ 26.1 (a) Information technology conversion costs incurred in both periods primarily consisted of redundant IT platform integrations designed to improve processes and drive efficiencies. 56 --------------------------------------------------------------------------------(b) Includes costs incurred related to the proposed spin-off of certain telecommunications network assets into an independent, publicly traded REIT. See Note 13 to the consolidated financial statements for additional information related to the proposed transaction. (c) Includes charges related to the workforce reduction completed in the first quarter of 2014 as discussed above, as well as other restructuring activities. Summary of Liability Activity Related to Both Merger and Integration Costs and Restructuring Charges As of September 30, 2014, we had unpaid merger, integration and restructuring liabilities totaling $7.0 million, which consisted of $0.6 million associated with restructuring initiatives and $6.4 million related to merger and integration activities, which are included in other current liabilities in the accompanying consolidated balance sheet. Payments of these liabilities will be funded through operating cash flows (see Note 9). Operating Income Operating income decreased $68.0 million, or 31.0 percent and $195.9 million, or 28.7 percent during the three and nine month periods ended September 30, 2014, respectively, as compared to the same periods in 2013. The decreases were primarily due to reductions in business, consumer and wholesale revenues as a result of declining demand for dedicated copper-based circuits, voice line losses and intercarrier compensation reform, respectively. Increases in postretirement and pension expense due to the effects of curtailment gains recognized in each period, higher sales and marketing expenses attributable to our brand awareness initiatives and additional depreciation expense resulting from additions to property, plant and equipment also contributed to the declines in operating income for the three and nine month periods ended September 30, 2014. Other (Expense) Income, Net Set forth below is a summary of other (expense) income, net for the three and nine month periods ended September 30: Three Months Ended Nine Months Ended (Millions) 2014 2013 2014 2013 Interest income $ 0.1 $ - $ 1.0 $ 1.0 Loss on sale of non-operating assets - - - (3.3 ) Other (expense) income, net (0.1 ) (4.9 ) (0.6 ) (4.2 ) Ineffectiveness of interest rate swaps (0.1 ) (0.7 ) (0.3 ) 1.5 Other (expense) income, net $ (0.1 ) $ (5.6 ) $ 0.1 $ (5.0 ) Loss on Early Extinguishment of Debt During the third quarter of 2013, Windstream Corp. retired all $500.0 million of the outstanding 7.000 percent notes due March 15, 2019 ("2019 Notes") using proceeds from the private placement of $500.0 million in aggregate principal amount of 7.750 percent senior unsecured notes due October 1, 2021 ("2021 Notes"). During the nine month period ended September 30, 2013 , Windstream Corp. also retired all $650.0 million of the outstanding 8.875 percent PAETEC Notes due June 30, 2017 ("PAETEC 2017 Notes"). The PAETEC 2017 Notes were repurchased using proceeds from the issuance of $700.0 million of 6.375 percent notes due August 1, 2023 ("2023 Notes"). Windstream Corp. also amended its senior secured credit facility including issuance of Tranche B4, the proceeds of which were used to repay Tranche A2, Tranche B and Tranche B2 during the first quarter of 2013. The retirements and a portion of the credit facility amendment were accounted for under the extinguishment method of accounting, and, as a result, Windstream Corp. recognized losses due to the extinguishment of the aforementioned debt obligations. 57 --------------------------------------------------------------------------------The loss on early extinguishment of debt was as follows for the three and nine month period ended September 30, 2013: (Millions) Three Months Ended Nine Months Ended 2019 Notes: Premium on early redemption $ (13.6 ) $ (13.6 ) Third-party fees for early redemption (0.5 ) (0.5 ) Unamortized debt issuance costs on original issuance (0.6 ) (0.6 ) Loss on early extinguishment for 2019 Notes (14.7 ) (14.7 ) Senior secured credit facility: Unamortized debt issuance costs on original issuance - $ (2.5 ) Loss on early extinguishment for senior secured credit facility - (2.5 ) PAETEC 2017 Notes: Premium on early redemption - (51.5 ) Third-party fees for early redemption - (1.0 ) Unamortized premium on original issuance - 41.2 Loss on early extinguishment for PAETEC 2017 Notes - (11.3 ) Total loss on early extinguishment of debt $ (14.7 ) $ (28.5 ) Interest Expense Set forth below is a summary of interest expense for the three and nine month periods ended September 30: Three Months Ended Nine Months Ended (Millions) 2014 2013 2014 2013 Senior secured credit facility, Tranche A $ 4.2 $ 4.6 $ 12.8 $ 13.8 Senior secured credit facility, Tranche B 17.9 18.8 53.3 55.3 Senior secured credit facility, revolving line of credit 5.4 4.9 16.5 9.4 Senior unsecured notes 96.2 101.3 288.2 322.1 Credit facility extension fees - - - 6.2 Notes issued by subsidiaries 11.2 11.2 33.6 36.8 Impacts of interest rate swaps 7.3 9.2 22.1 40.3 Interest on capital and other lease obligations 2.0 0.8 4.1 2.1 Less capitalized interest expense (0.8 ) (2.0 ) (2.8 ) (6.3 ) Total interest expense $ 143.4 $ 148.8 $ 427.8 $ 479.7 Interest expense decreased $5.4 million, or 3.6 percent and $51.9 million, or 10.8 percent for the three and nine month periods ended September 30, 2014, respectively, as compared to the same periods in 2013. The decreases in both 2014 periods were primarily due to the payoffs of $800.0 million of 8.125 percent notes due August 1, 2013 and $500.0 million of 7.0 percent notes due March 15, 2019 which were both completed in the third quarter of 2013, the payoff of the PAETEC 2017 Notes completed in January 2013, and the absence of credit facility extension fees related to refinancing activities completed in the first quarter of 2013. These decreases were partially offset by additional borrowings subsequent to September 30, 2013 under the revolving line of credit and Tranche B5 of the senior credit facility. Windstream Corp. has entered into ten interest rate swap agreements to mitigate the interest rate risk inherent in its variable rate senior secured credit facility. Four of the swaps are off-market swaps; therefore, they contain an embedded financing element, which the swap counterparties recover through an incremental charge in Windstream Corp.'s fixed rate over what would be charged for an on-market swap. As such, a portion of the cash payment on the swaps represents the rate Windstream Corp. would pay on a hypothetical on-market interest rate swap and is recognized in interest expense. The remaining six pay fixed, receive variable interest rate swap agreements, are designated as cash flow hedges of the previously unhedged interest rate risk inherent in Windstream Corp.'s senior secured credit facility and mature on June 17, 2016. See Note 4 for additional details. 58 --------------------------------------------------------------------------------Income Taxes Income tax expense decreased $19.8 million, or 99.5 percent and $26.5 million, or 55.9 percent, for the three and nine month periods ended September 30, 2014, respectively, as compared to the same periods in 2013. The decreases in income tax expense for the three and nine month periods ended September 30, 2014 were primarily due to reductions in income before taxes. The decrease in the nine month period of 2014 was partially offset by the effect of a discrete item recognized in the first quarter of 2013 of $17.8 million of previously unrecognized tax benefits, including interest, as a result of the expiration of the statute of limitations. This discrete item was solely related to 2013 and had no impact to our 2014 income tax expense. Our effective tax rate was 1.2 percent and 35.5 percent for the three and nine month periods ended September 30, 2014, respectively, as compared to 39.4 percent and 28.0 percent in the same periods in 2013. A $3.1 million tax benefit, net of reserves, related to research and development credits was recognized in the third quarter of 2014 and decreased our effective tax rate in the three and nine month periods ended September 30, 2014, while the discrete item in 2013 discussed above significantly lowered our effective tax rate in the nine month period ended September 30, 2013. For 2014, our annualized effective income tax rate is expected to range between 38.0 percent and 39.0 percent, excluding one-time discrete items. Changes in our relative profitability, as well as recent and proposed changes to federal and state tax laws may cause the rate to change from historical rates. In determining our quarterly provision for income taxes, we use an estimated annual effective tax rate, which is based on our expected annual income, statutory rates and tax planning opportunities. Significant or unusual items are separately recognized in the quarter in which they occur. Regulatory Matters We are subject to regulatory oversight by the FCC for particular interstate matters and state public utility commissions ("PUCs") for certain intrastate matters. We are also subject to various federal and state statutes that direct such regulations. We actively monitor and participate in proceedings at the FCC and PUCs and engage federal and state legislatures on matters of importance to us. From time to time federal and state legislation is introduced dealing with various matters that could affect our business. Most proposed legislation of this type never becomes law. It is difficult to predict what kind of legislation, if any, may be introduced and ultimately will become law. Federal Regulation and Legislation Intercarrier Compensation and USF Reform On November 18, 2011, the FCC released an order ("the Order") that established a framework for reform of the intercarrier compensation system and the federal USF. The Order included two primary provisions: • the elimination of terminating switched access rates and other per-minute terminating charges between service providers by 2018, through annual reductions in the rates, mitigated in some cases by two recovery mechanisms; and • the provision of USF support for voice and broadband services. In reforming the USF, the Order established the Connect America Fund ("CAF"), which included a short-term ("CAF Phase I") and a longer-term ("CAF Phase II") framework. CAF Phase I provides for continued legacy USF funding frozen at 2011 levels as well as the opportunity for incremental broadband funding to a number of unserved and underserved locations. CAF Phase I, Round 1, incremental broadband support was limited to $775 per unserved location in 2012. We elected to accept approximately $0.7 million of the $60.4 million in incremental support allocated to us for 2012. As a result of our aggressive broadband deployment to date, we had very few unserved locations remaining in our service areas for which $775 in incremental support would have made broadband deployment economical. The FCC, however, approved our supported modifications to the rules governing CAF Phase I, Round 2, incremental support. As a result, we were authorized to receive an additional $86.7 million in incremental support for upgrades and new deployments of broadband service. Of the total amount of $86.7 million made available to us, we received $60.7 million in December 2013 and the remaining $26.0 million in the first quarter of 2014. Pursuant to commitments we made while the FCC was considering the rules for Round 2, we will match, on at least a dollar-for-dollar basis, the total amount of Round 2 funding received. The portion of capital expenditures funded by us are included in our capital expenditure totals for each period presented in the accompanying consolidated statements of cash flow. 59 -------------------------------------------------------------------------------- The FCC continues to work to establish final rules for CAF Phase II funding based on a forward-looking cost model to further extend broadband to high-cost areas. The FCC anticipates making the offer of CAF Phase II support for right-of-first-refusal ("ROFR") elections to price cap carriers, including us, before the end of 2014. If that offer occurs, the deadline for acceptance will be 120 days later, anticipated to be in early 2015. If we decline the ROFR election for any state, we will still be eligible to participate in a bidding process, along with other interested competitors, for support in that state. In an order released in June 2014, the FCC stated that it expected to be prepared to conduct the competitive bidding process by the end of 2015. At this time, we cannot predict what effects that the final CAF Phase II rules may have on our future consolidated revenues, expenses, or cash flows. Possible outcomes resulting from the final rules may impose on us additional capital expenditure requirements for broadband service expansion, which could have an adverse impact on our future liquidity. Until the implementation of CAF Phase II is complete, the annual "legacy" USF funding will continue to be frozen at 2011 levels. We were required to use one-third of the frozen legacy support to operate and build broadband networks in areas substantially unserved by an unsubsidized competitor in 2013. In 2014, this condition applies to two-thirds of the frozen legacy support, and in 2015 it increases to 100 percent. Our expectation is that our legacy federal USF support will continue to be approximately the same until CAF Phase II is implemented. As part of the Order's reform of intercarrier compensation, the FCC established two recovery mechanisms that mitigate the revenue reductions resulting from the reduction and ultimate elimination of terminating access rates. First, the FCC established the ARC, a fee which may be assessed to some of our retail customers. Second, the ARM is a form of additional federal universal service support designed to allow carriers to recover some of the revenue reductions that cannot be recovered through assessment of the ARC. Carriers are required to use ARM support to build and operate broadband networks in areas substantially unserved by an unsubsidized competitor offering fixed voice and broadband service. Our ARM support is expected to decrease incrementally from $51.9 million in 2014 to an estimated $12.3 million in 2017, with a portion of the decrease offset by future increases in ARC revenues. Absent a change by the FCC to its current rules, the ARM will phase out annually in one-third increments, beginning in July 2017, and will be eliminated completely as of July 2019. On April 25, 2012, the FCC decided that originating access rates for intrastate long distance traffic exchanged between an Internet-protocol network and the traditional telecommunications network should be subject to default rates equal to interstate originating access rates beginning on July 1, 2014. The FCC refused at that time to adopt a mechanism that would allow companies to recover the loss of originating access revenues resulting from the change. Our court challenge to this ruling was rejected in May 2014. We continue to assess the impacts of the FCC's intercarrier compensation reform on our wholesale business activities. Set forth below is a summary of intercarrier compensation revenue and federal universal service support included in wholesale revenues within the consolidated statements of income for the three and nine month periods ended September 30: Three Months Ended Nine Months Ended (Millions) 2014 2013 2014 2013 Intercarrier compensation revenue $ 38.6 $ 51.6 $ 126.4 $ 162.6 Federal universal service support $ 35.4 $ 40.9 $ 116.6 $ 115.4 Broadband Stimulus As part of the American Recovery and Reinvestment Act of 2009 ("ARRA"), approximately $7.2 billion was allocated for the purpose of expanding broadband services to unserved and underserved areas. The Rural Utilities Service ("RUS"), part of the United States Department of Agriculture, approved eighteen of our applications for these funds for projects totaling $241.7 million. The RUS will fund 75 percent of these approved grants, or $181.3 million, and we will fund the remainder of at least $60.4 million. 60 --------------------------------------------------------------------------------Selected information related to the broadband stimulus expenditures and receipts is as follows for the three and nine month periods ended September 30: Three Months Ended Nine Months Ended Inception to (Millions) 2014 2013 2014 2013 Date Stimulus capital expenditures funded by RUS $ 1.3 $ 8.7 $ 11.6 $ 28.8 $ 174.8 Stimulus capital expenditures funded by Windstream (a) 8.5 8.9 38.9 30.0 131.8 Total stimulus capital expenditures $ 9.8 $ 17.6 $ 50.5 $ 58.8 $ 306.6 Funds received from RUS $ 4.1 $ 17.8 $ 25.8 $ 53.5 $ 143.5 (a) Stimulus capital expenditures funded by us are included in our capital expenditure totals for each period presented in the accompanying consolidated statements of cash flows. This total includes certain non-reimbursable charges for which we are responsible for the full amount of the cost. Internet Network Regulation On January 14, 2014, the U.S. Court of Appeals for the D.C. Circuit vacated FCC regulations that had prohibited fixed service providers from engaging in unreasonable discrimination and blocking lawful content when offering retail broadband service to consumer, small business and other end user customers. The Court, however, did not overturn the FCC requirement that all providers of broadband Internet access service disclose network management practices, performance characteristics, and commercial terms of service. On May 15, 2014, the FCC proposed to re-institute the "no-blocking" rule and to create a new rule that would bar commercially unreasonable actions from threatening Internet openness. Neither the FCC's previous regulatory regime nor the proposed framework has caused a change in our existing procedures or operations. As such, we cannot predict at this time the impact that the court decision or future regulations may have on our future revenues or expenses, or whether such impact would be material. State Regulation and Legislation State Universal Service We recognize revenue from the receipt of state universal service funding in a limited number of states in which we operate. For the three and nine month periods ended September 30, 2014, we recognized $28.3 million and $86.0 million, respectively, in state USF revenue, which included approximately $16.7 million and $51.0 million, respectively, from the Texas USF. These payments are intended to provide support, apart from federal USF receipts, for the high cost of operating in certain rural markets. There are two high-cost programs of the Texas USF, one for large companies and another for small companies. In the nine month period ended September 30, 2014, we received $44.3 million from the large company program and $6.7 million from the small company program. The purpose of the Texas USF is to assist telecommunications carriers with providing basic local telecommunications services at reasonable rates to customers in high cost rural areas and to qualifying low-income and disabled customers. By order of the Texas PUC, the Texas USF distributes support to eligible carriers serving areas identified as high cost, on a per-line basis. Texas USF support payments are based on the number of actual lines in service and therefore are subject to reductions when customers discontinue service or migrate to a competitive carrier. All service providers of telecommunications services in Texas contribute to the Texas USF through the payment of a monthly surcharge collected from their customers. Several states are currently conducting reviews of their universal service funds. In particular, the Texas PUC currently is considering needs-based reforms that could adversely impact our Texas USF support, but pursuant to state legislation adopted last year, any such reforms cannot take effect prior to 2017. We continue to work with the Texas PUC and industry members to obtain a reasonable outcome. We are not yet able to determine the financial impact of any future Texas USF reform. New Mexico, Oklahoma, and Pennsylvania are also considering reforms to their state universal service funds. We receive $8.4 million annually from the New Mexico fund, $3.4 million annually from the Oklahoma fund and $13.3 million annually from the Pennsylvania fund. We cannot estimate at this time the financial impact that would result from changes, if any, to these other state funds. 61 -------------------------------------------------------------------------------- See "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Item 7 of Part II of our Annual Report on Form 10-K for the year ended December 31, 2013, filed with the SEC on February 27, 2014, for more information regarding our federal and state regulatory matters. FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES Liquidity and Capital Resources We rely largely on operating cash flows and long-term debt to provide for our liquidity requirements. We expect cash flows from operations will be sufficient to fund ongoing working capital requirements, planned capital expenditures, scheduled debt principal and interest payments and dividend payments through the remainder of 2014. We also have access to capital markets and available borrowing capacity under our revolving credit agreements. Our unrestricted cash position increased by $55.5 million to $103.7 million at September 30, 2014, from $48.2 million at December 31, 2013, as compared to a decrease of $58.6 million during the same period in 2013. Cash inflows in the nine month period of 2014 were primarily from operating activities, the receipt of CAF support and additional grant funds received for broadband stimulus projects. These inflows were partially offset by cash outflows for capital expenditures and dividend payments to shareholders. |