ITEM 2. MANAGEMENT’S DISCUSSIO
N AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
The Securities and Exchange Commission (“SEC”) encourages companies to disclose forward-looking information so that investors can better understand a company’s future prospects and make informed investment decisions. Certain statements in this Quarterly Report on Form 10-Q, including those which relate to the impact on future revenue sources, pending and future regulatory orders, continued expansion of the telecommunications network and expected changes in the sources of our revenue and cost structure resulting from our entrance into new communications markets, are forward-looking statements and are made pursuant to the safe harbor provisions of the Securities Litigation Reform Act of 1995. These forward-looking statements reflect, among other things, our current expectations, plans, strategies and anticipated financial results. There are a number of risks, uncertainties and conditions that may cause our actual results to differ materially from those expressed or implied by these forward-looking statements. Many of these circumstances are beyond our ability to control or predict. Moreover, forward-looking statements necessarily involve assumptions on our part. These forward-looking statements generally are identified by the words “believe”, “expect”, “anticipate”, “estimate”, “project”, “intend”, “plan”, “should”, “may”, “will”, “would”, “will be”, “will continue” or similar expressions. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause actual results, performance or achievements of Consolidated Communications Holdings, Inc. and its subsidiaries (“Consolidated”, the “Company”, “we” or “our”) to be different from those expressed or implied in the forward-looking statements. All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the cautionary statements that appear throughout this report. A detailed discussion of these and other risks and uncertainties that could cause actual results and events to differ materially from such forward–looking statements is included in our 2017 Annual Report on Form 10-K filed with the SEC. Furthermore, undue reliance should not be placed on forward-looking statements, which speak only as of the date they are made. Except as required under federal securities laws or the rules and regulations of the SEC, we disclaim any intention or obligation to update or revise publicly any forward-looking statements. Management’s Discussion and Analysis (“MD&A”) should be read in conjunction with our unaudited condensed consolidated financial statements and accompanying notes to the financial statements (“Notes”) as of and for the quarter and nine months ended September 30, 2018 included in Item 1 of Part I of this Quarterly Report on Form 10-Q.
Throughout this MD&A, we refer to certain measures that are not measures of financial performance in accordance with accounting principles generally accepted in the United States (“US GAAP” or “GAAP”). We believe the use of these non-GAAP measures on a consolidated basis provides the reader with additional information that is useful in understanding our operating results and trends. These measures should be viewed in addition to, rather than as a substitute for, those measures prepared in accordance with GAAP. See the “Non-GAAP Measures” section below for a more detailed discussion on the use and calculation of these measures.
Overview
Consolidated Communications is a broadband and business communications provider offering a wide range of communication solutions to consumer, commercial and carrier customers across a 23-state service area and an advanced fiber network spanning more than 36,000 fiber route miles. We offer residential Internet, video, phone and home security services as well as multi-service residential and small business bundles. Our business product suite includes data and Internet solutions, voice, data center services, security services, managed and IT Services, and an expanded suite of cloud services. We provide wholesale solutions to carriers and other service providers including data, voice and network connections.
We generate the majority of our consolidated operating revenues primarily from subscriptions to our video, data and transport services (collectively “broadband services”) to business and residential customers. Commercial and carrier services represent the largest source of our operating revenues and are expected to be key growth areas in the future. We continue to focus on broadband and commercial growth opportunities and are continually enhancing our broadband services and expanding our commercial product offerings for both small and large businesses in order to capitalize on technological advances in the industry. Our acquisition of FairPoint Communications, Inc. (“FairPoint”), as described below, provides us significantly greater scale and an expanded fiber network which allows for additional growth
opportunities and expansion. We leverage our advanced fiber networks and tailor our services for business customers by developing solutions to fit their specific needs. In addition, we are expanding our suite of cloud services, which increases efficiency and enables greater scalability and reliability for businesses. We anticipate future momentum in commercial and carrier services as these products gain traction as well as from the demand from customers for additional bandwidth and data-based services.
We market our residential services by leading with broadband or bundled services. Our “triple play” bundle includes Internet, video and phone services. As consumer demands for bandwidth continue to increase, our focus is on enhancing our broadband services, and progressively increasing consumer data speeds. We offer data speeds of up to 1 Gbps in select markets, and up to 100 Mbps in markets where 1 Gbps is not yet available, depending on the geographical region. A
s of September 30, 2018, approximately 42% of the homes we serve on our legacy network had availability to broadband speeds of up to 100 Mbps. The majority of the homes in our former FairPoint service areas have availability to broadband speeds of 20 mbps or less. As part of our integration initiatives of FairPoint, we plan to increase broadband speeds to more than 500,000 residents and small businesses across the Northern New England service area by the end of 2018. The upgrades are expected to enable customers to receive broadband speeds up to three times the speeds currently available and provide nearly 100,000 additional homes with access to data speeds of 1 Gbps.
Our competitive consumer broadband speeds allow us to continue to meet the needs of our customers and the demand for higher speeds driven by Over-The-Top (“OTT”) content viewing. The availability of higher broadband speeds also complements our TV Everywhere service, which allows our video subscribers to watch their favorite shows, movies and livestreams on any device. In addition, we offer other in-demand OTT content, including: DIRECTV®, DIRECTV NOWSM, fuboTV, Philo, HBO NOW®, FlixFling and VEMOX.
The consumer demand for OTT services, either to augment their current video subscription viewing or to entirely replace their video subscription, may impact our future video subscriber base, which could result in a decline in video revenue as well as a reduction in video programing costs. Total video connections decreased 9% as of September 30, 2018 compared to the same period in 2017. We believe the trend in changing consumer viewing habits will continue to impact our business results and complement our strategy of providing consumers higher broadband speed to facilitate OTT content viewing.
Operating revenues also continue to be impacted by the anticipated industry-wide trend of a decline in voice services, access lines and related network access revenue. Many customers are choosing to subscribe to alternative communication services and competition for these subscribers continues to increase. Total voice connections decreased 7% as of September 30, 2018 compared to the same period in 2017. Competition from wireless providers, Competitive Local Exchange Carriers and cable television providers has increased in recent years in the markets we serve. We have been able to mitigate some of the access line losses through marketing initiatives and product offerings, such as our VoIP service.
As discussed in the “Regulatory Matters” section below, our operating revenues are impacted by legislative or regulatory changes at the federal and state levels, which could reduce or eliminate the current subsidies revenue we receive. A number of proceedings and recent orders relate to universal service reform, intercarrier compensation and network access charges. There are various ongoing legal challenges to the orders that have been issued. As a result, it is not yet possible to fully determine the impact of the regulatory changes on our operations.
Significant Recent Developments
Acquisitions
FairPoint Communications, Inc.
On July 3, 2017, we completed our merger with FairPoint (the “Merger”) and, pursuant to the terms of a definitive agreement and plan of merger (as amended, the “Merger Agreement”), acquired all the issued and outstanding shares of FairPoint in exchange for shares of our common stock. As a result, FairPoint became a wholly-owned subsidiary of the Company. FairPoint is an advanced communications provider to business, wholesale and residential customers within its service territory, which spans across 17 states. FairPoint owns and operates a robust fiber-based network with more than
22,000 route miles of fiber, including 17,000 route miles of fiber in northern New England. The financial results for FairPoint have been included in our consolidated financial statements as of the acquisition date. The acquisition reflects our strategy to diversify revenue and cash flows among multiple products and to expand our network to new markets.
At the effective time of the Merger, each share of common stock of FairPoint issued and outstanding immediately prior to the effective time of the Merger converted into and became the right to receive 0.7300 shares of common stock of Consolidated and cash in lieu of fractional shares, pursuant to the terms of the Merger Agreement. Based on the closing price of our common stock on the last complete trading day prior to the effective date of the Merger, the total value of the consideration exchanged was approximately $431.0 million, exclusive of debt of approximately $919.3 million. On the date of the Merger, we issued an approximate aggregate total of 20.1 million shares of our common stock to the former FairPoint stockholders and we assumed approximately 2,615,153 outstanding warrants, each eligible to purchase one share of the Company’s common stock at an exercise price of $66.86 per share, subject to adjustment in accordance with the warrant agreement. On January 24, 2018, all of the warrants expired in accordance with their terms without being exercised.
To finance the Merger, in December 2016, we secured committed debt financing through a $935.0 million incremental term loan facility, as described in the “Liquidity and Capital Resources” section below, that, in addition to cash on hand and other sources of liquidity, was used to repay and redeem certain existing indebtedness of FairPoint and pay the fees and expenses in connection with the Merger.
Divestitures
In connection with our acquisition of FairPoint, in August 2017, we entered into a letter of intent to sell our subsidiaries Peoples Mutual Telephone Company and Peoples Mutual Long Distance Company (collectively, “Peoples”), which were acquired as part of the acquisition of FairPoint. Peoples operates as a local exchange carrier in Virginia and provides telecommunications services to residential and business customers. In November 2017, the Company entered into an agreement to sell all of the issued and outstanding stock of Peoples in exchange for cash of approximately $21.0 million, net of certain contractual and customary working capital adjustments. The sale was completed on July 31, 2018 and during the quarter and nine months ended September 30, 2018, we recognized a loss of $0.2 million on the sale, net of selling costs, which is included in selling, general and administrative expense in the condensed consolidated statement of operations. We recognized a taxable gain on the transaction resulting in current income tax expense of $0.8 million during the quarter and nine months ended September 30, 2018 to reflect the tax impact of the divestiture.
Results of Operations
The following tables reflect our financial results on a consolidated basis and key operating metrics as of and for the quarters and nine months ended September 30, 2018 and 2017.
Financial Data
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Quarter Ended September 30,
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Nine Months Ended September 30,
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(In millions, except for percentages)
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2018
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2017
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$
Change
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%
Change
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2018
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2017
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$
Change
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%
Change
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Operating Revenues
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Commercial and carrier:
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Data and transport services (includes VoIP)
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$
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87.7
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$
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85.6
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$
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2.1
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2
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%
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$
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261.3
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$
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188.0
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$
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73.3
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39
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%
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Voice services
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50.1
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54.3
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(4.2)
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(8)
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153.6
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98.5
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55.1
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56
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Other
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13.9
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13.4
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0.5
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4
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40.0
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22.3
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17.7
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79
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151.7
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153.3
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(1.6)
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(1)
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454.9
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308.8
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146.1
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47
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Consumer:
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Broadband (VoIP and Data)
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63.9
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63.9
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—
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—
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189.5
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120.6
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68.9
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57
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Video services
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21.8
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23.4
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(1.6)
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(7)
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66.7
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68.8
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(2.1)
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(3)
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Voice services
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50.7
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57.2
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(6.5)
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(11)
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154.4
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83.1
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71.3
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86
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136.4
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144.5
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(8.1)
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(6)
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410.6
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272.5
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138.1
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51
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Subsidies
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19.2
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20.9
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(1.7)
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(8)
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65.4
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41.9
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23.5
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56
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Network access
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38.1
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41.2
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(3.1)
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(8)
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115.2
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69.9
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45.3
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65
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Other products and services
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2.7
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3.4
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(0.7)
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(21)
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8.2
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10.1
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(1.9)
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(19)
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Total operating revenues
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348.1
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363.3
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(15.2)
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(4)
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1,054.3
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703.2
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351.1
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50
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Operating Expenses
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Cost of services and products (exclusive of depreciation and amortization)
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152.9
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148.3
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4.6
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3
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457.2
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290.5
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166.7
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57
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Selling, general and administrative costs
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85.6
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91.2
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(5.6)
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(6)
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252.3
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163.0
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89.3
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55
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Acquisition and other transaction costs
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0.2
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27.1
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(26.9)
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(99)
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1.8
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30.6
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(28.8)
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(94)
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Depreciation and amortization
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109.1
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104.4
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4.7
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5
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328.7
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187.1
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141.6
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76
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Total operating expenses
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347.8
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371.0
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(23.2)
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(6)
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1,040.0
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671.2
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368.8
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55
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Income (loss) from operations
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0.3
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(7.7)
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8.0
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104
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14.3
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32.0
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(17.7)
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(55)
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Interest expense, net
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(33.5)
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(36.3)
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(2.8)
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(8)
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(99.0)
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(99.9)
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(0.9)
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(1)
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Other income
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9.4
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9.3
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0.1
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1
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31.0
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23.3
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7.7
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33
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Income tax benefit
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(9.0)
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(6.3)
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(2.7)
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(43)
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(17.2)
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(9.9)
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(7.3)
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(74)
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Net loss
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(14.8)
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(28.4)
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13.6
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48
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(36.5)
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(34.7)
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(1.8)
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(5)
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|
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Net income attributable to noncontrolling interest
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0.1
|
|
|
—
|
|
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0.1
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|
100
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|
|
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0.3
|
|
|
0.1
|
|
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0.2
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|
200
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|
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Net loss attributable to common shareholders
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$
|
(14.9)
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$
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(28.4)
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$
|
13.5
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48
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$
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(36.8)
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$
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(34.8)
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$
|
(2.0)
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(6)
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Adjusted EBITDA
(1)
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$
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133.7
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$
|
137.3
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$
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(3.6)
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(3)
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%
|
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$
|
404.9
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$
|
280.9
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$
|
124.0
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44
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%
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(1)
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A non-GAAP measure. See the “Non-GAAP Measures” section below for additional information and reconciliation to the most directly comparable GAAP measure.
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Key Operating Statistics
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|
|
As of September 30,
|
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|
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2018
|
|
2017
|
|
Change
|
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% Change
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Consumer customers
|
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641,845
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683,519
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(41,674)
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(6)
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%
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Voice connections
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921,896
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990,162
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(68,266)
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(7)
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|
Data connections
|
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781,912
|
|
783,945
|
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(2,033)
|
|
(0)
|
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Video connections
|
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95,889
|
|
105,480
|
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(9,591)
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(9)
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Total connections
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1,799,697
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1,879,587
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(79,890)
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(4)
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%
|
The comparability of our consolidated results of operations was impacted by the FairPoint acquisition that closed on July 3, 2017, as described above. FairPoint’s results are included in our consolidated financial statements as of the date of the acquisition.
Revenue from Contracts with Customers
We account for revenue in accordance with ASC 606 (“ASC 606” or the “new standard”),
Revenue from Contracts with Customers
, which we adopted on January 1, 2018. Promised services in our revenue contracts with customers are considered distinct and are accounted for as separate performance obligations. Revenue is recognized when or as performance obligations are satisfied. The impact on revenue as a result of the adoption of ASC 606 was not material.
In accordance with ASC 606, contract acquisition costs are deferred and amortized over the expected customer life. Historically, these costs were expensed as incurred. The change in accounting for contract acquisition costs was the largest impact to the Company upon adoption of ASC 606.
For a more complete discussion of the adoption impacts, refer to Note 1 to the Condensed Consolidated Financial Statements, included in this report in Part I - Item 1 “Financial Statements”.
Operating Revenues
Commercial and Carrier
Data and Transport Services
We provide a variety of business communication services to small, medium and large business customers, including many services over our advanced fiber network. The services we offer include scalable high speed broadband Internet access and VoIP phone services, which range from basic service plans to virtual hosted systems. In addition to Internet and VoIP services, we also offer private line data services to businesses that include dedicated Internet access through our Metro Ethernet network. Wide Area Network products include point-to-point and multi-point deployments from 2.5 Mbps to 10 Gbps to accommodate the growth patterns of our business customers. Data center and disaster recovery solutions provide a reliable and local colocation option for commercial customers. We also offer wholesale services to regional and national interexchange and wireless carriers, including cellular backhaul and other fiber transport solutions.
Data and transport services revenues increased $2.1 million and $73.3 million during the quarter and nine months ended September 30, 2018, respectively, compared to the same periods in 2017 primarily due to the acquisition of FairPoint. Excluding the addition of FairPoint revenues for the first six months of 2018, data and transport services revenues increased $7.0 million during the nine months ended September 30, 2018 compared to the same period in 2017, primarily due to continued growth in Metro Ethernet and VoIP services.
Voice Services
Voice services include basic local phone and long-distance service packages for business customers. The plans include options for voicemail, conference calling, linking multiple office locations and other custom calling features such as caller ID, call forwarding, speed dialing and call waiting. Services can be charged at a fixed monthly rate, a measured rate or can be bundled with selected services at a discounted rate. Through the acquisition of FairPoint, we are now a full service 9-1-1 provider and have installed and now maintain two turn-key, state of the art statewide next-generation emergency 9-1-1 systems. These systems, located in Maine and Vermont, have processed over a million calls relying on the caller's location information for routing. Next-generation emergency 9-1-1 systems are an improvement over traditional 9-1-1 and are expected to provide the foundation to handle future communication modes such as texting and video.
Voice services revenues decreased $4.2 million and increased $55.1 million during the quarter and nine months ended September 30, 2018, respectively, compared to the same periods in 2017 primarily due to the acquisition of FairPoint. Excluding the addition of FairPoint revenues for the first six months of 2018, voice services revenues decreased $6.9 million during the nine months ended September 30, 2018 compared to the same period in 2017 due to a 6% decline in access lines as commercial customers are increasingly choosing alternative technologies, including our own VoIP product, and the broad range of features that Internet based voice services can offer.
Other
Other services include business equipment sales
and related hardware and
maintenance support, rental income of customer premise equipment,
video services and other miscellaneous revenues
. Other services revenues increased $0.5 million and $17.7 million during the quarter and nine months ended September 30, 2018, respectively, compared to the same periods in 2017 primarily due to the acquisition of FairPoint. Excluding the addition of FairPoint revenues for the first six months of 2018, other services revenues increased $1.4 million during the nine months ended September 30, 2018 compared to the same period in 2017 due to a non-recurring fee recognized in the third quarter of 2018 as well as an increase in business system sales.
Consumer
Broadband Services
Broadband services include revenues from residential customers for subscriptions to our VoIP and data products. We offer high speed Internet access at speeds of up to 1 Gbps, depending on the nature of the network facilities that are available, the level of service selected and the location. Our VoIP digital phone service is also available in certain markets as an alternative to the traditional telephone line. Broadband services revenues increased $68.9 million during the nine months ended September 30, 2018 compared to the same period in 2017 primarily due to the acquisition of FairPoint. Excluding the addition of FairPoint revenues for the first six months of 2018, broadband services revenues increased $0.2 million during the nine months ended September 30, 2018 compared to the same period in 2017 despite a 5% decrease in data connections as a result of price increases implemented during 2018. However, the increase in data revenue was offset by a decline in VoIP revenue during the same periods due to a 10% decline in connections as more consumers continue to rely exclusively on wireless service.
Video Services
Depending on geographic market availability, our video services range from limited basic service to advanced digital television, which includes several plans, each with hundreds of local, national and music channels including premium and pay-per-view channels as well as video on-demand service. Certain customers may also subscribe to our advanced video services, which consist of high-definition television, digital video recorders (“DVR”) and/or a whole home DVR. Video services revenues decreased $1.6 million and $2.1 million during the quarter and nine months ended September 30, 2018, respectively, compared to the same periods in 2017. Excluding the addition of FairPoint revenues for the first six months of 2018, video services revenues decreased $5.3 million during the nine months ended September 30, 2018 compared to the same period in 2017 primarily due to a 10% decrease in connections as consumers are choosing to subscribe to alternative video services such as OTT content.
Voice Services
We offer several different basic local phone service packages and long-distance calling plans, including unlimited flat-rate calling plans. The plans include options for voicemail and other custom calling features such as caller ID, call forwarding and call waiting. Voice services revenues decreased $6.5 million and increased $71.3 million during the quarter and nine months ended September 30, 2018, respectively, compared to the same periods in 2017 primarily due to the acquisition of FairPoint. Excluding the addition of FairPoint revenues for the first six months of 2018, voice services revenues decreased $8.6 million during the nine months ended September 30, 2018 compared to the same period in 2017 primarily due to a 10% decline in access lines. The number of local access lines in service directly affects the recurring revenues we generate from end users and continues to be impacted by the industry-wide decline in access lines. We expect to continue to experience erosion in voice connections due to competition from alternative technologies, including our own competing VoIP product.
Subsidies
Subsidies consist of both federal and state subsidies, which are designed to promote widely available, quality broadband services at affordable prices with higher data speeds in rural areas. Subsidies revenues decreased $1.7 million and increased $23.5 million during the quarter and nine months ended September 30, 2018, respectively, compared to the same periods in 2017 primarily due to the acquisition of FairPoint and a settlement for frozen local switching support (“LSS”) of $6.3 million recognized during the nine months ended September 30, 2018. The increase was reduced in part by the scheduled reductions in the annual Connect America Fund (“CAF”) Phase II funding rate in August 2018 and 2017, as well as a decrease in state funding support for our Texas Incumbent Local Exchange Carrier (“ILEC”). See the “Regulatory Matters” section below for further discussion of the LSS matter as well as the subsidies we receive.
Network Access Services
Network access services include interstate and intrastate switched access revenues, network special access services and end user access. Switched access revenues include access services to other communications carriers to terminate or originate long-distance calls on our network. Special access circuits provide dedicated lines and trunks to business customers and interexchange carriers. Network access revenues decreased $3.1 million and increased $45.3 million during the quarter and nine months ended September 30, 2018, respectively, compared to the same periods in 2017 primarily due to the acquisition of FairPoint. Excluding the addition of FairPoint revenues for the first six months of 2018, network access services revenues decreased $6.4 million during the nine months ended September 30, 2018 compared to the same period in 2017 primarily as a result of the continuing decline in minutes of use, voice connections and carrier circuits; however, a portion of the decrease can be attributed to carriers shifting to our fiber Metro Ethernet product, contributing to the growth in that area.
Other Products and Services
Other products and services include revenues from telephone directory publishing, video advertising, billing and support services and other miscellaneous revenue. Other products and services revenues decreased $0.7 million and $1.9 million during the quarter and nine months ended September 30, 2018, respectively, compared to the same periods in 2017.
Excluding the addition of FairPoint revenues for the first six months of 2018, other products and services revenues decreased $2.6 million during the nine months ended September 30, 2018 compared to the same period in 2017 primarily due to a decline in telephone directory advertising and ad insertion revenues.
Operating Expenses
Cost of Services and Products
Cost of services and products increased $4.6 million and $166.7 million during the quarter and nine months ended September 30, 2018, respectively, compared to the same periods in 2017 due to the acquisition of FairPoint which accounted for $156.7 million
of the year-to-date increase
. Cost of goods sold related to equipment sales increased as a result of an increase in business system sales in the current year periods. Access expense increased due to new recurring circuit and co-location costs as a result of an increase in commercial services. Employee costs also increased primarily due to an increase in employee salaries and benefits in 2018.
Selling, General and Administrative Costs
Selling, general and administrative costs decreased $5.6 million and increased $89.3 million during the quarter and nine months ended September 30, 2018, respectively, compared to the same periods in 2017
primarily due to the addition of the operations for FairPoint for the first six months of 2018, which accounted for $89.8 million of the year-to-date increase
. The decline in selling, general and administrative costs was primarily due to a reduction in sales commissions as a result of the adoption of ASC 606 in 2018, which requires contract acquisition costs to be deferred and amortized over the contract performance period. In 2017, these costs were expensed as incurred. Advertising expense also decreased due to a reduction in radio advertising and marketing promotions in the third quarter of 2018. However, these declines in expense were offset in part by integration costs incurred in 2018 associated with the FairPoint acquisition which included severance costs of $3.8 million and $5.7 million during the quarter and nine months ended September 30, 2018, respectively. In addition, professional fees increased in 2018 for legal, audit and tax services.
Acquisition and Other Transaction Costs
Acquisition and other transaction costs decreased $26.9 million and $28.8 million during the quarter and nine months ended September 30, 2018, respectively, compared to the same periods in 2017 as a result of the acquisition of FairPoint, which closed in July 2017. Transaction costs consist primarily of legal, finance and other professional fees incurred in connection with the Merger as well as expenses related to change-in-control payments to former employees of the acquired company.
Depreciation and Amortization
Depreciation and amortization expense increased $4.7 million and $141.6 million during the quarter and nine months ended September 30, 2018, respectively, compared to the same periods in 2017, primarily as a result of the acquisition of FairPoint which accounted for $144.8 million of the year-to-date increase. The remaining change in depreciation and amortization expense during the quarter and nine months ended September 30, 2018 was primarily due to ongoing capital expenditures related to network enhancements and success-based capital projects for consumer and commercial services as well as an increase in amortization expense for customer relationships acquired in the FairPoint acquisition. These increases in depreciation and amortization expense were largely offset by certain assets and intangibles becoming fully depreciated or amortized in 2017.
Reclassifications
Certain amounts in our 2017 condensed consolidated financial statements have been reclassified to conform to the current year presentation. In accordance with the adoption of ASU No. 2017-07,
Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost
, certain components of net periodic benefit cost were reclassified from operating expense to non-operating income (expense) in our condensed consolidated statement of operations. In addition, the classifications of certain operating revenues have been reclassified amongst the revenue categories based on a new methodology following the acquisition of FairPoint. These reclassifications had no effect on total revenue or net income.
Regulatory Matters
Our revenues are subject to broad federal and/or state regulation, which include such telecommunications services as local telephone service, network access service and toll service and are derived from various sources, including:
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Business and residential subscribers of basic exchange services;
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Surcharges mandated by state commissions and the Federal Communications Commission (“FCC”);
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Long distance carriers for network access service;
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Competitive access providers and commercial customers for network access service; and
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Support payments from federal or state programs.
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The telecommunications industry is subject to extensive federal, state and local regulation. Under the Telecommunications Act of 1996, federal and state regulators share responsibility for implementing and enforcing statutes and regulations designed to encourage competition and to preserve and advance widely available, quality telephone service at affordable prices.
At the federal level, the FCC generally exercises jurisdiction over facilities and services of local exchange carriers, such as our rural telephone companies, to the extent they are used to provide, originate or terminate interstate or international communications. The FCC has the authority to condition, modify, cancel, terminate or revoke our operating authority for failure to comply with applicable federal laws or FCC rules, regulations and policies. Fines or penalties also may be imposed for any of these violations.
State regulatory commissions generally exercise jurisdiction over carriers’ facilities and services to the extent they are used to provide, originate or terminate intrastate communications. In particular, state regulatory agencies have substantial oversight over interconnection and network access by competitors of our incumbent local exchange companies. In addition, municipalities and other local government agencies regulate the public rights-of-way necessary to install and operate networks. State regulators can sanction our rural telephone companies or revoke our certifications if we violate relevant laws or regulations.
FCC Matters
In general, telecommunications service in rural areas is more costly to provide than service in urban areas. The lower customer density means that switching and other facilities serve fewer customers and loops are typically longer, requiring greater expenditures per customer to build and maintain. By supporting the high-cost of operations in rural markets, Universal Service Fund (“USF”) subsidies promote widely available, quality telephone service at affordable prices in rural areas.
An order adopted by the FCC in 2011 (the “Order”) has significantly impacted the amount of support revenue we receive from the USF, CAF and intercarrier compensation (“ICC”). The Order reformed core parts of the USF, broadly recast the
existing ICC scheme, established the CAF to replace support revenues provided by the current USF and redirected support from voice services to broadband services. In 2012, CAF Phase I was implemented, which froze USF support to price cap carriers until the FCC implemented a broadband cost model to shift support from voice services to broadband services. The Order also modified the methodology used for ICC traffic exchanged between carriers. The initial phase of ICC reform was effective on July 1, 2012, beginning the transition of our terminating switched access rates to bill-and-keep over a seven year period for our price cap study areas and nine years for our rate of return study areas, and as a result, we anticipate that our network access revenue for 2018 will be reduced by approximately $3.0 million.
In December 2014, the FCC released a report and order that addressed, among other things, the transition to CAF Phase II funding for price cap carriers and the acceptance criteria for CAF Phase II funding. For companies that accept the CAF Phase II funding, there is a three year transition period in instances in which their current CAF Phase I funding exceeds the CAF Phase II funding. If CAF Phase II funding exceeds CAF Phase I funding, the transitional support is waived and CAF Phase II funding begins immediately. Companies are required to commit to a statewide build out requirement to 10 Mbps downstream and 1 Mbps upstream in funded locations.
We accepted the CAF Phase II funding in August 2015, which was effective as of January 1, 2015. The annual funding under CAF Phase I of $36.6 million was replaced by annual funding under CAF Phase II of $13.9 million through 2020. With the sale of our Iowa ILEC in 2016, this amount was further reduced to $11.5 million through 2020. Subsequently, with the acquisition of FairPoint, this amount increased to $48.9 million through 2020. With the sale of our Virginia ILEC in 2018, this amount was reduced to $48.1 million through 2020. The acceptance of CAF Phase II funding at a level lower than the frozen CAF Phase I support results in CAF Phase II transitional funding over a three year period based on the difference between the CAF Phase I funding and the CAF Phase II funding at the rates of 75% in the first year, 50% in the second year and 25% in the third year. We accepted CAF Phase II support in all of our operating states except Colorado and Kansas where the offered CAF Phase II support was declined. We continue to receive frozen CAF Phase I support in Colorado and Kansas until such time as the FCC CAF Phase II auction assigns support to another provider. The FCC auction process for CAF Phase II funding occurred during the quarter ended September 30, 2018. The winners have been announced and funding is expected to occur in the first half of 2019.
The specific obligations associated with CAF Phase II funding include the obligation to serve approximately 124,500 locations by December 31, 2020 (with interim milestones of 40%, 60% and 80% completion by December 2017, 2018 and 2019, respectively); to provide broadband service to those locations with speeds of 10 Mbps per second down and 1 Mbps up; to achieve latency of less than 100 milliseconds; to provide data of at least 100 gigabytes per month; and to offer pricing reasonably comparable to pricing in urban areas. The Company met this milestone for 2017 and as of September 30, 2018, we are on target to achieve the 2018 milestone.
The annual FCC price cap filing was made on June 18, 2018 and became effective on July 3, 2018. This filing reflects incorporating the Consolidated and FairPoint holding companies, which once combined changed the revenue threshold and amounts allocated to the price cap subsidiaries. The changes allowed some properties to raise their access recovery charge rates and was offset by a decrease in CAF ICC support. The net impact is an increase of $1.8 million in support funding for the July 2018 through June 2019 tariff period.
Local Switching Support
In 2015, FairPoint filed a Petition with the FCC asking the FCC to direct National Exchange Carrier Association (“NECA”) to stop subtracting frozen LSS from FairPoint’s ICC Eligible Recovery for FairPoint’s rate of return ILECs that participate in the NECA pooling process. This issue is unique to rate of return affiliates of price cap carriers because such companies are considered price cap carriers for the FCC’s CAF funding, but remain rate of return for ICC purposes. Effective January 1, 2012, FairPoint rate of return ILECs were placed under the price cap CAF Phase I interim support mechanism, whereby the ILECs continued to receive frozen USF support for all forms of USF support received during 2011, including LSS. The rate of return rules for ICC included LSS support in that mechanism as well; therefore, NECA subtracted the frozen LSS support from the ICC Eligible Recovery amounts in accordance with FCC rules prohibiting duplicate recovery. When FairPoint accepted CAF Phase II support effective January 1, 2015, there was no longer any duplicate support and FairPoint requested NECA to stop subtracting LSS from FairPoint’s ICC Eligible Recovery. NECA declined to make that change, which led to FairPoint filing a Petition with the FCC asking the FCC to direct NECA to comply with FCC rules on ICC
Eligible Recovery for rate of return ILECs. This issue also applies to Consolidated’s operations in Minnesota, which are also rate of return ILECs associated with a price cap company. The combined LSS support for the period from January 1, 2015 through December 31, 2017 is approximately $12.3 million. Our ongoing ICC Eligible Recovery support for 2018 would increase by approximately $3.6 million, and thereafter, decline by 5% per year through 2021. On March 31, 2018, we obtained the required votes necessary for an approved order and on April 19, 2018, the FCC issued its order approving our petition. As a result, during the nine months ended September 30, 2018, we recognized subsidies revenue of $6.3 million and a contingent asset of $8.7 million as a pre-acquisition gain contingency for the FairPoint LSS revenue prior to the acquisition date.
FCC Rules for Business Data Services
On April 20, 2017, the FCC adopted new rules for Business Data Services (“BDS”) which went into effect August 1, 2017. BDS services are high speed data services provided on a point to point basis. The rules apply to interstate BDS services in areas served by price cap carriers. Under the new BDS rules, all packet-switched services and all transport services, channel terminations connecting wholesale customers to our networks and end user channel terminations in counties deemed competitive are competitive. End user channel terminations for DS0, DS1 and DS3 services are non-competitive in counties deemed by the FCC to be non-competitive, but are eligible for Phase I price flexibility. The FCC published a list of counties deemed competitive and non-competitive. Geographic areas previously under Phase II price flexibility will not be rate regulated for any BDS services.
In our price cap operations we can continue to offer competitive BDS services under tariff or we can remove the services from tariff. All competitive services must be detariffed within three years of the effective date of the BDS rules. We have complete price flexibility for BDS services deemed competitive.
BDS services are subject to vigorous competition. We cannot determine the impact of the BDS rules on our revenues or operations. The FCC has issued a Notice of Proposed Rulemaking to address BDS services for rate of return companies. The timing of an order is unknown at this time.
State Matters
California
In an ongoing proceeding relating to the New Regulatory Framework, the California Public Utilities Commission (“CPUC”) adopted Decision 06-08-030 in 2006, which grants carriers broader pricing freedom in the provision of telecommunications services, bundling of services, promotions and customer contracts. This decision adopted a new regulatory framework, the Uniform Regulatory Framework (“URF”), which among other things (i) eliminates price regulation and allows full pricing flexibility for all new and retail services, (ii) allows new forms of bundles and promotional packages of telecommunication services, (iii) allocates all gains and losses from the sale of assets to shareholders and (iv) eliminates almost all elements of rate of return regulation, including the calculation of shareable earnings. In December 2010, the CPUC issued a ruling to initiate a new proceeding to assess whether, or to what extent, the level of competition in the telecommunications industry is sufficient to control prices for the four largest ILECs in the state. Subsequently, the CPUC issued a ruling temporarily deferring the proceeding. When the CPUC may open this proceeding is unclear and on hold at this time. The CPUC’s actions in this and future proceedings could lead to new rules and an increase in government regulation. The Company will continue to monitor this matter.
Texas
The Texas Public Utilities Regulatory Act (“PURA”) directs the Public Utilities Commission of Texas (“PUCT”) to adopt and enforce rules requiring local exchange carriers to contribute to a state universal service fund that helps telecommunications providers offer basic local telecommunications service at reasonable rates in high-cost rural areas. The Texas Universal Service Fund is also used to reimburse telecommunications providers for revenues lost by providing lifeline service. Our Texas rural telephone companies receive disbursements from this fund.
Our Texas ILECs have historically received support from two state funds, the small and rural incumbent local exchange company plan High Cost Fund (“HCF”) and the High Cost Assistance Fund (“HCAF”). The HCF is a line-based fund used to keep local rates low. The rate is applied on all residential lines and up to five single business lines. The amount we receive from the HCAF is a frozen monthly amount that was originally developed to offset high intrastate toll rates.
In September 2011, the Texas state legislature passed Senate Bill No. 980/House Bill No. 2603 which, among other things, mandated the PUCT to review the Universal Service Fund and issue recommendations by January 1, 2013 with the intent to effectively reduce the size of the Universal Service Fund. This would be accomplished by implementing an urban floor to offset state funding reductions with a phase-in period of four years. The PUCT recommended that (i) frozen line counts be lifted effective September 1, 2013 and (ii) rural and urban local rate benchmarks be developed. The large company fund review was completed in September 2012 and the PUCT addressed the small fund participants in Docket 41097
Rate Rebalancing
(“Docket 41097”), as discussed below.
In June 2013, the Texas state legislature passed Senate Bill No. 583 (“SB 583”). The provisions of SB 583 were effective September 1, 2013 and froze HCF and HCAF support for the remainder of 2013. As of January 1, 2014, our annual $1.4 million HCAF support was eliminated and the frozen HCF support returned to funding on a per line basis. In July 2013, the Company entered into a settlement agreement with the PUCT on Docket 41097, which was approved by the PUCT in August 2013. In accordance with the provisions of the settlement agreement, the HCF draw will be reduced by approximately $1.2 million annually over a four year period beginning June 1, 2014 through 2018. However, we have the ability to fully offset this reduction with increases to residential rates where market conditions allow.
In addition, the PUCT is required to develop a needs test for post-2017 funding and has held workshops on various proposals. The PUCT issued its recommendation to the Texas state commissioners in May 2014, which was approved in December 2014. The needs test allows for a one-time disaggregation of line rates from a per line flat rate, then a competitive test must be met to receive funding. The Company filed its submission for the needs test on December 28, 2016. The PUCT issued docket 46699 on January 4, 2017 to review the filing and a decision was granted in the second quarter of 2017. The order eliminated per line support for two of our exchanges resulting in a decline in annual revenues of approximately $0.4 million in 2018. All other exchanges continue to receive per line support.
New York
With the acquisition of FairPoint, we assumed grants from the NY Broadband Program (the "NYBB"). In 2015, New York established the $500 million NYBB to provide state grant funding to support projects that deliver high-speed Internet access to unserved and underserved areas with a goal of achieving statewide broadband access in New York by the end of 2018.
FairPoint received and accepted award letters in March 2017 for grant awards totaling $36.7 million from the NYBB Phase 2 grants. These grants will support, in part, the extension and upgrading of high-speed broadband services to over 10,321 locations in our New York service territory. During the second quarter of 2017, a bid for Phase 3 grants was submitted by FairPoint, the final phase of the NYBB grants. On January 31, 2018, the state notified us that we were awarded a portion of our Phase 3 bid. However, based on a reduction in the number of locations awarded under the bid, we did not accept the Phase 3 grant. We expect to treat the Phase 2 reimbursements as a contribution in aid of construction given the nature of the arrangement.
To be eligible for the grant, the network must be capable of delivering speeds of 100 Mbps or greater in unserved and underserved locations. As a condition of the grant, we are required to offer the NYBB’s Required Pricing Tier as a service option to residential users for a period of five years from completion of construction of the network. This pricing requirement will provide for broadband Internet service at minimum speeds of 25/4 Mbps (download/upload).
FairPoint Merger Requirements
As part of our acquisition of FairPoint, we have regulatory commitments that vary by state, some of which require capital investments in our network over several years through 2020. The requirements include improved data speeds and other service quality improvements in select locations primarily in our Northern New England, New York and Illinois markets. In New Hampshire and Vermont, we are required to invest 13% and 14%, respectively, of total state revenues in capital improvements per year for 2018, 2019 and 2020. For our service territory in Maine, we are required to make capital expenditures of $16.4 million per year from 2018 through 2020. In addition, we are required to invest an incremental $1.0 million per year in each of these three states for service quality improvements. In New York, we are required to invest $4.0 million over three years to expand the broadband network to over 300 locations. In Illinois, we are required to invest an additional $1.0 million by December 31, 2018 to increase broadband availability and speeds in areas we serve by the FairPoint Illinois ILECs. We achieved all of the 2017 requirements and, as of September 30, 2018, we expect to achieve all of the 2018 requirements by December 31, 2018.
Other Regulatory Matters
We are also subject to a number of regulatory proceedings occurring at the federal and state levels that may have a material impact on our operations. The FCC and state commissions have authority to issue rules and regulations related to our business. A number of proceedings are pending or anticipated that are related to such telecommunications issues as competition, interconnection, access charges, intercarrier compensation, broadband deployment, consumer protection and universal service reform. Some proceedings may authorize new services to compete with our existing services. Proceedings that relate to our cable television operations include rulemakings on set top boxes, carriage of programming, industry consolidation and ways to promote additional competition. There are various on-going legal challenges to the scope or validity of FCC orders that have been issued. As a result, it is not yet possible to fully determine the impact of the related FCC rules and regulations on our operations.
Non-Operating Items
Other Income and Expense, Net
Interest expense, net of interest income, decreased $2.8 million and $0.9 million during the quarter and nine months ended September 30, 2018, respectively, compared to the same periods in 2017 primarily due to ticking fees and the amortization of commitment fees incurred in 2017 related to the committed financing secured for the acquisition of FairPoint, as described in the “Liquidity and Capital Resources” section below. These increases were largely reduced by additional interest expense from the issuance of the $935.0 million incremental term loan discussed below during the quarter ended September 30, 2017 and an increase in variable interest rates in the current year.
Other income increased $0.1 million and $7.7 million during the quarter and nine months ended September 30, 2018, respectively, compared to the same periods in 2017 primarily due to changes in investment income from our wireless partnership interests. Pension and post-retirement expense also declined in the current year periods.
Income Taxes
Income taxes decreased $2.7 million and $7.3 million during the quarter and nine months ended September 30, 2018, respectively, compared to the same periods in 2017. Our effective tax rate was 37.8% and 18.1% for the quarters ended September 30, 2018 and 2017, respectively and 32.1% and 22.1% for the nine-month periods ended September 30, 2018 and 2017, respectively. During the quarter ended September 30, 2018, adjustments were made to the provisional estimates that were disclosed as of December 31, 2017 under Staff Accounting Bulletin No. 118 (“SAB 118”) for the Tax Cuts and Jobs Act of 2017 (the “Tax Act”) that resulted in a $4.4 million decrease to our tax provision. The Company recorded additional purchase accounting tax adjustments outside the measurement period related to the acquisition of FairPoint that resulted in a $1.1 million increase to our tax provision. On July 31, 2018, we completed the sale of all the issued and outstanding stock of Peoples in a taxable transaction. We recorded an increase of $0.8 million to our deferred tax liabilities and a corresponding increase to our deferred tax provision to reflect the taxable temporary differences associated with the excess of the reported amount of its investment in Peoples over the underlying tax basis. For the quarter ended September 30, 2017, we recorded a net increase of $5.2 million to our net state deferred tax liabilities and a corresponding increase to
our state tax provision due to the acquisition of FairPoint. The Company incurred non-deductible expenses in relation to the FairPoint acquisition that resulted in an increase to our tax provision of $2.3 million. The Company also recorded a number of purchase accounting tax adjustments, which did not impact our tax provision, related to the FairPoint acquisition that included release of a portion of the valuation allowances, state deferred tax rate changes and nondeductible transaction expenses. We recognized these in the quarter ended September 30, 2017. In addition, for the quarter and nine-month periods ended September 30, 2018 and 2017, the effective tax rate differed from the federal and state statutory rates due to various permanent income tax differences and differences in allocable income for the Company’s state tax filings. Exclusive of these adjustments, our effective tax rate would have been approximately 26.8% and 42.2% for the quarters ended September 30, 2018 and 2017, respectively and 27.2% and 39.4% for the nine-month periods ended September 30, 2018 and 2017, respectively. The primary driver in the difference in effective tax rates, exclusive of adjustments, in the 2018 and 2017 periods disclosed is the change in the corporate tax rate from 35% to 21% due to the enactment of the Tax Act.
Non-GAAP Measures
In addition to the results reported in accordance with US GAAP, we also use certain non-GAAP measures such as EBITDA and adjusted EBITDA to evaluate operating performance and to facilitate the comparison of our historical results and trends. These financial measures are not measures of financial performance under US GAAP and should not be considered in isolation or as a substitute for net income as a measure of performance and net cash provided by operating activities as a measure of liquidity. They are not, on their own, necessarily indicative of cash available to fund cash needs as determined in accordance with GAAP. The calculation of these non-GAAP measures may not be comparable to similarly titled measures used by other companies. Reconciliations of these non-GAAP measures to the most directly comparable financial measures presented in accordance with GAAP are provided below.
EBITDA is defined as net earnings before interest expense, income taxes and depreciation and amortization. Adjusted EBITDA is comprised of EBITDA, adjusted for certain items as permitted or required under our credit facility as described in the reconciliations below. These measures are a common measure of operating performance in the telecommunications industry and are useful, with other data, as a means to evaluate our ability to fund our estimated uses of cash.
The following table is a reconciliation of net loss to adjusted EBITDA for the quarters and nine months ended September 30, 2018 and 2017:
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Quarter Ended
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Nine Months Ended
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September 30,
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September 30,
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(In thousands, unaudited)
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2018
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2017
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2018
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2017
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Net loss
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$
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(14,815)
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$
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(28,394)
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$
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(36,573)
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$
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(34,725)
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Add (subtract):
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Interest expense, net of interest income
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33,524
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36,307
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99,079
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99,896
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Income tax benefit
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(8,993)
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(6,289)
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(17,250)
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(9,862)
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Depreciation and amortization
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109,119
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104,406
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328,759
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187,084
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EBITDA
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118,835
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106,030
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374,015
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242,393
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Adjustments to EBITDA:
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Other, net
(1)
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5,208
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21,797
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(1,655)
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14,216
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Investment distributions
(2)
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8,121
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8,641
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28,815
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22,021
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Non-cash, stock-based compensation
(3)
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1,538
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889
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3,754
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2,319
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Adjusted EBITDA
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$
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133,702
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$
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137,357
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$
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404,929
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$
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280,949
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(1)
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Includes the equity earnings from our investments, dividend income, income attributable to noncontrolling interests in subsidiaries, acquisition and transaction related costs, including severance, non-cash pension and post-retirement benefits and certain other miscellaneous items.
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(2)
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Includes all cash dividends and other cash distributions received from our investments.
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(3)
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Represents compensation expenses in connection with the issuance of stock awards, which, because of the non-cash nature of these expenses, are excluded from adjusted EBITDA.
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Liquidity and Capital Resources
Outlook and Overview
Our operating requirements have historically been funded from cash flows generated from our business and borrowings under our credit facilities. We expect that our future operating requirements will continue to be funded from cash flows from operating activities, existing cash and cash equivalents and, if needed, borrowings under our revolving credit facility and our ability to obtain future external financing. We anticipate that we will continue to use a substantial portion of our cash flow to fund capital expenditures, meet scheduled payments of long-term debt, make dividend payments and invest in future business opportunities.
The following table summarizes our cash flows:
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Nine Months Ended September 30,
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(In thousands)
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2018
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2017
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Cash flows provided by (used in):
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Operating activities
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$
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264,036
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$
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125,224
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Investing activities
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(163,893)
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(981,378)
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Financing activities
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(111,974)
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852,391
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Decrease in cash and cash equivalents
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$
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(11,831)
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$
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(3,763)
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Cash Flows Provided by Operating Activities
Net cash provided by operating activities was $264.0 million during the nine-month period ended September 30, 2018, an increase of $138.8 million compared to the same period in 2017. Cash flows provided by operating activities increased primarily as a result of the additional cash flows provided by the addition of the FairPoint operations as of July 2017 as well as additional transaction costs paid in 2017 related to the acquisition of FairPoint. Cash distributions received from our wireless partnerships also increased $6.8 million during the nine-month period ended September 30, 2018 compared to the same period in 2017. In addition, income tax refunds increased approximately $10.1 million from prior year. However, cash contributions to our defined benefit pension plans increased $16.9 million in 2018 compared to 2017 of which $11.8 million is attributable to the acquisition of FairPoint.
Cash Flows Used In Investing Activities
Net cash used in investing activities was $163.9 million during the nine-month period ended September 30, 2018 and consisted primarily of cash used for capital expenditures.
Capital Expenditures
Capital expenditures continue to be our primary recurring investing activity and were $186.8 million during the nine-month period ended September 30, 2018, an increase of $67.5 million compared to the same period in 2017 driven by the acquisition of FairPoint in the quarter ended September 30, 2017. Capital expenditures for the remainder of 2018 are expected to be $53.0 million to $58.0 million, of which approximately 50% is planned for success-based capital projects for consumer and commercial initiatives. Capital expenditures for the remainder of 2018 and subsequent years will depend on various factors, including competition, changes in technology, regulatory changes and the timing in the deployment of new services. We expect to continue to invest in existing and new services and the expansion of our fiber network in order to retain and acquire more customers through a broader set of products and an expanded network footprint.
Business Dispositions
During the quarter ended September 30, 2018, we received cash proceeds of $21.0 million for the sale of Peoples, our local exchange carrier in Virginia.
Cash Flows Used In Financing Activities
Net cash used in financing activities consists primarily of our proceeds from and principal payments on long-term borrowings and the payment of dividends.
Long-term Debt
Credit Agreement
In October 2016, the Company, through certain of its wholly owned subsidiaries, entered into a Third Amended and Restated Credit Agreement with various financial institutions (as amended, the “Credit Agreement”). The Credit Agreement consists of a $110.0 million revolving credit facility, an initial term loan in the aggregate amount of $900.0 million (the “Initial Term Loan”) and an incremental term loan in the aggregate amount of $935.0 million (the “Incremental Term Loan”), collectively (the “Term Loans”). The Incremental Term Loan was issued on July 3, 2017 upon completion of the FairPoint Merger, as described below. The Credit Agreement also includes an incremental loan facility which provides the ability to borrow, subject to certain terms and conditions, incremental loans in an aggregate amount of up to the greater of (a) $300.0 million and (b) an amount which would cause its senior secured leverage ratio not to exceed 3.00:1.00 (the “Incremental Facility”). Borrowings under the Credit Agreement are secured by substantially all of the assets of the Company and its subsidiaries, including certain of the FairPoint subsidiaries acquired in the Merger, with the exception of Consolidated Communications of Illinois Company and our majority-owned subsidiary, East Texas Fiber Line Incorporated.
The Initial Term Loan was issued in an original aggregate principal amount of $900.0 million with a maturity date of October 5, 2023, but is subject to earlier maturity on March 31, 2022 if the Company’s unsecured Senior Notes due in October 2022 are not repaid in full or redeemed in full on or prior to March 31, 2022. The Initial Term Loan contains an original issuance discount of 0.25% or $2.3 million, which is being amortized over the term of the loan. The Initial Term Loan requires quarterly principal payments of $2.25 million and has an interest rate of 3.00% plus the London Interbank Offered Rate (“LIBOR“) subject to a 1.00% LIBOR floor.
In connection with the execution of the Merger Agreement, in December 2016, the Company entered into two amendments to its Credit Agreement to secure committed financing related to the acquisition of FairPoint. On December 14, 2016, we entered into Amendment No. 1 to the Credit Agreement and on December 21, 2016, the Company entered into Amendment No. 2 to the Credit Agreement, pursuant to which a syndicate of lenders agreed to provide an incremental term loan in an aggregate principal amount of up to $935.0 million under the Credit Agreement, subject to the satisfaction of certain conditions. The Incremental Term Loan was made pursuant to the Incremental Facility set forth in the Credit Agreement. Fees of $2.5 million paid to the lenders in connection with Amendment No. 1 are reflected as an additional discount on the Initial Term Loan and are being amortized over the term of the debt as interest expense. Ticking fees accrued on the incremental term loan commitments from January 15, 2017 through the July 3, 2017 Merger closing date at a rate of 3.00% plus LIBOR subject to a 1.00% LIBOR floor and became due and payable on the closing date. In connection with entering into the committed financing, commitment fees of $14.0 million were capitalized in December 2016 and were amortized to interest expense over the term of the commitment period through July 2017.
On July 3, 2017, the Merger with FairPoint was completed and the net proceeds from the incurrence of the Incremental Term Loan were used, in part, to repay and redeem certain existing indebtedness of FairPoint and to pay certain fees and expenses in connection with the Merger and the related financing. The Incremental Term Loan included an original issue discount of 0.50% and has the same maturity date and interest rate as the Initial Term Loan. The Incremental Term Loan requires quarterly principal payments of $2.34 million which began in December 2017.
In addition, effective contemporaneously with the Merger, the Company entered into Amendment No. 3 to the Credit Agreement to increase the permitted amount of outstanding letters of credit from $15.0 million to $20.0 million and to provide that certain existing letters of credit of FairPoint be deemed to be letters of credit under the Credit Agreement.
Our revolving credit facility has a maturity date of October 5, 2021 and an applicable margin (at our election) of between 2.50% and 3.25% for LIBOR-based borrowings or between 1.50% and 2.25% for
alternate base rate borrowings, in each case depending on our total net leverage ratio. Based on our leverage ratio as of September 30, 2018, the borrowing margin for the three month period ending December 31, 2018 will be at a weighted-average margin of
3.00% f
or a LIBOR-based loan or
2.00%
for an alternate base rate loan. The applicable borrowing margin for the revolving credit facility is adjusted quarterly to reflect the leverage ratio from the prior quarter-end. As of
September 30, 2018, alternate base rate borrowings of $16.0 million were outstanding under the revolving credit facility.
At December 31, 2017,
t
here were borrowings of $22.0 million outstanding under the revolving credit facility,
which consisted of LIBOR-based borrowings of $17.0 million and alternate base rate borrowings of $5.0 million. Stand-by letters of credit of
$17.2
million were outstanding under our revolving credit facility as of September 30, 2018. The stand-by letters of credit are renewable annually and reduce the borrowing availability under the revolving credit facility. As of September 30, 2018, $76.8 million was available for borrowing under the revolving credit facility.
The weighted-average interest rate on outstanding borrowings under our credit facility was 5.27% and 4.58%
as of September 30, 2018 and
December 31, 2017, respectively
. Interest is payable at least quarterly
.
Credit Agreement Covenant Compliance
The Credit Agreement contains various provisions and covenants, including, among other items, restrictions on the ability to pay dividends, incur additional indebtedness and issue certain capital stock. We have agreed to maintain certain financial ratios, including interest coverage and total net leverage ratios, all as defined in the Credit Agreement. As of September 30, 2018, we were in compliance with the Credit Agreement covenants
.
In general, our Credit Agreement restricts our ability to pay dividends to the amount of our available cash as defined in our Credit Agreement. As of September 30, 2018, and including the $27.6 million dividend paid on November 1, 2018, we had $312.7 million in dividend availability under the credit facility covenant.
Under our Credit Agreement, if our total net leverage ratio, as defined in the Credit Agreement, as of the end of any fiscal quarter is greater than 5.10:1.00, we will be required to suspend dividends on our common stock unless otherwise permitted by an exception for dividends that may be paid from the portion of proceeds of any sale of equity not used to fund acquisitions or make other investments. During any dividend suspension period, we will be required to repay debt in an amount equal to 50.0% of any increase in available cash, among other things. In addition, we will not be permitted to pay dividends if an event of default under the Credit Agreement has occurred and is continuing. Among other things, it will be an event of default if our total net leverage ratio or interest coverage ratio as of the end of any fiscal quarter is greater than 5.25:1.00 or less than 2.25:1.00, respectively. As of September 30, 2018, our total net leverage ratio under the Credit Agreement was 4.33:1.00, and our interest coverage ratio was 4.15:1.00.
6.50% Senior Notes due 2022
In September 2014, we completed an offering of $200.0 million aggregate principal amount of 6.50% Senior Notes due in October 2022 (the “Existing Notes”). The Existing Notes were priced at par, which resulted in total gross proceeds of $200.0 million. On June 8, 2015, we completed an additional offering of $300.0 million in aggregate principal amount of 6.50% Senior Notes due 2022 (the “New Notes” and together with the Existing Notes, the “Senior Notes”). The New Notes were issued as additional notes under the same indenture pursuant to which the Existing Notes were previously issued on in September 2014. The New Notes were priced at 98.26% of par with a yield to maturity of 6.80% and resulted in total gross proceeds of approximately $294.8 million, excluding accrued interest. The discount is being amortized using the effective interest method over the term of the notes.
The Senior Notes mature on October 1, 2022 and interest is payable semi-annually on April 1 and October 1 of each year. Consolidated Communications, Inc. (“CCI”) is the primary obligor under the Senior Notes, and we and certain of our
wholly‑owned subsidiaries, including certain FairPoint subsidiaries, have fully and unconditionally guaranteed the Senior Notes. The Senior Notes are senior unsecured obligations of the Company.
Senior Notes Covenant Compliance
Subject to certain exceptions and qualifications, the indenture governing the Senior Notes contains customary covenants that, among other things, limits CCI’s and its restricted subsidiaries’ ability to: incur additional debt or issue certain preferred stock; pay dividends or make other distributions on capital stock or prepay subordinated indebtedness; purchase or redeem any equity interests; make investments; create liens; sell assets; enter into agreements that restrict dividends or other payments by restricted subsidiaries; consolidate, merge or transfer all or substantially all of its assets; engage in transactions with its affiliates; or enter into any sale and leaseback transactions. The indenture also contains customary events of default.
Among other matters, the Senior Notes indenture provides that CCI may not pay dividends or make other restricted payments, as defined in the indenture, if its total net leverage ratio is 4.75:1.00 or greater. This ratio is calculated differently than the comparable ratio under the Credit Agreement; among other differences, it takes into account, on a pro forma basis, synergies expected to be achieved as a result of certain acquisitions not yet reflected in historical results. As of September 30, 2018, this ratio was 4.38:1.00. If this ratio is met, dividends and other restricted payments may be made from cumulative consolidated cash flow since April 1, 2012, less 1.75 times fixed charges, less dividends and other restricted payments made since May 30, 2012. Dividends may be paid and other restricted payments may also be made from a “basket” of $50.0 million, none of which has been used to date, and pursuant to other exceptions identified in the indenture. Since dividends of $516.1 million have been paid since May 30, 2012, including the quarterly dividend declared in July 2018 and paid on November 1, 2018, there was $1,060.1 million of the $1,576.2 million of cumulative consolidated cash flow since May 30, 2012 available to pay dividends as of September 30, 2018. As of September 30, 2018, the Company was in compliance with all terms, conditions and covenants under the indenture governing the Senior Notes.
Capital Leases
We lease certain facilities and equipment under various capital leases which expire between 2018 and 2027. As of September 30, 2018, the present value of the minimum remaining lease commitments was approximately $33.5 million, of which $13.5 million was due and payable within the next twelve months.
The leases require total remaining rental payments of
$39.6 million as of September 30, 2018, of which $2.2 million will be paid to LATEL LLC, a related party entity.
Dividends
We paid $82.6 million and $66.7 million in dividend payments to stockholders during the nine-month periods ended September 30, 2018 and 2017, respectively. In July 2018, our board of directors declared a quarterly dividend of $0.38738 per common share, which was paid on November 1, 2018 to stockholders of record at the close of business on October 15, 2018. In addition, on October 29, 2018, our board of directors declared its next quarterly dividend of $0.38738 per common share, which is payable on February 1, 2019 to stockholders of record at the close of business on January 15, 2019. Our current annual dividend rate is approximately $1.55 per share.
The cash required to fund dividend payments is in addition to our other expected cash needs, which we expect to fund with cash flows from our operations. In addition, we expect we will have sufficient availability under our revolving credit facility to fund dividend payments in addition to any expected fluctuations in working capital and other cash needs, although we do not intend to borrow under this facility to pay dividends.
We believe that our dividend policy will limit, but not preclude, our ability to grow. If we continue paying dividends at the level currently anticipated under our dividend policy, we may not retain a sufficient amount of cash, and may need to seek refinancing to fund a material expansion of our business, including any significant acquisitions or to pursue growth opportunities requiring capital expenditures significantly beyond our current expectations. In addition, because we expect a significant portion of cash available will be distributed to holders of common stock under our dividend policy, our ability
to pursue any material expansion of our business will depend more than it otherwise would on our ability to obtain third-party financing.
Sufficiency of Cash Resources
The following table sets forth selected information regarding our financial condition.
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September 30,
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December 31,
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(In thousands, except for ratio)
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2018
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2017
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Cash and cash equivalents
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$
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3,826
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$
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15,657
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Working capital (deficit)
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(78,572)
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(42,281)
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Current ratio
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0.72
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0.83
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Our net working capital position declined $36.3 million as of September 30, 2018 compared to December 31, 2017 primarily as a result of an increase in accrued compensation related to the timing of expenditures and an increase in accrued interest related to the timing of the semi-annual interest payments for our Senior Notes. In addition, income tax receivable decreased $9.4 million as a result of tax refunds received during the nine months ended September 30, 2018.
Our most significant uses of funds in the remainder of 2018 are expected to be for: (i) dividend payments of approximately $27.6 million; (ii) interest payments on our indebtedness of approximately $41.0 million and principal payments on debt of $4.6 million; and (iii) capital expenditures of between $53.0 million and $58.0 million. In the future our ability to use cash may be limited by our other expected uses of cash, including our dividend policy, and our ability to incur additional debt will be limited by our existing and future debt agreements.
We believe that cash flows from operating activities, together with our existing cash and borrowings available under our revolving credit facility, will be sufficient for at least the next twelve months to fund our current anticipated uses of cash. After that, our ability to fund these expected uses of cash and to comply with the financial covenants under our debt agreements will depend on the results of future operations, performance and cash flow. Our ability to fund these expected uses from the results of future operations will be subject to prevailing economic conditions and to financial, business, regulatory, legislative and other factors, many of which are beyond our control.
We may be unable to access the cash flows of our subsidiaries since certain of our subsidiaries are parties to credit or other borrowing agreements, or are subject to statutory or regulatory restrictions, that restrict the payment of dividends or making intercompany loans and investments, and those subsidiaries are likely to continue to be subject to such restrictions and prohibitions for the foreseeable future. In addition, future agreements that our subsidiaries may enter into governing the terms of indebtedness may restrict our subsidiaries’ ability to pay dividends or advance cash in any other manner to us.
To the extent that our business plans or projections change or prove to be inaccurate, we may require additional financing or require financing sooner than we currently anticipate. Sources of additional financing may include commercial bank borrowings, other strategic debt financing, sales of nonstrategic assets, vendor financing or the private or public sales of equity and debt securities. There can be no assurance that we will be able to generate sufficient cash flows from operations in the future, that anticipated revenue growth will be realized or that future borrowings or equity issuances will be available in amounts sufficient to provide adequate sources of cash to fund our expected uses of cash. Failure to obtain adequate financing, if necessary, could require us to significantly reduce our operations or level of capital expenditures which could have a material adverse effect on our financial condition and the results of operations.
Surety Bonds
In the ordinary course of business, we enter into surety, performance and similar bonds as required by certain jurisdictions in which we provide services. As of September 30, 2018, we had approximately $5.7 million of these bonds outstanding.
Defined Benefit Pension Plans
As required, we contribute to a qualified defined pension plan (the “Retirement Plan”) and non-qualified supplemental retirement plans (the “Supplemental Plans”) and other post-retirement benefit plans, which provide retirement benefits to
certain eligible employees. In connection with the acquisition of FairPoint, we have assumed sponsorship of its two non-contributory qualified defined benefit pension plans (collectively with the Retirement Plan and Supplemental Plans, the “Pension Plans”) and post-retirement benefit plan as of the date of acquisition as described in the Note 9 to the Condensed Consolidated Financial Statements, included in this report in Part I – Item 1 “Financial Statements”. Contributions are intended to provide for benefits attributed to service to date. Our funding policy is to contribute annually an actuarially determined amount consistent with applicable federal income tax regulations.
The cost to maintain our Pension Plans and future funding requirements are affected by several factors including the expected return on investment of the assets held by the Pension Plans, changes in the discount rate used to calculate pension expense and the amortization of unrecognized gains and losses. Returns generated on the Pension Plans assets have historically funded a significant portion of the benefits paid under the Pension Plans. We estimate the weighted average long-term rate of return on assets will be 7.03%. The Pension Plans invest in marketable equity securities which are exposed to changes in the financial markets. If the financial markets experience a downturn and returns fall below our estimate, we could be required to make a material contribution to the Pension Plans, which could adversely affect our cash flows from operations.
In 2018, we expect to make contributions totaling approximately $26.2 million to our Pension Plans and $10.0 million to our other post-retirement benefit plans, which represents an increase of $17.2 million from the total contributions made in 2017 of which $11.8 million is attributable to the acquisition of FairPoint. As of September 30, 2018, we have contributed $20.8 million and $7.9 million to our Pension Plans and our other post-retirement benefit plans, respectively. Our contribution amounts meet the minimum funding requirements as set forth in employee benefit and tax laws.
Income Taxes
The timing of cash payments for income taxes, which is governed by the Internal Revenue Service and other taxing jurisdictions, will differ from the timing of recording tax expense and deferred income taxes, which are reported in accordance with GAAP. For example, tax laws in effect regarding accelerated or “bonus” depreciation for tax reporting resulted in less cash payments than the GAAP tax expense. Acceleration of tax deductions could eventually result in situations where cash payments will exceed GAAP tax expense.
Regulatory Matters
As discussed in the “Regulatory Matters” section above, in December 2014, the FCC released a report and order that significantly impacts the amount of support revenue we receive from the USF, CAF and ICC by redirecting support from voice services to broadband services. The annual funding under CAF Phase I of $36.6 million was replaced by annual funding under CAF Phase II of $13.9 million through 2020. With the sale of our Iowa ILEC in 2016, this amount was further reduced to $11.5 million through 2020. Subsequently, with the acquisition of FairPoint in July 2017, this amount increased to $48.9 million through 2020. With the sale of our Virginia ILEC in 2018, our annual funding was reduced to $48.1 million through 2020. The acceptance of CAF Phase II funding at a level lower than the frozen CAF Phase I support results in CAF Phase II Transitional funding over a three year period based on the difference between the CAF Phase I funding and the CAF Phase II funding at the rates of 75% in the first year, 50% in the second year and 25% in the third year.
The Order also modifies the methodology used for ICC traffic exchanged between carriers. As a result of implementing the provisions of the Order, our network access revenue decreased approximately $0.8 million and $2.4 million for the quarter and nine months ended September 30, 2018, respectively, compared to the same periods in 2017. We anticipate that network access revenue will continue to decline as a result of the Order through 2018 by as much as $3.0 million.
As discussed in the “Regulatory Matters” section above, the LSS matter settled in our favor during the nine months ended September 30, 2018. The combined LSS support for the period from January 1, 2015 through December 31, 2017 is approximately $12.3 million. Our ongoing ICC Eligible Recovery support for 2018 is expected to increase by approximately $3.6 million, and thereafter, decline by 5% per year through 2021. During the nine months ended September 30, 2018, we recognized subsidies revenue of $6.3 million and a contingent asset of $8.7 million as a pre-acquisition gain contingency for the FairPoint LSS revenue prior to the acquisition date.
Critical Accounting Estimates
Our condensed consolidated financial statements and accompanying notes are prepared in accordance with US GAAP. Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses. These estimates and assumptions are affected by management’s application of accounting policies. Our judgments are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making estimates about the carrying values of assets and liabilities that are not readily apparent from other sources. For a full discussion of our accounting estimates and assumptions that we have identified as critical in the preparation of our condensed consolidated financial statements, refer to our 2017 Annual Report on Form 10-K filed with the SEC.
Recent Accounting Pronouncements
For information regarding the impact of certain recent accounting pronouncements, see Note 1 “Summary of Significant Accounting Policies” to the Condensed Consolidated Financial Statements, included in this report in Part I - Item 1 “Financial Statements”.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RIS
K
Our exposure to market risk is primarily related to the impact of interest rate fluctuations on our debt obligations. Market risk is the potential loss arising from adverse changes in market interest rates on our variable rate obligations. In order to manage the volatility relating to changes in interest rates, we utilize derivative financial instruments such as interest rate swaps to maintain a mix of fixed and variable rate debt. We do not use derivatives for trading or speculative purposes. Our interest rate swap agreements effectively convert a portion of our floating-rate debt to a fixed-rate basis, thereby reducing the impact of interest rate changes on future cash interest payments. We calculate the potential change in interest expense caused by changes in market interest rates by determining the effect of the hypothetical rate increase on the portion of our variable rate debt that is not subject to a variable rate floor or hedged through the interest rate swap agreements.
As of September 30, 2018, the majority of our variable rate debt was subject to a 1.00% London Interbank Offered Rate floor thereby reducing the impact of fluctuations in interest rates. Based on our variable rate debt outstanding as of September 30, 2018, a 1.00% change in market interest rates would increase or decrease annual interest expense by approximately $6.5 million.
As of September 30, 2018, the fair value of our interest rate swap agreements amounted to a net asset of $17.6 million. Total pre-tax deferred gains related to our interest rate swap agreements included in accumulated other comprehensive loss was $22.0 million as of September 30, 2018.
ITEM 4. CONTROLS AND PROCEDURE
S
We maintain disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (“Exchange Act”) that are designed to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is (i) recorded, processed, summarized and reported within the time periods specified in SEC rules and forms and (ii) accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. There are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures. Accordingly, even effective disclosure controls and procedures can only provide reasonable assurance of achieving their control objectives. In connection with the filing of this Form 10-Q, management evaluated, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, the effectiveness of the design to provide reasonable assurance of achieving their objectives and operation of our disclosure controls and procedures as of September 30, 2018. Based upon that evaluation and subject to the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective as of September 30, 2018.
Changes in Internal Control Over Financial Reporting
Based upon the evaluation performed by our management, which was conducted with the participation of our Chief Executive Officer and Chief Financial Officer, there have been no changes in our internal controls over financial reporting during the quarter ended September 30, 2018 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting, except as noted below.
During the quarter ended March 31, 2018, we completed our migration of the enterprise resource planning (“ERP”) system used by FairPoint for financial reporting and human resources to the Company’s ERP system. This effort now provides a single platform for the Company to process financial information and human resources. The combined processes include accounts payable, purchasing, property, plant and equipment, payroll, general ledger and financial reporting. We believe that the migration to the single ERP system enhanced our internal controls over financial reporting and disclosure controls and procedures. As of September 30, 2018, management is in the process of integrating FairPoint’s internal controls over financial reporting.
Limitations on the Effectiveness of Controls
We are responsible for establishing and maintaining adequate internal control over financial reporting. Our internal control systems are designed to provide reasonable assurance to the Company’s management, Board of Directors and Audit Committee regarding the reliability of financial reporting and the preparation of published financial statements in accordance with generally accepted accounting principles.