CITIZENS COMMUNICATIONS COMPANY FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2005
UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) |X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2005 ------------------ or |_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _________to__________ Commission file number: 001-11001 --------- CITIZENS COMMUNICATIONS COMPANY ------------------------------- (Exact name of registrant as specified in its charter) Delaware 06-0619596 - ------------------------------- ------------------------------------- (State or other jurisdiction of (I.R.S. Employer Indentification No.) incorporation or organization) 3 High Ridge Park Stamford, Connecticut 06905 - ---------------------------------------- ------------ (Address of principal executive offices) (Zip Code) (203) 614-5600 ---------------------------------------------------------------- (Registrant's telephone number, including area code) N/A -------------------------------------------------------- (Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No --- --- Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes X No --- --- Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes No X --- --- The number of shares outstanding of the registrant's Common Stock as of October 31, 2005 was 333,897,838.
<TABLE> <CAPTION> CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES Index Page No. -------- Part I. Financial Information (Unaudited) Financial Statements <S> <C> Consolidated Balance Sheets at September 30, 2005 and December 31, 2004 2 Consolidated Statements of Operations for the three months ended September 30, 2005 and 2004 3 Consolidated Statements of Operations for the nine months ended September 30, 2005 and 2004 4 Consolidated Statements of Shareholders' Equity for the year ended December 31, 2004 and the nine months ended September 30, 2005 5 Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2005 and 2004 5 Consolidated Statements of Cash Flows for the nine months ended September 30, 2005 and 2004 6 Notes to Consolidated Financial Statements 7 Management's Discussion and Analysis of Financial Condition and Results of Operations 22 Quantitative and Qualitative Disclosures about Market Risk 33 Controls and Procedures 34 Part II. Other Information Legal Proceedings 35 Unregistered Sales of Equity Securities and Use of Proceeds, Issuer Purchases of Equity Securities 35 Exhibits 35 Signature 37 </TABLE> 1
<TABLE> <CAPTION> PART I. FINANCIAL INFORMATION Item 1. Financial Statements -------------------- CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS ($ in thousands, except share amounts) (Unaudited) September 30, 2005 December 31, 2004 ------------------ ----------------- ASSETS Current assets: <S> <C> <C> Cash and cash equivalents $ 286,609 $ 167,463 Accounts receivable, less allowances of $31,947 and $35,996, respectively 207,925 233,690 Other current assets 41,701 45,605 Assets of discontinued operations - 24,122 ------------------ ----------------- Total current assets 536,235 470,880 Property, plant and equipment, net 3,192,090 3,335,850 Goodwill, net 1,921,465 1,921,465 Other intangibles, net 590,327 685,111 Investments 20,121 23,062 Other assets 195,179 232,051 ------------------ ----------------- Total assets $6,455,417 $6,668,419 ================== ================= LIABILITIES AND EQUITY Current liabilities: Long-term debt due within one year $ 227,762 $ 6,380 Accounts payable and other current liabilities 375,844 410,405 Liabilities of discontinued operations - 735 ------------------ ----------------- Total current liabilities 603,606 417,520 Deferred income taxes 311,836 232,766 Customer advances for construction and contributions in aid of construction 92,389 94,601 Other liabilities 288,985 294,294 Long-term debt 4,006,967 4,266,998 Shareholders' equity: Common stock, $0.25 par value (600,000,000 authorized shares; 334,637,000 and 339,633,000 outstanding and 343,956,000 and 339,635,000 issued at September 30, 2005 and December 31, 2004, respectively) 85,989 84,909 Additional paid-in capital 1,455,795 1,664,627 Accumulated deficit (162,125) (287,719) Accumulated other comprehensive loss, net of tax (100,663) (99,569) Treasury stock (127,362) (8) ------------------ ----------------- Total shareholders' equity 1,151,634 1,362,240 ------------------ ----------------- Total liabilities and equity $6,455,417 $6,668,419 ================== ================= </TABLE> The accompanying Notes are an integral part of these Consolidated Financial Statements. 2
<TABLE> <CAPTION> PART I. FINANCIAL INFORMATION (Continued) CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2005 AND 2004 ($ in thousands, except per-share amounts) (Unaudited) 2005 2004 --------------- -------------- <S> <C> <C> Revenue $ 537,346 $ 539,188 Operating expenses: Cost of services (exclusive of depreciation and amortization) 51,050 49,655 Other operating expenses 210,352 202,680 Management succession and strategic alternatives expenses (see Note 12) - 75,858 Depreciation and amortization 134,327 140,908 --------------- -------------- Total operating expenses 395,729 469,101 --------------- -------------- Operating income 141,617 70,087 Investment and other income (loss) 6,768 (13,654) Interest expense 85,228 90,863 --------------- -------------- Income (loss) from continuing operations before income taxes 63,157 (34,430) Income tax expense (benefit) 24,781 (21,934) --------------- -------------- Income (loss) from continuing operations 38,376 (12,496) Discontinued operations (see Note 5): Income from operations of discontinued conferencing business - 1,869 Income tax expense - 663 --------------- -------------- Income from discontinued operations - 1,206 --------------- -------------- Net income (loss) available to common shareholders $ 38,376 $ (11,290) =============== ============== Basic income (loss) per common share: Income (loss) from continuing operations $ 0.11 $ (0.04) Income from discontinued operations - - --------------- -------------- Net income (loss) available to common shareholders $ 0.11 $ (0.04) =============== ============== Diluted income (loss) per common share: Income (loss) from continuing operations $ 0.11 $ (0.04) Income from discontinued operations - - --------------- -------------- Net income (loss) available to common shareholders $ 0.11 $ (0.04) =============== ============== </TABLE> The accompanying Notes are an integral part of these Consolidated Financial Statements. 3
<TABLE> <CAPTION> PART I. FINANCIAL INFORMATION (Continued) CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2005 AND 2004 ($ in thousands, except per-share amounts) (Unaudited) 2005 2004 --------------- -------------- <S> <C> <C> Revenue $1,606,367 $1,629,295 - Operating expenses: Cost of services (exclusive of depreciation and amortization) 145,766 151,915 Other operating expenses 614,985 624,858 Management succession and strategic alternatives expenses (see Note 12) - 90,632 Depreciation and amortization 411,990 428,191 --------------- -------------- Total operating expenses 1,172,741 1,295,596 --------------- -------------- Operating income 433,626 333,699 Investment and other income 12,749 16,849 Interest expense 253,096 286,296 --------------- -------------- Income from continuing operations before income taxes 193,279 64,252 Income tax expense 69,892 12,869 --------------- -------------- Income from continuing operations 123,387 51,383 Discontinued operations (see Note 5): Income from operations of discontinued conferencing business (including gain on disposal of $14,061) 15,550 6,241 Income tax expense 13,343 2,254 --------------- -------------- Income from discontinued operations 2,207 3,987 --------------- -------------- Net income available to common shareholders $ 125,594 $ 55,370 =============== ============== Basic income per common share: Income from continuing operations $ 0.36 $ 0.18 Income from discontinued operations 0.01 0.01 --------------- -------------- Net income available to common shareholders $ 0.37 $ 0.19 =============== ============== Diluted income per common share: Income from continuing operations $ 0.36 $ 0.17 Income from discontinued operations 0.01 0.01 --------------- -------------- Net income available to common shareholders $ 0.37 $ 0.18 =============== ============== </TABLE> The accompanying Notes are an integral part of these Consolidated Financial Statements. 4
<TABLE> <CAPTION> PART I. FINANCIAL INFORMATION (Continued) CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY FOR THE YEAR ENDED DECEMBER 31, 2004 AND THE NINE MONTHS ENDED SEPTEMBER 30, 2005 ($ in thousands) (Unaudited) Accumulated Additional Other Total Common Stock Paid-In Accumulated Comprehensive Treasury Stock Shareholders' ------------------ -------------------- Shares Amount Capital Deficit Loss Shares Amount Equity -------- --------- ----------- ------------ ------------ -------- ----------- ----------- <S> <C> <C> <C> <C> <C> <C> <C> <C> <C> Balance January 1, 2004 295,434 $73,858 $1,953,317 $ (365,181) $ (71,676) (10,725) $ (175,135) $1,415,183 Stock plans 4,821 1,206 14,236 - - 6,407 106,823 122,265 Conversion of EPPICS 10,897 2,724 133,621 - - 725 11,646 147,991 Conversion of Equity Units 28,483 7,121 396,221 - - 3,591 56,658 460,000 Dividends on common stock of $2.50 per share - - (832,768) - - - - (832,768) Net income - - - 72,150 - - - 72,150 Tax benefit on equity forward contract - - - 5,312 - - - 5,312 Other comprehensive loss, net of tax and reclassifications adjustment - - - - (27,893) - - (27,893) -------- --------- ----------- ------------ ------------ -------- ----------- ----------- Balance December 31, 2004 339,635 84,909 1,664,627 (287,719) (99,569) (2) (8) 1,362,240 Stock plans 2,097 524 21,673 - - 2,532 33,768 55,965 Conversion of EPPICS 2,224 556 24,822 - - 57 776 26,154 Dividends on common stock of $0.75 per share - - (255,327) - - - - (255,327) Shares repurchased - - - - - (11,906) (161,898) (161,898) Net income - - - 125,594 - - - 125,594 Other comprehensive loss, net of tax and reclassifications adjustment - - - - (1,094) - - (1,094) -------- --------- ----------- ------------ ------------ -------- ----------- ----------- Balance September 30, 2005 343,956 $85,989 $1,455,795 $ (162,125) $(100,663) (9,319) $ (127,362) $1,151,634 ======== ========= =========== ============ ============ ======== =========== =========== </TABLE> CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2005 AND 2004 ($ in thousands) (Unaudited) <TABLE> <CAPTION> For the three months ended September 30, For the nine months ended September 30, -------------------------------------------- -------------------------------------------- 2005 2004 2005 2004 --------------------- --------------------- --------------------- --------------------- <S> <C> <C> <C> <C> Net income (loss) $ 38,376 $ (11,290) $ 125,594 $ 55,370 Other comprehensive loss, net of tax and reclassifications adjustments* (19) (16,652) (1,094) (17,692) --------------------- --------------------- --------------------- --------------------- Total comprehensive income (loss) $ 38,357 $ (27,942) $ 124,500 $ 37,678 ===================== ===================== ===================== ===================== * Consists of unrealized holding (losses)/gains of marketable securities and realized gains taken to income as a result of the sale of securities. The accompanying Notes are an integral part of these Consolidated Financial Statements. </TABLE> 5
PART I. FINANCIAL INFORMATION (Continued) CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2005 AND 2004 ($ in thousands) (Unaudited) <TABLE> <CAPTION> 2005 2004 ---------------- --------------- <S> <C> <C> Income from continuing operations $ 123,387 $ 51,383 Adjustments to reconcile income from continuing operations to net cash provided by operating activities: Depreciation and amortization 411,990 428,191 Gain on expiration/settlement of customer advances (492) (25,345) Stock based compensation expense 6,433 44,212 Loss on debt exchange 3,175 - Loss on extinguishment of debt - 20,368 Investment gain (493) - (Gain)/loss on sale of assets - (9,365) Other non-cash adjustments 7,848 14,709 Deferred income taxes 56,231 15,123 Change in accounts receivable 25,765 18,354 Change in accounts payable and other liabilities (28,506) (25,808) Change in other current assets (993) 5,076 ---------------- --------------- Net cash provided by continuing operating activities 604,345 536,898 Cash flows from (used by) investing activities: Proceeds from sale of assets, net of selling expenses 24,195 59,045 Securities sold 1,112 - Capital expenditures (175,460) (200,180) Other assets (purchased) distributions received, net (803) (26,715) ---------------- --------------- Net cash used by investing activities (150,956) (167,850) Cash flows from (used by) financing activities: Repayment of customer advances for construction and contributions in aid of construction (1,720) (2,092) Long-term debt payments (6,173) (513,795) Premiums paid to retire debt - (20,368) Issuance of common stock 46,739 530,197 Dividends paid (255,327) (747,937) Shares repurchased (161,898) - ---------------- --------------- Net cash used by financing activities (378,379) (753,995) Cash provided by discontinued operations Proceeds from sale of discontinued operations 43,565 - Net cash provided by discontinued operations 571 303 ---------------- --------------- 44,136 303 Increase (decrease) in cash and cash equivalents 119,146 (384,644) Cash and cash equivalents at January 1, 167,463 583,671 ---------------- --------------- Cash and cash equivalents at September 30, $ 286,609 $ 199,027 ================ =============== Cash paid during the period for: Interest $ 244,395 $ 264,174 Income taxes $ 2,235 $ 2,196 Non-cash investing and financing activities: Change in fair value of interest rate swaps $ (9,298) $ 973 Conversion of EPPICS $ 26,154 $ 111,378 Debt-for-debt exchange $ 2,171 $ - Investment writedowns $ - $ 5,286 </TABLE> The accompanying Notes are an integral part of these Consolidated Financial Statements. 6
PART I. FINANCIAL INFORMATION (Continued) CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES (1) Summary of Significant Accounting Policies: ------------------------------------------- (a) Basis of Presentation and Use of Estimates: ------------------------------------------- Citizens Communications Company and its subsidiaries are referred to as "we," "us," "our" or the "Company" in this report. Our unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) and should be read in conjunction with the consolidated financial statements and notes included in our 2004 Annual Report on Form 10-K. Certain reclassifications of balances previously reported have been made to conform to the current presentation. All significant intercompany balances and transactions have been eliminated in consolidation. These unaudited consolidated financial statements include all adjustments, which consist of normal recurring accruals necessary to present fairly the results for the interim periods shown. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions which affect the amounts of assets, liabilities, revenue and expenses we have reported and our disclosure of contingent assets and liabilities at the date of the financial statements. Actual results may differ from those estimates. We believe that our critical estimates are accounting for allowance for doubtful accounts, impairment of long-lived assets, intangible assets, depreciation and amortization, employee benefit plans, income taxes, contingencies, and pension and postretirement benefits expenses among others. Certain information and footnote disclosures have been excluded and/or condensed pursuant to Securities and Exchange Commission rules and regulations. The results of the interim periods are not necessarily indicative of the results for the full year. (b) Cash Equivalents: ----------------- We consider all highly liquid investments with an original maturity of three months or less to be cash equivalents. (c) Revenue Recognition: -------------------- Incumbent Local Exchange Carrier (ILEC) - Revenue is recognized when services are provided or when products are delivered to customers. Revenue that is billed in advance includes: monthly recurring network access services, special access services and monthly recurring local line charges. The unearned portion of this revenue is initially deferred as a component of other liabilities on our consolidated balance sheet and recognized in revenue over the period that the services are provided. Revenue that is billed in arrears includes: non-recurring network access services, switched access services, non-recurring local services and long-distance services. The earned but unbilled portion of this revenue is recognized in revenue in our statement of operations and accrued in accounts receivable in the period that the services are provided. Excise taxes are recognized as a liability when billed. Installation fees and their related direct and incremental costs are initially deferred and recognized as revenue and expense over the average term of a customer relationship. We recognize as current period expense the portion of installation costs that exceeds installation fee revenue. Electric Lightwave, LLC (ELI) - Revenue is recognized when the services are provided. Revenue from long-term prepaid network services agreements, including Indefeasible Rights to Use (IRU), are deferred and recognized on a straight-line basis over the terms of the related agreements. Installation fees and their related direct and incremental costs are initially deferred and recognized as revenue and expense over the average term of a customer relationship. We recognize as current period expense the portion of installation costs that exceeds installation fee revenue. (d) Property, Plant and Equipment: ------------------------------ Property, plant and equipment are stated at original cost or fair market value for our acquired properties, including capitalized interest. Maintenance and repairs are charged to operating expenses as incurred. The gross book value of routine property, plant and equipment retired is charged against accumulated depreciation. (e) Goodwill and Other Intangibles: ------------------------------- Intangibles represent the excess of purchase price over the fair value of identifiable tangible assets acquired. We undertake studies to determine the fair values of assets and liabilities acquired and allocate purchase prices to assets and liabilities, including 7
intangibles. On January 1, 2002, we adopted Statement of Financial Accounting Standards (SFAS) No. 142, "Goodwill and Other Intangible Assets," which applies to all goodwill and other intangible assets recognized in the statement of financial position at that date, regardless of when the assets were initially recognized. This statement requires that goodwill and other intangibles (primarily trade name) with indefinite useful lives no longer be amortized to earnings, but instead be tested for impairment, at least annually. In performing this test, the Company first compares the carrying amount of its reporting units to their respective fair values. If the carrying amount of any reporting unit exceeds its fair value, the Company is required to perform step two of the impairment test by comparing the implied fair value of the reporting unit's goodwill with its carrying amount. The amortization of goodwill and other intangibles with indefinite useful lives ceased upon adoption of the statement on January 1, 2002. We annually (during the fourth quarter) examine the carrying value of our goodwill and trade name to determine whether there are any impairment losses. SFAS No. 142 also requires that intangible assets (primarily customer base) with estimated useful lives be amortized over those lives and be reviewed for impairment in accordance with SFAS No. 144, "Accounting for Impairment or Disposal of Long-Lived Assets" to determine whether any changes to these lives are required. We periodically reassess the useful life of our intangible assets with estimated useful lives to determine whether any changes to those lives are required. (f) Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed ---------------------------------------------------------------------- of: --- We review long-lived assets to be held and used and long-lived assets to be disposed of, including intangible assets with estimated useful lives, for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. Recoverability of assets to be held and used is measured by comparing the carrying amount of the asset to the future undiscounted net cash flows expected to be generated by the asset. Recoverability of assets held for sale is measured by comparing the carrying amount of the assets to their estimated fair market value. If any assets are considered to be impaired, the impairment is measured by the amount by which the carrying amount of the assets exceeds the estimated fair value. (g) Derivative Instruments and Hedging Activities: ---------------------------------------------- We account for derivative instruments and hedging activities in accordance with SFAS No. 149, "Amendment of Statement 133 on Accounting for Derivative Instruments and Hedging." SFAS No. 149 requires that all derivative instruments, such as interest rate swaps, be recognized in the financial statements and measured at fair value regardless of the purpose or intent of holding them. We have interest rate swap arrangements related to a portion of our fixed rate debt. These hedge strategies satisfy the fair value hedging requirements of SFAS No. 149. As a result, the fair value of the hedges is carried on the balance sheet in other assets and the related underlying liabilities are also adjusted to fair value by the same amount. During the third quarter of 2005 we entered into a series of forward rate agreements. These agreements protect us from a rapid rise in short-term interest rates, which would negatively impact some of our interest rate swap arrangements. These forward rate agreements did not qualify for hedge accounting. As a result, the fair value of the agreements is recorded on our balance sheet in other current assets. Changes in fair value are recognized in current earnings. (h) Stock Plans: ------------ We have various employee stock-based compensation plans. Awards under these plans are granted to eligible officers, management employees, non-management employees and non-employee directors. Awards may be made in the form of incentive stock options, non-qualified stock options, stock appreciation rights, restricted stock or other stock based awards. As permitted by current accounting rules, we apply Accounting Principles Board Opinions (APB) No. 25 and related interpretations in accounting for the employee stock plans resulting in the use of the intrinsic value to value the stock. SFAS No. 123, "Accounting for Stock-Based Compensation" and SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure, an amendment of SFAS No. 123," established accounting and disclosure requirements using a fair-value-based method of accounting for stock-based employee compensation plans. As permitted by existing accounting standards, the Company has elected to continue to apply the intrinsic-valued-based method of accounting described above, and has adopted only the disclosure requirements of SFAS No. 123, as amended. 8
In December 2004, the FASB issued SFAS No. 123 (revised 2004), "Share-Based Payment," ("SFAS No. 123R"). SFAS 123R requires that stock-based employee compensation be recorded as a charge to earnings. In April 2005, the Securities and Exchange Commission required the adoption of SFAS No. 123R for annual periods beginning after June 15, 2005. Accordingly, we will adopt SFAS 123R commencing January 1, 2006 and expect to recognize approximately $2,800,000 of expense for the year ended December 31, 2006. We provide pro forma net income (loss) and pro forma net income (loss) per common share disclosures for employee and non-employee director stock option grants based on the fair value of the options at the date of grant. For purposes of presenting pro forma information, the fair value of options granted is computed using the Black Scholes option-pricing model. Had we determined compensation cost based on the fair value at the grant date for the Management Equity Incentive Plan (MEIP), Equity Incentive Plan (EIP) and Directors' Deferred Fee Equity Plan, our pro forma net income and net income per common share available for common shareholders would have been as follows: <TABLE> <CAPTION> Three Months Ended September 30, Nine Months Ended September 30, -------------------------------- ------------------------------- 2005 2004 2005 2004 ------------ ------------ ------------- ----------- ($ in thousands) Net income (loss) available for common shareholders <S> <C> <C> <C> <C> As reported $ 38,376 $(11,290) $ 125,594 $ 55,370 Add: Stock-based employee compensation expense included in reported net income, net of related tax effects 1,283 23,681 4,021 27,509 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (2,109) (27,430) (6,640) (35,126) --------- -------- --------- -------- Pro forma $ 37,550 $(15,039) $ 122,975 $ 47,753 ========= ======== ========= ======== Net income (loss) per common share available for common shareholders As reported: Basic $ 0.11 $ (0.04) $ 0.37 $ 0.19 Diluted $ 0.11 $ (0.04) $ 0.37 $ 0.18 Pro forma: Basic $ 0.11 $ (0.05) $ 0.36 $ 0.16 Diluted $ 0.11 $ (0.05) $ 0.36 $ 0.16 </TABLE> (i) Net Income (Loss) Per Common Share Available for Common Shareholders: --------------------------------------------------------------------- Basic net income (loss) per common share is computed using the weighted average number of common shares outstanding during the period being reported on. Except when the effect would be antidilutive, diluted net income (loss) per common share reflects the dilutive effect of the assumed exercise of stock options using the treasury stock method at the beginning of the period being reported on as well as common shares that would result from the conversion of convertible debt (EPPICS). In addition, the related interest on the debt (net of tax) is added back to income since it would not be paid if the debt was converted to common stock. 9
(2) Recent Accounting Literature and Changes in Accounting Principles: ------------------------------------------------------------------ Variable Interest Entities -------------------------- In December 2003, the FASB issued FASB Interpretation No. 46 (revised December 2003) ("FIN 46R"), "Consolidation of Variable Interest Entities," which addresses how a business enterprise should evaluate whether it has a controlling financial interest in an entity through means other than voting rights and accordingly should consolidate the entity. FIN 46R replaces FASB Interpretation No. 46, "Consolidation of Variable Interest Entities," which was issued in January 2003. We are required to apply FIN 46R to variable interests in variable interest entities or VIEs created after December 31, 2003. For any VIEs that must be consolidated under FIN 46R that were created before January 1, 2004, the assets, liabilities and noncontrolling interests of the VIE initially would be measured at their carrying amounts with any difference between the net amount added to the balance sheet and any previously recognized interest being recognized as the cumulative effect of an accounting change. If determining the carrying amounts is not practicable, fair value at the date FIN 46R first applies may be used to measure the assets, liabilities and noncontrolling interest of the VIE. We reviewed all of our investments and determined that the EPPICS, issued by our consolidated wholly-owned subsidiary, Citizens Utilities Trust and the related Citizens Utilities Capital L.P., were our only VIEs. The adoption of FIN 46R on January 1, 2004 did not have any material impact on our financial position or results of operations (see Note 14). Exchanges of Productive Assets ------------------------------ In December 2004, the FASB issued SFAS No. 153, "Exchanges of Nonmonetary Assets," an amendment of APB Opinion No. 29. SFAS No. 153 addresses the measurement of exchanges of certain non-monetary assets (except for certain exchanges of products or property held for sale in the ordinary course of business). The Statement requires that non-monetary exchanges be accounted for at the fair value of the assets exchanged, with gains or losses being recognized, if the fair value is determinable within reasonable limits and the transaction has commercial substance. SFAS No. 153 is effective for nonmonetary exchanges occurring in fiscal periods beginning after June 15, 2005. The Company does not expect the adoption of the new standard to have a material impact on the Company's financial position, results of operations and cash flows. Accounting for Conditional Asset Retirement Obligations ------------------------------------------------------- In March 2005, the FASB issued FIN 47, "Accounting for Conditional Asset Retirement Obligations," an interpretation of FASB No. 143. FIN 47 clarifies that the term conditional asset retirement obligation as used in FASB No. 143 refers to a legal obligation to perform an asset retirement activity in which the timing or method of settlement are conditional on a future event that may or may not be within the control of the entity. FIN 47 also clarifies when an entity would have sufficient information to reasonably estimate the fair value of an asset retirement obligation. FIN 47 is effective for the year ended December 31, 2005. Accordingly, we will adopt FIN 47 during the fourth quarter of 2005. The Company does not expect the implementation of FIN 47 to have a material effect on the Company's financial position, results of operations or cash flows. Accounting Changes and Error Corrections ---------------------------------------- In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and Error Corrections," a replacement of APB Opinion No. 20 and FASB Statement No. 3. SFAS No. 154 changes the accounting for, and reporting of, a change in accounting principle. SFAS No. 154 requires retrospective application to prior period's financial statements of voluntary changes in accounting principle, and changes required by new accounting standards when the standard does not include specific transition provisions, unless it is impracticable to do so. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. Partnerships ------------ In June 2005, the FASB issued EITF No. 04-5, "Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights," which provides new guidance on how general partners in a limited partnership should determine whether they control a limited partnership. EITF No. 04-5 is effective for fiscal periods beginning after December 15, 2005. The Company does not expect the adoption of EITF No. 04-5 to have a material impact on the Company's financial position, results of operations or cash flows. 10
(3) Accounts Receivable: -------------------- The components of accounts receivable at September 30, 2005 and December 31, 2004 are as follows: <TABLE> <CAPTION> ($ in thousands) September 30, 2005 December 31, 2004 --------------------- -------------------- <S> <C> <C> Customers $ 209,756 $ 227,385 Other 30,116 42,301 Less: Allowance for doubtful accounts (31,947) (35,996) --------------------- -------------------- Accounts receivable, net $ 207,925 $ 233,690 ===================== ==================== </TABLE> The Company maintains an allowance for estimated bad debts based on its estimate of collectibility of its accounts receivables. Bad debt expense, which is recorded as a reduction of revenue, was $990,000 and $7,196,000 for the three months ended September 30, 2005 and 2004, respectively, and $9,133,000 and $13,665,000 for the nine months ended September 30, 2005 and 2004, respectively. In addition, additional reserves are provided for known or impending telecommunications bankruptcies, disputes or other significant collection issues. (4) Property, Plant and Equipment, Net: ----------------------------------- Property, plant and equipment at September 30, 2005 and December 31, 2004 is as follows: <TABLE> <CAPTION> ($ in thousands) September 30, 2005 December 31, 2004 --------------------- --------------------- <S> <C> <C> Property, plant and equipment $ 6,579,972 $ 6,428,364 Less: accumulated depreciation (3,387,882) (3,092,514) --------------------- --------------------- Property, plant and equipment, net $ 3,192,090 $ 3,335,850 ===================== ===================== </TABLE> Depreciation expense is principally based on the composite group method. Depreciation expense was $102,732,000 and $109,278,000 for the three months ended September 30, 2005 and 2004, respectively, and $317,206,000 and $333,301,000 for the nine months ended September 30, 2005 and 2004, respectively. (5) Discontinued Operations and Net Assets Held for Sale: ----------------------------------------------------- Conference Call USA ------------------- In February 2005, we entered into a definitive agreement to sell Conference-Call USA, LLC (CCUSA), our conferencing services business. On March 15, 2005, we completed the sale for $43,565,000 in cash, subject to adjustments under the terms of the agreement. The pre-tax gain on the sale of CCUSA was $14,061,000. Our after-tax gain was approximately $1,167,000. The book income taxes recorded upon sale are primarily attributable to a low tax basis in the assets sold. In accordance with SFAS No. 144, any component of our business that we dispose of or classify as held for sale that has operations and cash flows clearly distinguishable from operations, and for financial reporting purposes, and that will be eliminated from the ongoing operations, should be classified as discontinued operations. Accordingly, we have classified the results of operations of CCUSA as discontinued operations in our consolidated statement of operations and have restated prior periods. CCUSA had revenues of approximately $24,600,000 and operating income of approximately $8,000,000 for the year ended December 31, 2004. At December 31, 2004, CCUSA's net assets totaled approximately $23,400,000. The company had no outstanding debt specifically identified with CCUSA and therefore no interest expense was allocated to discontinued operations. In addition, we ceased to record depreciation expense effective February 16, 2005. 11
Summarized financial information for CCUSA (discontinued operations) is set forth below: December 31, ($ in thousands) 2004 ---------------- Current assets $ 2,819 Net property, plant and equipment 2,450 Goodwill 18,853 ---------------- Total assets of discontinued operations $24,122 ================ Current liabilities $ 735 ---------------- Total liabilities of discontinued operations $ 735 ================ <TABLE> <CAPTION> For the three months ended September 30, For the nine months ended September 30, -------------------------------------------- ------------------------------------------ ($ in thousands) 2005 2004 2005 2004 -------------------- --------------------- -------------------- ------------------- <S> <C> <C> <C> <C> Revenue $ - $ 6,205 $ 4,607 $ 18,657 Operating income - 1,869 1,489 6,241 Income taxes - 663 449 2,254 Net income - 1,206 1,040 3,987 Gain on disposal of CCUSA, net of tax - - 1,167 - </TABLE> Public Utilities ---------------- On April 1, 2004, we completed the sale of our Vermont electric distribution operations for approximately $13,992,000 in cash, net of selling expenses. With that transaction, we completed the divestiture of our public utilities services business pursuant to plans announced in 1999. Losses on the sales of our Vermont properties were included in the impairment charges recorded in 2003. 12
(6) Other Intangibles: ------------------ Other intangibles at September 30, 2005 and December 31, 2004 are as follows: <TABLE> <CAPTION> ($ in thousands) September 30, 2005 December 31, 2004 --------------------- --------------------- <S> <C> <C> <C> <C> Customer base - amortizable over 84 to 96 months $ 994,605 $ 994,605 Trade name - non-amortizable 122,058 122,058 --------------------- --------------------- Other intangibles 1,116,663 1,116,663 Accumulated amortization (526,336) (431,552) --------------------- --------------------- Total other intangibles, net $ 590,327 $ 685,111 ===================== ===================== </TABLE> Amortization expense was $31,595,000 and $31,630,000 for the three months ended September 30, 2005 and 2004, respectively and $94,784,000 and $94,890,000 for the nine months ended September 30, 2005 and 2004. Amortization expense, based on our estimate of useful lives, is estimated to be $126,380,000 per year through 2008 and $57,533,000 in 2009, at which point these assets will have been fully amortized. (7) Long-Term Debt: --------------- The activity in our long-term debt from December 31, 2004 to September 30, 2005 is as follows: <TABLE> <CAPTION> Nine Months Ended September 30, 2005 ------------------------------------------------- Interest Interest Rate* at December 31, Rate September 30, September 30, ($ in thousands) 2004 Payments Swap Other 2005 2005 - ---------------- ----- -------- ----- ----- ----- ---- Rural Utilities Service Loan <S> <C> <C> <C> <C> <C> <C> Contracts $ 29,108 $ (6,092) $ - $ - $ 23,016 6.075% Senior Unsecured Debt 4,131,803 - (9,298) 2,171 4,124,676 8.043% EPPICS** (reclassified as a result of adopting FIN 46R) 63,765 - - (26,154) 37,611 5.000% ELI Capital Leases 4,421 (81) - - 4,340 10.364% Industrial Development Revenue Bonds 58,140 - - - 58,140 5.559% ---------- --------- -------- --------- ----------- TOTAL LONG TERM DEBT $4,287,237 $ (6,173) $(9,298) $(23,983) $ 4,247,783 ---------- ========= ======== ========= ----------- Less: Debt Discount (13,859) (13,054) Less: Current Portion (6,380) (227,762) ---------- ----------- $4,266,998 $ 4,006,967 ========== =========== * Interest rate includes amortization of debt issuance costs, debt premiums or discounts. The interest rate for Rural Utilities Service Loan Contracts, Senior Unsecured Debt, and Industrial Development Revenue Bonds represent a weighted average of multiple issuances. ** In accordance with FIN 46R, the Trust holding the EPPICS and the related Citizens Utilities Capital L.P. are now deconsolidated (see Note 14). Total future minimum cash payment commitments under ELI's long-term capital leases including interest amounted to $9,478,000 as of September 30, 2005. As of September 30, 2005, we have available lines of credit with financial institutions in the aggregate amount of $250,000,000. Associated facility fees vary, depending on our debt leverage ratio, and are 0.375% per annum as of September 30, 2005. The expiration date for the facility is October 29, 2009. During the term of the facility we may borrow, repay and reborrow funds. The credit facility is available for general corporate purposes but may not be used to fund dividend payments. There have never been any borrowings under the facility. </TABLE> 13
For the nine months ended September 30, 2005, we retired an aggregate principal amount of $32,327,000 of debt, including $26,154,000 of EPPICS that were converted to our common stock. During the second quarter of 2005, we entered into two debt-for-debt exchanges of our debt securities. As a result, $50,000,000 of our 7.625% Notes due 2008 were exchanged for approximately $52,171,000 of our 9.00% Notes due 2031. The 9.00% Notes are callable on the same general terms and conditions as the 7.625% Notes exchanged. No cash was exchanged in these transactions, however a non-cash pre-tax loss of approximately $3,175,000 was recognized in accordance with EITF No. 96-19, "Debtor's Accounting for a Modification or Exchange of Debt Instruments" which is included in investment and other income. (8) Net Income (Loss) Per Common Share: ----------------------------------- The reconciliation of the income (loss) per common share calculation for the three and nine months ended September 30, 2005 and 2004, respectively, is as follows: <TABLE> <CAPTION> ($ in thousands, except per-share amounts) For the three months ended September 30, For the nine months ended September 30, ---------------------------------------- --------------------------------------- 2005 2004 2005 2004 ----------------- ----------------- ----------------- ----------------- Net income (loss) used for basic and diluted - -------------------------------------------- earnings per common share: ------------------------- <S> <C> <C> <C> <C> Income (loss) from continuing operations $ 38,376 $ (12,496) $ 123,387 $ 51,383 Income from discontinued operations - 1,206 2,207 3,987 --------------- --------------- --------------- --------------- Net income (loss) available to common shareholders $ 38,376 $ (11,290) $ 125,594 $ 55,370 =============== =============== =============== =============== Effect of conversion of preferred securities - EPPICS 217 - - - --------------- --------------- --------------- --------------- Diluted net income (loss) available to common shareholders $ 38,593 $ (11,290) $ 125,594 $ 55,370 =============== =============== =============== =============== Basic earnings (loss) per common share: - --------------------------------------- Weighted-average shares outstanding - basic 338,928 309,732 339,027 294,455 --------------- --------------- --------------- --------------- Income (loss) from continuing operations $ 0.11 $ (0.04) $ 0.36 $ 0.18 Income from discontinued operations - - 0.01 0.01 --------------- --------------- --------------- --------------- Net income (loss) available to common shareholders $ 0.11 $ (0.04) $ 0.37 $ 0.19 =============== =============== =============== =============== Diluted earnings (loss) per common share: - ----------------------------------------- Weighted-average shares outstanding 338,928 309,732 339,027 294,455 Effect of dilutive shares 3,117 4,480 3,090 5,783 Effect of conversion of preferred securities - EPPICS 2,364 - - - ---------------- --------------- --------------- --------------- Weighted-average shares outstanding - diluted 344,409 314,212 342,117 300,238 ================ =============== =============== =============== Income (loss) from continuing operations $ 0.11 $ (0.04) $ 0.36 $ 0.17 Income from discontinued operations - - 0.01 0.01 ---------------- --------------- --------------- --------------- Net income (loss) available to common shareholders $ 0.11 $ (0.04) $ 0.37 $ 0.18 ================ =============== =============== =============== </TABLE> Stock Options ------------- For the three and nine months ended September 30, 2005, options of 1,900,000 and 1,910,000, respectively, at exercise prices ranging from $13.45 to $18.46 issuable under employee compensation plans were excluded from the computation of diluted EPS for those periods because the exercise prices were greater than the average market price of common shares and, therefore, the effect would be antidilutive. For the three and nine months ended September 30, 2004, options of 1,913,000 and 2,495,000, respectively, at exercise prices ranging from $13.30 to $18.46 issuable under employee compensation plans were excluded from the computation of diluted EPS for those periods because the exercise prices were greater than the average market price of common shares and, therefore, the effect would be antidilutive. 14
In connection with the payment of the special, non-recurring dividend of $2 per common share on September 2, 2004, the exercise price and number of all outstanding options were adjusted such that each option had the same value to the holder after the dividend as it had before the dividend. In accordance with FASB Interpretation No. 44 ("FIN 44"), "Accounting for Certain Transactions involving Stock Compensation" and EITF 00-23, "Issues Related to the Accounting for Stock Compensation under APB No. 25 and FIN 44", there is no accounting consequence for changes made to the exercise price and the number of shares of a fixed stock option or award as a direct result of the special, non-recurring dividend. In addition, restricted stock awards of 1,495,000 shares for the three and nine months ended September 30, 2005 and restricted stock awards of 1,543,000 shares for the three and nine months ended September 30, 2004, are excluded from our basic weighted average shares outstanding and included in our dilutive shares until the shares are no longer contingent upon the satisfaction of all specified conditions. EPPICS ------ As a result of our July 2004 dividend announcement with respect to our common shares, our 5% Company Obligated Mandatorily Redeemable Convertible Preferred Securities due 2036 (EPPICS) began to convert to Citizens common shares. As of September 30, 2005, approximately 87% of the EPPICS outstanding, or about $174,146,000 aggregate principal amount of units, have converted to 13,904,153 Citizens common shares, including 782,000 shares issued from treasury. At September 30, 2005, we had 542,088 shares of potentially dilutive EPPICS, which were convertible into common stock at a 4.36 to 1 ratio at an exercise price of $11.46 per share. As a result of the September 2004 special, non-recurring dividend, the EPPICS exercise price for conversion into common stock was reduced from $13.30 to $11.46. These securities have been included in the diluted income per share calculation for the three months ended September 30, 2005, however they have been excluded from the calculation for the nine months ended September 30, 2005 because their inclusion would have had an antidilutive effect. At September 30, 2004, we had 1,797,000 shares of potentially dilutive EPPICS, which were convertible into common stock at a 4.36 to 1 ratio at an exercise price of $11.46 per share. These securities have not been included in the diluted income per common share calculation for the three and nine months ended September 30, 2004 because their inclusion would have had an antidilutive effect. Stock Units ----------- At September 30, 2005 and 2004, we had 210,334 and 454,331 stock units, respectively, issuable under our Directors' Deferred Fee Equity Plan and Non-Employee Directors' Retirement Plan. These securities have not been included in the diluted income per share calculation because their inclusion would have had an antidilutive effect. (10) Segment Information: -------------------- We operate in two segments, ILEC and ELI (a competitive local exchange carrier (CLEC)). The ILEC segment provides both regulated and unregulated communications services to residential, business and wholesale customers and is typically the incumbent provider in its service areas. As permitted by SFAS No. 131, we have utilized the aggregation criteria in combining our markets because all of the Company's ILEC properties share similar economic characteristics: they provide the same products and services to similar customers using comparable technologies in all the states we operate. The regulatory structure is generally similar. Differences in the regulatory regime of a particular state do not materially impact the economic characteristics or operating results of a particular property. 15
<TABLE> <CAPTION> ($ in thousands) For the three months ended September 30, 2005 ---------------------------------------------- Total ILEC ELI Segments -------------- -------------- --------------- <S> <C> <C> <C> Revenue $ 497,576 $ 39,770 $ 537,346 Depreciation and amortization 128,115 6,212 134,327 Operating income 137,015 4,602 141,617 Capital expenditures 57,888 3,244 61,132 ($ in thousands) For the three months ended September 30, 2004 ------------------------------------------------------------ Total ILEC ELI Electric (1) Segments -------------- -------------- --------------- ------------- Revenue $ 499,978 $ 39,210 $ - $ 539,188 Depreciation and amortization 134,787 6,121 - 140,908 Strategic alternatives and management succession expenses 73,051 2,807 - 75,858 Operating income (loss) 69,324 774 (11) 70,087 Capital expenditures 65,622 1,907 - 67,529 </TABLE> (1) Consists principally of post-sale activities associated with the completion of our utility divestiture program. These costs could not be accrued as a selling cost at the time of sale. <TABLE> <CAPTION> ($ in thousands) For the nine months ended September 30, 2005 ---------------------------------------------- Total ILEC ELI Segments -------------- -------------- --------------- <S> <C> <C> <C> Revenue $ 1,489,590 $ 116,777 $ 1,606,367 Depreciation and amortization 393,192 18,798 411,990 Operating income 423,589 10,037 433,626 Capital expenditures 162,226 13,134 175,360 ($ in thousands) For the nine months ended September 30, 2004 ------------------------------------------------------------ Total ILEC ELI Electric Segments -------------- -------------- --------------- ------------- Revenue $ 1,502,283 $ 117,277 $ 9,735 $ 1,629,295 Depreciation and amortization 410,290 17,901 - 428,191 Strategic alternatives and management succession expenses 87,279 3,353 - 90,632 Operating income (loss) 330,910 5,121 (2,332) 333,699 Capital expenditures 191,934 8,066 - 200,000 </TABLE> The following table reconciles segment capital expenditures to total consolidated capital expenditures. <TABLE> <CAPTION> For the three months ended For the nine months ended ($ in thousands) September 30, September 30, ------------------------------ ----------------------------- 2005 2004 2005 2004 -------------- -------------- --------------- ------------- <S> <C> <C> <C> <C> Total segment capital expenditures $ 61,132 $ 67,529 $ 175,360 $ 200,000 General capital expenditures 25 9 100 180 -------------- -------------- --------------- ------------- Consolidated reported capital expenditures $ 61,157 $ 67,538 $ 175,460 $ 200,180 ============== ============== =============== ============= </TABLE> 16
(11) Derivative Instruments and Hedging Activities: ---------------------------------------------- Interest rate swap agreements are used to hedge a portion of our debt that is subject to fixed interest rates. Under our interest rate swap agreements, we agree to pay an amount equal to a specified variable rate of interest times a notional principal amount, and to receive in return an amount equal to a specified fixed rate of interest times the same notional principal amount. The notional amounts of the contracts are not exchanged. No other cash payments are made unless the agreement is terminated prior to maturity, in which case the amount paid or received in settlement is established by agreement at the time of termination and represents the market value, at the then current rate of interest, of the remaining obligations to exchange payments under the terms of the contracts. The interest rate swap contracts are reflected at fair value in our consolidated balance sheet and the related portion of fixed-rate debt being hedged is reflected at an amount equal to the sum of its book value and an amount representing the change in fair value of the debt obligations attributable to the interest rate risk being hedged. The notional amounts of fixed-rate indebtedness hedged as of September 30, 2005 and December 31, 2004 were $500,000,000 and $300,000,000, respectively. Such contracts require us to pay variable rates of interest (estimated average pay rates of approximately 8.13% as of September 30, 2005 and approximately 6.12% as of December 31, 2004) and receive fixed rates of interest (average receive rates of 8.46% as of September 30, 2005 and 8.44% as of December 31, 2004, respectively). The fair value of these derivatives is reflected in other assets as of September 30, 2005, in the amount of $(4,832,000) and the related underlying debt has been decreased by a like amount. The net amounts received during the three and nine months ended September 30, 2005 as a result of these contracts amounted to $498,000 and $2,708,000, respectively, and are included as a reduction of interest expense. During the third quarter of 2005, we entered into a series of forward rate agreements with our swap counter-parties that fixed the underlying variable rate component of some of our swaps at the market rate as of the date of execution for certain future rate-setting dates. At September 30, 2005, the rates obtained under these forward rate agreements were below market rates. The fair value of these derivatives is reflected in other current assets as of September 30, 2005, in the amount of $1,305,000. Changes in the fair value of these forward rate agreements are recorded in investment and other income. We do not anticipate any nonperformance by counterparties to our derivative contracts as all counterparties have investment grade credit ratings. (12) Management Succession and Strategic Alternatives Expenses: ---------------------------------------------------------- On July 11, 2004, our Board of Directors announced that it had completed its review of the Company's financial and strategic alternatives. Through the first nine months of 2004, we expensed approximately $90,632,000 related to management succession and our exploration of financial and strategic alternatives. (13) Investment and Other Income (Loss): ----------------------------------- The components of investment and other income (loss) are as follows: <TABLE> <CAPTION> Three Months Ended September 30, Nine Months Ended September 30, ----------------------------------- ----------------------------------- ($ in thousands) 2005 2004 2005 2004 ----------------- ---------------- ----------------- ----------------- <S> <C> <C> <C> <C> Investment income (loss) $ 2,913 $ (2,742) $ 9,120 $ 2,869 Gain (loss) on expiration/settlement of customer advances (176) - 492 25,345 Loss on exchange of debt - - (3,175) - Premium on debt repurchases - (20,368) - (20,368) Investment gain 688 - 1,576 - Gain on forward rate agreements 1,305 - 1,305 - Gain/(loss) on sale of assets - 10,735 - 9,365 Other, net 2,038 (1,279) 3,431 (362) ----------------- ---------------- ----------------- ----------------- Total investment and other income (loss) $ 6,768 $ (13,654) $ 12,749 $ 16,849 ================= ================ ================= ================= </TABLE> In connection with our exchange of debt during the second quarter of 2005, we recognized a non-cash pre-tax loss of approximately $3,175,000. Investment gain represents the gain on the sale of shares of Prudential Financial, Inc. during the first quarter, and Global Crossing LTD during the second and third quarters of 2005. 17
During 2005 and 2004, we recognized income in connection with certain retained liabilities associated with customer advances for construction from our disposed water properties, as a result of some of these liabilities terminating. Gain/(loss) on sale of assets represents the gain/(loss) recognized on the sale of fixed assets during 2004. (14) Company Obligated Mandatorily Redeemable Convertible Preferred Securities: -------------------------------------------------------------------------- In 1996, our consolidated wholly-owned subsidiary, Citizens Utilities Trust (the Trust), issued, in an underwritten public offering, 4,025,000 shares of 5% Company Obligated Mandatorily Redeemable Convertible Preferred Securities due 2036 (EPPICS), representing preferred undivided interests in the assets of the Trust, with a liquidation preference of $50 per security (for a total liquidation amount of $201,250,000). These securities have an adjusted conversion price of $11.46 per Citizens common share. The conversion price was reduced from $13.30 to $11.46 during the third quarter of 2004 as a result of the $2.00 per share special, non-recurring dividend. The proceeds from the issuance of the Trust Convertible Preferred Securities and a Company capital contribution were used to purchase $207,475,000 aggregate liquidation amount of 5% Partnership Convertible Preferred Securities due 2036 from another wholly-owned subsidiary, Citizens Utilities Capital L.P. (the Partnership). The proceeds from the issuance of the Partnership Convertible Preferred Securities and a Company capital contribution were used to purchase from us $211,756,000 aggregate principal amount of 5% Convertible Subordinated Debentures due 2036. The sole assets of the Trust are the Partnership Convertible Preferred Securities, and our Convertible Subordinated Debentures are substantially all the assets of the Partnership. Our obligations under the agreements related to the issuances of such securities, taken together, constitute a full and unconditional guarantee by us of the Trust's obligations relating to the Trust Convertible Preferred Securities and the Partnership's obligations relating to the Partnership Convertible Preferred Securities. In accordance with the terms of the issuances, we paid the annual 5% interest in quarterly installments on the Convertible Subordinated Debentures in the first, second and third quarters of 2005 and the four quarters of 2004. Only cash was paid (net of investment returns) to the Partnership in payment of the interest on the Convertible Subordinated Debentures. The cash was then distributed by the Partnership to the Trust and then by the Trust to the holders of the EPPICS. As of September 30, 2005, EPPICS representing a total principal amount of $174,146,000 had been converted into 13,904,153 shares of Citizens common stock, and a total of $27,104,000 remains outstanding to third parties. Our long-term debt footnote indicates $37,611,000 of EPPICS outstanding at September 30, 2005 of which $10,506,000 is intercompany debt. Our accounting treatment of the EPPICS debt is in accordance with FIN 46R (see Note 2). We adopted the provisions of FIN 46R (revised December 2003) ("FIN 46R"), "Consolidation of Variable Interest Entities," effective January 1, 2004. 18
(15) Retirement Plans: ----------------- The following table provides the components of net periodic benefit cost: <TABLE> <CAPTION> Pension Benefits -------------------------------------------------------- For the three months ended For the nine months ended September 30, September 30, ---------------------------- ------------------------- ($ in thousands) 2005 2004 2005 2004 ------------- ------------- ------------ ------------ Components of net periodic benefit cost - --------------------------------------- <S> <C> <C> <C> <C> Service cost $ 1,509 $ 1,133 $ 4,588 $ 4,311 Interest cost on projected benefit obligation 11,710 11,859 34,812 34,851 Return on plan assets (15,093) (14,286) (45,278) (42,902) Amortization of prior service cost and unrecognized net obligation (61) (61) (183) (183) Amortization of unrecognized loss 2,748 2,911 7,411 6,619 ------------- ------------- ------------ ------------ Net periodic benefit cost $ 813 $ 1,556 $ 1,350 $ 2,696 ============= ============= ============ ============ Other Postretirement Benefits -------------------------------------------------------- For the three months ended For the nine months ended September 30, September 30, ---------------------------- ------------------------- ($ in thousands) 2005 2004 2005 2004 ------------- ------------- ------------ ------------ Components of net periodic benefit cost - --------------------------------------- Service cost $ 188 $ 48 $ 784 $ 846 Interest cost on projected benefit obligation 2,736 3,203 9,041 9,517 Return on plan assets (312) (641) (936) (1,701) Amortization of prior service cost and unrecognized net obligation (732) (162) (941) (150) Amortization of unrecognized loss 1,478 809 4,962 3,927 ------------- ------------- ------------ ------------ Net periodic benefit cost $ 3,358 $ 3,257 $ 12,910 $ 12,439 ============= ============= ============ ============ </TABLE> We expect that our pension expense for 2005 will be approximately $1,800,000 (it was $3,600,000 in 2004) and no contribution will be required to be made by us to the pension plan in 2005. We expect that our retiree medical cost for 2005 will be approximately $17,000,000 (it was $16,600,000 in 2004). In December 2003, the Medicare Prescription Drug Improvement and Modernization Act of 2003 (the Act) became law. The Act introduces a prescription drug benefit under Medicare. It includes a federal subsidy to sponsors of retiree health care benefit plans that provide a benefit that is at least actuarially equivalent to the Medicare Part D benefit. The amount of the federal subsidy will be based on 28 percent of an individual beneficiary's annual eligible prescription drug costs ranging between $250 and $5,000. We have determined that the company sponsored postretirement healthcare plans that provide prescription drug benefits are actuarially equivalent to the Medicare Prescription Drug benefit. We will incorporate the impact of the federal subsidy as of the next measurement date, which is December 31, 2005. (16) Related Party Transaction: -------------------------- In June 2005, the Company sold for cash its interests in certain key man life insurance policies on the lives of Leonard Tow, our former Chairman and Chief Executive Officer, and his wife, a former director. The cash surrender value of the policies purchased by Dr. Tow totaled approximately $24,195,000, and we recognized a gain of approximately $457,000 that is included in investment and other income. 19
(17) Commitments and Contingencies: ------------------------------ The City of Bangor, Maine, filed suit against us on November 22, 2002, in the U.S. District Court for the District of Maine (City of Bangor v. Citizens Communications Company, Civ. Action No. 02-183-B-S). The City alleged, among other things, that we are responsible for the costs of cleaning up environmental contamination alleged to have resulted from the operation of a manufactured gas plant owned by Bangor Gas Company from 1852-1948 and by us from 1948-1963. In acquiring the operation in 1948 we acquired the stock of Bangor Gas Company and merged it into the Company. The City alleged the existence of extensive contamination of the Penobscot River and asserted that money damages and other relief at issue in the lawsuit could exceed $50,000,000. The City also requested that punitive damages be assessed against us. We filed an answer denying liability to the City, and asserted a number of counterclaims against the City. In addition, we identified a number of other potentially responsible parties that may be liable for the damages alleged by the City and joined them as parties to the lawsuit. These additional parties include Honeywell Corporation, Guilford Transportation (operating as Maine Central Railroad), UGI Utilities, Inc. and Centerpoint Energy Resources Corporation. The Court dismissed all but two of the City's claims, including its claims for joint and several liability under the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA) and the claim against us for punitive damages. Trial was conducted in September and October 2005 for the first (liability) phase of the case, and a decision from the court is anticipated by year-end. We intend to continue to defend ourselves vigorously against the City's lawsuit. We have demanded that various of our insurance carriers defend and indemnify us with respect to the City's lawsuit, and on December 26, 2002, we filed a declaratory judgment action against those insurance carriers in the Superior Court of Penobscot County, Maine, for the purpose of establishing their obligations to us with respect to the City's lawsuit. We intend to vigorously pursue this lawsuit to obtain from our insurance carriers indemnification for any damages that may be assessed against us in the City's lawsuit as well as to recover the costs of our defense of that lawsuit. On June 7, 2004, representatives of Robert A. Katz Technology Licensing, LP, contacted us regarding possible infringement of several patents held by that firm. The patents cover a wide range of operations in which telephony is supported by computers, including obtaining information from databases via telephone, interactive telephone transactions, and customer and technical support applications. We are cooperating with the patent holder to determine if we are currently using any of the processes that are protected by its patents. If we determine that we are utilizing the patent holder's intellectual property, we expect to commence negotiations on a license agreement. On June 24, 2004, one of our subsidiaries, Frontier Subsidiary Telco Inc., received a "Notice of Indemnity Claim" from Citibank, N.A., that is related to a complaint pending against Citibank and others in the U.S. Bankruptcy Court for the Southern District of New York as part of the Global Crossing bankruptcy proceeding. Citibank bases its claim for indemnity on the provisions of a credit agreement that was entered into in October 2000 between Citibank and our subsidiary. We purchased Frontier Subsidiary Telco, Inc., in June 2001 as part of our acquisition of the Frontier telephone companies. The complaint against Citibank, for which it seeks indemnification, alleges that the seller improperly used a portion of the proceeds from the Frontier transaction to pay off the Citibank credit agreement, thereby defrauding certain debt holders of Global Crossing North America Inc. Although the credit agreement was paid off at the closing of the Frontier transaction, Citibank claims the indemnification obligation survives. Damages sought against Citibank and its co-defendants could exceed $1,000,000,000. In August 2004, we notified Citibank by letter that we believe its claims for indemnification are invalid and are not supported by applicable law. We have received no further communications from Citibank since our August 2004 letter. We are party to other legal proceedings arising in the normal course of our business. The outcome of individual matters is not predictable. However, we believe that the ultimate resolution of all such matters, after considering insurance coverage, will not have a material adverse effect on our financial position, results of operations, or our cash flows. We have budgeted capital expenditures in 2005 of approximately $265,000,000, including $249,000,000 for ILEC and $16,000,000 for ELI. Although we from time to time make short-term purchasing commitments to vendors with respect to these expenditures, we generally do not enter into firm, written contracts for such activities. The Company sold all of its utility businesses as of April 1, 2004. However, we have retained a potential payment obligation associated with our previous electric utility activities in the state of Vermont. The Vermont Joint Owners (VJO), a consortium of 14 Vermont utilities, including us, entered into a purchase power agreement with Hydro-Quebec in 1987. The agreement contains "step-up" provisions that state that if any VJO member defaults on its purchase obligation under the contract to purchase power 20
from Hydro-Quebec the other VJO participants will assume responsibility for the defaulting party's share on a pro-rata basis. Our pro-rata share of the purchase power obligation is 10%. If any member of the VJO defaults on its obligations under the Hydro-Quebec agreement, then the remaining members of the VJO, including us, may be required to pay for a substantially larger share of the VJO's total power purchase obligation for the remainder of the agreement (which runs through 2015). Paragraph 13 of FIN 45 requires that we disclose, "the maximum potential amount of future payments (undiscounted) the guarantor could be required to make under the guarantee." Paragraph 13 also states that we must make such disclosure "... even if the likelihood of the guarantor's having to make any payments under the guarantee is remote..." As noted above, our obligation only arises as a result of default by another VJO member such as upon bankruptcy. Therefore, to satisfy the "maximum potential amount" disclosure requirement we must assume that all members of the VJO simultaneously default, a highly unlikely scenario given that the two members of the VJO that have the largest potential payment obligations are publicly traded with credit ratings that are equal to or superior to ours, and that all VJO members are regulated utility providers with regulated cost recovery. Regardless, despite the remote chance that such an event could occur, or that the State of Vermont could or would allow such an event, assuming that all the members of the VJO defaulted on January 1, 2006 and remained in default for the duration of the contract (another 10 years), we estimate that our undiscounted purchase obligation for 2006 through 2015 would be approximately $1,400,000,000. In such a scenario the Company would then own the power and could seek to recover its costs. We would do this by seeking to recover our costs from the defaulting members and/or reselling the power to other utility providers or the northeast power grid. There is an active market for the sale of power. We could potentially lose money if we were unable to sell the power at cost. We caution that we cannot predict with any degree of certainty any potential outcome. 21
Item 2. Management's Discussion and Analysis of Financial Condition and Results ------------------------------------------------------------------------ of Operations ------------- This quarterly report on Form 10-Q contains forward-looking statements that are subject to risks and uncertainties which could cause actual results to differ materially from those expressed or implied in the statements. Forward-looking statements (including oral representations) are only predictions or statements of current plans, which we review continuously. Forward-looking statements may differ from actual future results due to, but not limited to, and our future results may be materially affected by, any of the following possibilities: o Changes in the number of our revenue generating units, which consists of access lines plus high-speed internet subscribers; o The effects of competition from wireless, other wireline carriers (through voice over internet protocol (VOIP) or otherwise), high-speed cable modems and cable telephony; o The effects of general and local economic and employment conditions on our revenues; o Our ability to effectively manage and otherwise monitor our operations, costs, regulatory compliance and service quality; o Our ability to successfully introduce new product offerings including our ability to offer bundled service packages on terms that are both profitable to us and attractive to our customers, and our ability to sell enhanced and data services in order to offset ongoing declines in highly profitable revenue from local services, access services and subsidies; o Our ability to comply with Section 404 of the Sarbanes-Oxley Act of 2002, which requires management to assess its internal control systems and disclose whether the internal control systems are effective, and the identification of any material weaknesses in our internal control over financial reporting; o Changes in accounting policies or practices adopted voluntarily or as required by generally accepted accounting principles or regulators; o The effects of changes in regulation in the telecommunications industry as a result of federal and state legislation and regulation, including potential changes in access charges and subsidy payments, regulatory network upgrade and reliability requirements, and portability requirements; o Our ability to comply with federal and state regulation (including state rate of return limitations on our earnings) and our ability to successfully renegotiate certain ILEC state regulatory plans as they expire or come up for renewal from time to time; o Our ability to manage our operating expenses, capital expenditures, pay dividends and reduce or refinance our debt; o Adverse changes in the ratings given to our debt securities by nationally accredited ratings organizations, which could limit or restrict the availability, and/or increase the cost of financing; o The effects of greater than anticipated competition requiring new pricing, marketing strategies or new product offerings and the risk that we will not respond on a timely or profitable basis; o The effects of bankruptcies in the telecommunications industry which could result in more price competition and potential bad debts; o The effects of technological changes on our capital expenditures and product and service offerings, including the lack of assurance that our ongoing network improvements will be sufficient to meet or exceed the capabilities and quality of competing networks; 22
o The effects of increased medical, retiree and pension expenses and related funding requirements; o Changes in income tax rates, tax laws, regulations or rulings, and/or federal or state tax assessments; o The effect of changes in the telecommunications market, including the likelihood of significantly increased price and service competition; o The effects of state regulatory cash management policies on our ability to transfer cash among our subsidiaries and to the parent company; o Our ability to successfully renegotiate union contracts; o Our ability to pay a $1.00 per common share dividend annually may be affected by our cash flow from operations, amount of capital expenditures, debt service requirements, cash paid for income taxes and our liquidity; o The effects of any future liabilities or compliance costs in connection with environmental and worker health and safety matters; o The effects of any unfavorable outcome with respect to any of our current or future legal, governmental, or regulatory proceedings, audits or disputes; and o The effects of more general factors, including changes in economic, business and industry conditions. Any of the foregoing events, or other events, could cause financial information to vary from management's forward-looking statements included in this report. You should consider these important factors in evaluating any statement in this Form 10-Q or otherwise made by us or on our behalf. The following information is unaudited and should be read in conjunction with the consolidated financial statements and related notes included in this report and as presented in our 2004 Annual Report on Form 10-K. We have no obligation to update or revise these forward-looking statements. Overview - -------- We are a communications company providing services to rural areas and small and medium-sized towns and cities as an incumbent local exchange carrier, or ILEC. We offer our ILEC services under the "Frontier" name. In addition, we provide competitive local exchange carrier, or CLEC, services to business customers and to other communications carriers in certain metropolitan areas in the western United States through Electric Lightwave, LLC, or ELI, our wholly-owned subsidiary. Competition in the telecommunications industry is increasing. We experience competition from other wireline local carriers, from VOIP providers such as Vonage, from other long distance carriers (including Regional Bell Operating Companies), from cable companies and internet service providers with respect to internet access and cable telephony, and from wireless carriers. Competition from cable companies and other high-speed internet service providers with respect to internet access is intense and increasing in many of our markets. We expect cable telephony competition to increase. Competition from wireless companies and other long distance companies is increasing in all of our markets. The telecommunications industry is undergoing significant changes and difficulties. The market is extremely competitive, resulting in lower prices. Demand and pricing for certain CLEC services have decreased substantially, particularly for long-haul services. These trends are likely to continue and result in a challenging revenue environment. These factors could also result in more bankruptcies in the sector and therefore affect our ability to collect money owed to us by carriers. Several long distance and interexchange carriers (IXCs) have filed for bankruptcy protection, which will allow them to substantially reduce their cost structure and debt. This could enable such companies to further reduce prices and increase competition. Revenues from data services such as high-speed internet continue to increase as a percentage of our total revenues and revenues from high margin services such as local line and access charges and subsidies are decreasing as a percentage of our revenues. These factors, along with increasing operating and employee costs will cause our cash generated by operations to decrease. 23
(a) Liquidity and Capital Resources ------------------------------- For the nine months ended September 30, 2005, we used cash flow from continuing operations, proceeds from the sale of non-strategic assets, stock option exercises and cash and cash equivalents to fund capital expenditures, dividends, interest payments, debt repayments and common stock repurchases. As of September 30, 2005, we had cash and cash equivalents aggregating $286.6 million. For the nine months ended September 30, 2005, our capital expenditures were $175.5 million, including $162.3 million for the ILEC segment, $13.1 million for the ELI segment and $0.1 million of general capital expenditures. We continue to closely scrutinize all of our capital projects, emphasize return on investment and focus our capital expenditures on areas and services that have the greatest opportunities with respect to revenue growth and cost reduction. For example, we will allocate significant capital to services such as high-speed internet in areas that are growing or demonstrate meaningful demand. We will continue to focus on managing our costs while increasing our investment in certain product areas such as high-speed internet. Increasing competition, offering new services, improving the capabilities or reducing the maintenance costs of our plant may cause our capital expenditures to increase in the future. We have budgeted approximately $265.0 million for our 2005 capital projects, including $249.0 million for the ILEC segment and $16.0 million for the ELI segment. Included in these budgeted capital amounts are approximately $6.9 million of capital expenditures associated with the Communications Assistance for Law Enforcement Act (CALEA). As of September 30, 2005, we have available lines of credit with financial institutions in the aggregate amount of $250.0 million. Associated facility fees vary, depending on our debt leverage ratio, and are 0.375% per annum as of September 30, 2005. The expiration date for the facility is October 29, 2009. During the term of the facility we may borrow, repay and reborrow funds. The credit facility is available for general corporate purposes but may not be used to fund dividend payments. There have never been any borrowings under the facility. Our ongoing annual dividends of $1.00 per share under our current policy utilizes a significant portion of our cash generated by operations and therefore limits our operating and financial flexibility and our ability to significantly increase capital expenditures particularly compared to the flexibility and ability to change capital spending we would have if we did not pay such dividends. While we believe that the amount of our dividends will allow for adequate amounts of cash flow for other purposes, any material reduction in cash generated by operations and any increases in capital expenditures, interest expense or cash taxes would reduce the amount of cash generated in excess of dividends. Losses of access lines, increases in competition, lower subsidy and access revenues and the other factors described above are expected to reduce our cash generated by operations and may require us to increase capital expenditures. The downgrades in our credit ratings in July 2004 to below investment grade may make it more difficult and expensive to refinance our maturing debt. We have in recent years paid relatively low amounts of cash taxes. We expect that over time our cash taxes will increase. We believe our operating cash flows, existing cash balances, and credit facility will be adequate to finance our working capital requirements, fund capital expenditures, make required debt payments through 2007, pay taxes, pay dividends to our stockholders in accordance with our dividend policy and support our short-term and long-term operating strategies. We have approximately $0.2 million, $227.8 million and $37.9 million of debt maturing in the remainder of 2005, 2006 and 2007, respectively, all of which we intend to pay at or prior to maturity utilizing available cash on hand. Share Repurchase Program - ------------------------ On May 25, 2005, our Board of Directors authorized the Company to repurchase over the following twelve-month period, up to $250.0 million of the Company's common stock, either in the open market or through negotiated transactions. This share repurchase program commenced on June 13, 2005. As of September 30, 2005, the Company had committed to repurchase a total of 12,656,500 common shares at an aggregate cost of approximately $172.0 million. Of that amount, 11,906,500 shares had settled by September 30, 2005, at a cash cost of approximately $161.9 million. 24
Debt Reduction and Debt Exchanges - --------------------------------- For the nine months ended September 30, 2005, we retired an aggregate principal amount of $32.3 million of debt, including $26.2 million of EPPICS that were converted to our common stock. During the second quarter of 2005, we entered into two debt-for-debt exchanges of our debt securities. As a result, $50.0 million of our 7.625% Notes due 2008 were exchanged for approximately $52.2 million of our 9.00% Notes due 2031. The 9.00% Notes are callable on the same general terms and conditions as the 7.625% Notes exchanged. No cash was exchanged in these transactions, however a non-cash pre-tax loss of approximately $3.2 million was recognized in accordance with EITF No. 96-19, "Debtor's Accounting for a Modification or Exchange of Debt Instruments" which is included in investment and other income. We may from time to time repurchase our debt in the open market, through tender offers or privately negotiated transactions. We may also exchange existing debt obligations for newly issued debt obligations. Interest Rate Management - ------------------------ In order to manage our interest expense, we have entered into interest swap agreements. Under the terms of these agreements, we make semi-annual, floating rate interest payments based on six month LIBOR and receive a fixed rate on the notional amount. The underlying variable rate on these swaps is set in arrears. During September 2005, we entered into a series of forward rate agreements that fixed the underlying variable rate component of some of our swaps at the market rate as of the date of execution for certain future rate-setting dates. At September 30, 2005, the rates obtained under these forward rate agreements were below market rates. Changes in the fair value of these forward rate agreements are recorded in investment and other income. The notional amounts of fixed-rate indebtedness hedged as of September 30, 2005 and December 31, 2004 were $500.0 and $300.0 million, respectively. Such contracts require us to pay variable rates of interest (estimated average pay rates of approximately 8.13% as of September 30, 2005 and approximately 6.12% as of December 31, 2004) and receive fixed rates of interest (average receive rate of 8.46% as of September 30, 2005 and 8.44% as of December 31, 2004). All interest rate swaps are accounted for under SFAS No. 149 as fair value hedges. For the nine months ended September 30, 2005, the interest savings resulting from these interest rate swaps totaled approximately $2.7 million. Sale of Non-Strategic Investments - --------------------------------- On February 1, 2005, we sold 20,672 shares of Prudential Financial, Inc. for approximately $1.1 million in cash. On March 15, 2005, we completed the sale of our conferencing business for approximately $43.6 million in cash. In June 2005, the Company sold for cash its interests in certain key man life insurance policies on the lives of Leonard Tow, our former Chairman and Chief Executive Officer, and his wife, a former director. The cash surrender value of the policies purchased by Dr. Tow totaled approximately $24.2 million, and we recognized a gain of approximately $457,000 that is included in investment and other income. During 2005, we sold 79,828 shares of Global Crossing Limited for approximately $1.1 million in cash. Off-Balance Sheet Arrangements - ------------------------------ We do not maintain any off-balance sheet arrangements, transactions, obligations or other relationships with unconsolidated entities that would be expected to have a material current or future effect upon our financial statements. EPPICS - ------ In 1996, our consolidated wholly-owned subsidiary, Citizens Utilities Trust (the Trust), issued, in an underwritten public offering, 4,025,000 shares of 5% Company Obligated Mandatorily Redeemable Convertible Preferred Securities due 2036 (Trust Convertible Preferred Securities or EPPICS), representing preferred undivided interests in the assets of the Trust, with a liquidation preference of $50 per security (for a total liquidation amount of $201.3 million). These securities have an adjusted conversion price of $11.46 per Citizens common share. The conversion price was reduced from $13.30 to $11.46 during the third quarter of 2004 as a result of the $2.00 per share special, non-recurring dividend. The proceeds from the issuance of the Trust Convertible Preferred Securities and a Company capital contribution were used to purchase $207.5 million aggregate liquidation amount of 5% Partnership Convertible Preferred Securities due 2036 from another wholly owned consolidated subsidiary, Citizens Utilities Capital L.P. (the Partnership). The proceeds from the issuance of the Partnership Convertible Preferred Securities and a Company capital contribution were used to purchase from us $211.8 million aggregate principal amount of 5% Convertible Subordinated Debentures due 2036. The sole assets of the Trust are the Partnership Convertible Preferred Securities, and our Convertible Subordinated Debentures are substantially all the assets of the Partnership. Our obligations under the agreements related to the issuances of such securities, 25
taken together, constitute a full and unconditional guarantee by us of the Trust's obligations relating to the Trust Convertible Preferred Securities and the Partnership's obligations relating to the Partnership Convertible Preferred Securities. In accordance with the terms of the issuances, we paid the annual 5% interest in quarterly installments on the Convertible Subordinated Debentures in the first, second and third quarters of 2005 and the four quarters of 2004. Only cash was paid (net of investment returns) to the Partnership in payment of the interest on the Convertible Subordinated Debentures. The cash was then distributed by the Partnership to the Trust and then by the Trust to the holders of the EPPICS. As of September 30, 2005, EPPICS representing a total principal amount of $174.2 million had been converted into 13,904,153 shares of Citizens common stock, and a total of $27.1 million remains outstanding to third parties. Our long-term debt footnote indicates $37.6 million of EPPICS outstanding at September 30, 2005 of which $10.5 million is intercompany debt. Our accounting treatment of the EPPICS debt is in accordance with FIN 46R (see Note 2 and 14). We adopted the provisions of FASB Interpretation No. 46R (revised December 2003) ("FIN 46R"), "Consolidation of Variable Interest Entities," effective January 1, 2004. Covenants - --------- The terms and conditions contained in our indentures and credit facilities agreements include the timely payment of principal and interest when due, the maintenance of our corporate existence, keeping proper books and records in accordance with GAAP, restrictions on the allowance of liens on our assets, and restrictions on asset sales and transfers, mergers and other changes in corporate control. We currently have no restrictions on the payment of dividends either by contract, rule or regulation. Our $200 million term loan facility with the Rural Telephone Finance Cooperative (RTFC) contains a maximum leverage ratio covenant. Under the leverage ratio covenant, we are required to maintain a ratio of (i) total indebtedness minus cash and cash equivalents in excess of $50.0 million to (ii) consolidated adjusted EBITDA (as defined in the agreement) over the last four quarters no greater than 4.00 to 1. Our $250 million credit facility contains a maximum leverage ratio covenant. Under the leverage ratio covenant, we are required to maintain a ratio of (i) total indebtedness minus cash and cash equivalents in excess of $50.0 million to (ii) consolidated adjusted EBITDA (as defined in the agreement) over the last four quarters no greater than 4.50 to 1. Although the credit facility is unsecured, it will be equally and ratably secured by certain liens and equally and ratably guaranteed by certain of our subsidiaries if we issue debt that is secured or guaranteed. We are in compliance with all of our debt and credit facility covenants. Divestitures - ------------ On August 24, 1999, our Board of Directors approved a plan of divestiture for our public utilities services businesses, which included gas, electric and water and wastewater businesses. We have sold all of these properties. All of the agreements relating to the sales provide that we will indemnify the buyer against certain liabilities (typically liabilities relating to events that occurred prior to sale), including environmental liabilities, for claims made by specified dates and that exceed threshold amounts specified in each agreement. On April 1, 2004, we completed the sale of our electric distribution facilities in Vermont for $14.0 million in cash, net of selling expenses. Critical Accounting Policies and Estimates - ------------------------------------------ We review all significant estimates affecting our consolidated financial statements on a recurring basis and record the effect of any necessary adjustment prior to their publication. Uncertainties with respect to such estimates and assumptions are inherent in the preparation of financial statements; accordingly, it is possible that actual results could differ from those estimates and changes to estimates could occur in the near term. The preparation of our financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of the contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Estimates and judgments are used when accounting for allowance for doubtful accounts, impairment of long-lived assets, intangible assets, depreciation and amortization, employee benefit plans, income taxes, contingencies, and pension and postretirement benefits expenses among others. 26
Management has discussed the development and selection of these critical accounting estimates with the audit committee of our Board of Directors and our audit committee has reviewed our disclosures relating to them. There have been no material changes to our critical accounting policies and estimates from the information provided in "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" included in our 2004 Annual Report on Form 10-K. New Accounting Pronouncements - ----------------------------- Stock-Based Compensation In December 2004, the FASB issued SFAS No. 123 (revised 2004), "Share-Based Payment," ("SFAS No. 123R"). SFAS No. 123R requires that stock-based employee compensation be recorded as a charge to earnings. In April 2005, the Securities and Exchange Commission required adoption of SFAS No. 123R for annual periods beginning after June 15, 2005. Accordingly, we will adopt SFAS 123R commencing January 1, 2006 and expect to recognize approximately $2.8 million of expense for the year ended December 31, 2006. Exchanges of Productive Assets In December 2004, the FASB issued SFAS No. 153, "Exchanges of Nonmonetary Assets," an amendment of APB Opinion No. 29. SFAS No. 153 addresses the measurement of exchanges of certain non-monetary assets (except for certain exchanges of products or property held for sale in the ordinary course of business). The Statement requires that non-monetary exchanges be accounted for at the fair value of the assets exchanged, with gains or losses being recognized, if the fair value is determinable within reasonable limits and the transaction has commercial substance. SFAS No. 153 is effective for nonmonetary exchanges occurring in fiscal periods beginning after June 15, 2005. The Company does not expect the adoption of the new standard to have a material impact on the Company's financial position, results of operations and cash flows. Accounting for Conditional Asset Retirement Obligations In March 2005, the FASB issued FIN 47, "Accounting for Conditional Asset Retirement Obligations," an interpretation of FASB No. 143. FIN 47 clarifies that the term conditional asset retirement obligation as used in FASB No. 143 refers to a legal obligation to perform an asset retirement activity in which the timing or method of settlement are conditional on a future event that may or may not be within the control of the entity. FIN 47 also clarifies when an entity would have sufficient information to reasonably estimate the fair value of an asset retirement obligation. FIN 47 is effective for the year ended December 31, 2005. Accordingly, we will adopt FIN 47 during the fourth quarter of 2005. The Company does not expect the implementation of FIN 47 to have a material effect on the Company's financial position, results of operations or cash flows. Accounting Changes and Error Corrections In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and Error Corrections," a replacement of APB Opinion No. 20 and FASB Statement No. 3. SFAS No. 154 changes the accounting for, and reporting of, a change in accounting principle. SFAS No. 154 requires retrospective application to prior period's financial statements of voluntary changes in accounting principle, and changes required by new accounting standards when the standard does not include specific transition provisions, unless it is impracticable to do so. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. Partnerships In June 2005, the FASB issued EITF No. 04-5, "Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights," which provides new guidance on how general partners in a limited partnership should determine whether they control a limited partnership. EITF No. 04-5 is effective for fiscal periods beginning after December 15, 2005. The Company does not expect the adoption of EITF No. 04-5 to have a material impact on the Company's financial position, results of operations or cash flows. 27
(b) Results of Operations --------------------- REVENUE ILEC revenue is generated primarily through the provision of local, network access, long distance and data services. Such services are provided under either a monthly recurring fee or based on usage at a tariffed rate and is not dependent upon significant judgments by management, with the exception of a determination of a provision for uncollectible amounts. CLEC revenue is generated through local, long distance, data and long-haul services. These services are primarily provided under a monthly recurring fee or based on usage at agreed upon rates and are not dependent upon significant judgments by management with the exception of the determination of a provision for uncollectible amounts and realizability of reciprocal compensation. CLEC usage based revenue includes amounts determined under reciprocal compensation agreements. While this revenue is governed by specific contracts with the counterparty, management defers recognition of disputed portions of such revenue until realizability is assured. Revenue earned from long-haul contracts is recognized over the term of the related agreement. Consolidated revenue for the three months ended September 30, 2005 decreased $1.8 million as compared with the prior year period. The decrease is due to a $2.4 million decrease in ILEC revenue, partially offset by a $0.6 million increase in ELI revenue. Consolidated revenue for the nine months ended September 30, 2005 decreased $22.9 million, or 1%, as compared with the prior year period. The decrease is due to a $12.7 million decrease in ILEC revenue, a $0.5 million decrease in ELI revenue and a $9.7 million decrease resulting from the sale in 2004 of our electric utility property. On March 15, 2005, we completed the sale of our conferencing service business. As a result of the sale, we have classified the results of operations as discontinued operations in our consolidated statement of operations and restated prior periods. Change in the number of our access lines is an important determinant of our revenue and profitability. We have been losing access lines primarily because of increased competition, changing consumer behavior, economic conditions, changing technology and by some customers disconnecting second lines when they add high-speed internet or cable modem service. We lost approximately 75,700 access lines during the nine months ended September 30, 2005 but added approximately 78,000 high-speed internet subscribers during this period on a net basis. The loss of lines during the first nine months of 2005 was primarily among residential customers. The non-residential line losses were principally in Rochester, New York, while the residential losses were throughout our markets. We expect to continue to lose access lines but to increase high-speed internet subscribers during 2005. A continued loss of access lines, combined with increased competition and the other factors discussed in MD&A, may cause our revenues to decrease. <TABLE> <CAPTION> TELECOMMUNICATIONS REVENUE ($ in thousands) For the three months ended September 30, For the nine months ended September 30, ---------------------------------------------- ----------------------------------------------- 2005 2004 $ Change % Change 2005 2004 $ Change % Change ----------- ----------- ----------- ----------------------- ----------- ------------ ---------- <S> <C> <C> <C> <C> <C> <C> <C> <C> Access services $ 145,915 $ 157,692 $(11,777) -7% $ 455,389 $ 474,399 $ (19,010) -4% Local services 208,630 214,299 (5,669) -3% 624,367 640,458 (16,091) -3% Long distance and data services 88,809 82,002 6,807 8% 255,897 240,177 15,720 7% Directory services 28,362 27,312 1,050 4% 84,866 82,987 1,879 2% Other 25,860 18,673 7,187 38% 69,071 64,262 4,809 7% ----------- ----------- ----------- ----------- ----------- ------------ ILEC revenue 497,576 499,978 (2,402) 0% 1,489,590 1,502,283 (12,693) -1% ELI 39,770 39,210 560 1% 116,777 117,277 (500) 0% ----------- ----------- ----------- ----------- ----------- ------------ $ 537,346 $ 539,188 $ (1,842) 0% $ 1,606,367 $1,619,560 $ (13,193) -1% =========== =========== =========== =========== =========== ============ </TABLE> Access Services Access services revenue for the three months ended September 30, 2005 decreased $11.8 million or 7%, as compared with the prior year period. Access service revenue includes subsidy payments we receive from federal and state agencies. Subsidy revenue decreased $11.3 million primarily due to a missed filing deadline (as discussed below), which resulted in the decrease of $10.4 million in Universal Service Fund (USF) support during the third quarter of 2005. USF subsidies also decreased due to increases in the national average cost per loop (NACPL). 28
Access services revenue for the nine months ended September 30, 2005 decreased $19.0 million or 4%, as compared with the prior year period. Switched access revenue decreased $6.0 million, as compared with the prior year period, primarily due to a decline in minutes of use. Special access revenue increased $9.2 million primarily due to growth in high-capacity circuits. Subsidy revenue decreased $22.2 million primarily due to decreased USF support of $18.0 million because of increases in the NACPL, the $10.4 million decrease due to the missed filing deadline and a decrease of $5.8 million related to changes in measured factors, partially offset by an increase of $8.2 million in USF surcharge rates. Increases in the number of competitive communications companies (including wireless companies) receiving federal subsidies may lead to further increases in the NACPL, thereby resulting in further decreases in our subsidy revenue in the future. The FCC and state regulators are currently considering a number of proposals for changing the manner in which eligibility for federal subsidies is determined as well as the amounts of such subsidies. The FCC is also reviewing the mechanism by which subsidies are funded. We cannot predict when or how these matters will be decided nor the effect on our subsidy revenues. Future reductions in our subsidy and access revenues are not expected to be accompanied by proportional decreases in our costs, so any further reductions in those revenues will directly affect our profitability. We filed one of our USF qualifying reports two business days late and have obtained a waiver from the FCC that permits acceptance of the late-filed report. As of September 30, 2005, we had not received the waiver from the FCC and, therefore, did not qualify for $10.4 million in USF funding during the third quarter of 2005. We expect to recognize such amount as revenue during the fourth quarter of 2005. Local Services Local services revenue for the three months ended September 30, 2005 decreased $5.7 million or 3% as compared with the prior year period. Local revenue decreased $7.0 million primarily due to the continued loss of access lines. Enhanced services revenue increased $1.3 million, as compared with the prior year period, primarily due to sales of additional feature packages. Local services revenue for the nine months ended September 30, 2005 decreased $16.1 million or 3% as compared with the prior year period. This decline is comprised of $12.6 million related to the continued loss of access lines and $4.0 million related to a reserve associated with state rate of return limitations on earnings. Enhanced services revenue increased $4.7 million, as compared with the prior year period, primarily due to sales of additional packages. Economic conditions or increasing competition could make it more difficult to sell our packages and bundles and cause us to lower our prices for those products and services, which would adversely affect our revenues and profitability. Long Distance and Data Services Long distance and data services revenue for the three months ended September 30, 2005 increased $6.8 million or 8%, as compared with the prior period primarily due to growth in sales of data services of $9.9 million (data includes high-speed internet) partially offset by decreased long distance revenue of $3.1 million because of lower pricing for long distance services. Long distance and data services revenue for the nine months ended September 30, 2005 increased $15.7 million or 7%, as compared with the prior period primarily due to growth of $25.6 million related to data services partially offset by decreased long distance revenue of $9.9 million as a result of a decline in the average rate per long distance minute. Our long distance revenues may continue to decrease in the future due to lower rates and/or minutes of use. Competing services such as wireless, VOIP, and cable telephony may result in a loss of customers, minutes of use and further declines in the rates we charge our customers. Directory Services Directory revenue for the three and nine months ended September 30, 2005 increased $1.1 million, or 4%, and $1.9 million, or 2%, respectively, as compared with the prior year periods due to growth in yellow pages advertising. Other Other revenue for the three months ended September 30, 2005 increased $7.2 million or 38%, as compared with the prior year primarily due to a $5.1 million decrease in bad debt expense, increased sales of customer premise equipment (CPE) of $1.5 million and sales of television service, which contributed $1.1 million. 29
Other revenue for the nine months ended September 30, 2005 increased $4.8 million, or 7% compared with the prior year primarily due to a $3.7 million decrease in bad debt expense and sales of television service, which contributed $2.1 million. ELECTRIC REVENUE ($ in thousands) For the nine months ended September 30, ---------------------------------------------- 2005 2004 $ Change % Change ----------- ----------- ----------- ---------- Electric revenue $ - $ 9,735 $ (9,735) -100% Electric revenue for the nine months ended September 30, 2005 decreased $9.7 million, as compared with the prior year period due to the sale of our Vermont electric division on April 1, 2004. We have sold all of our electric operations and as a result will have no operating results in future periods for these businesses. <TABLE> <CAPTION> COST OF SERVICES ($ in thousands) For the three months ended September 30, For the nine months ended September 30, ---------------------------------------------- ----------------------------------------------- 2005 2004 $ Change % Change 2005 2004 $ Change % Change ----------- ----------- ----------- ----------------------- ----------- ------------ ---------- <S> <C> <C> <C> <C> <C> <C> <C> <C> Network access $ 51,050 $ 49,655 $ 1,395 3% $ 145,766 $ 146,392 $ (626) 0% Electric energy and fuel oil purchased - - - - - 5,523 (5,523) -100% ----------- ----------- ----------- ----------- ----------- ------------ $ 51,050 $ 49,655 $ 1,395 3% $ 145,766 $ 151,915 $ (6,149) -4% =========== =========== =========== =========== =========== ============ </TABLE> Network access expenses for the three months ended September 30, 2005 increased $1.4 million, or 3%, as compared with the prior year period primarily due to increased costs in circuit expense due to more data traffic associated with increased high-speed internet customers and greater long distance minutes of use in the ILEC sector, and higher costs at ELI due to increased demand. Electric energy and fuel oil purchased for the nine months ended September 30, 2005 decreased $5.5 million, as compared with the prior year period due to the sale of our Vermont electric division on April 1, 2004. We have sold all of our electric operations and as a result will have no operating results in future periods for these businesses. <TABLE> <CAPTION> OTHER OPERATING EXPENSES ($ in thousands) For the three months ended September 30, For the nine months ended September 30, ---------------------------------------------- ----------------------------------------------- 2005 2004 $ Change % Change 2005 2004 $ Change % Change ----------- ----------- ----------- ---------- ----------- ----------- ------------ ---------- <S> <C> <C> <C> <C> <C> <C> <C> <C> Operating expenses $ 157,243 $ 155,249 $ 1,994 1% $ 453,653 $ 468,507 $ (14,854) -3% Taxes other than income taxes 23,075 19,887 3,188 16% 73,889 71,521 2,368 3% Sales and marketing 30,034 27,544 2,490 9% 87,443 84,830 2,613 3% ----------- ----------- ----------- ----------- ----------- ------------ $ 210,352 $ 202,680 $ 7,672 4% $ 614,985 $ 624,858 $ (9,873) -2% =========== =========== =========== =========== =========== ============ </TABLE> Operating expenses for the three months ended September 30, 2005 increased $2.0 million, or 1%, as compared with the prior year period primarily due to rate increases for federal USF mandated contributions and annual fees to regulatory agencies. Operating expenses for the nine months ended September 30, 2005 decreased $14.9 million, or 3%, as compared with the prior year period primarily due to lower billing expenses as a result of the conversion of our billing system in 2004 partially offset by rate increases for federal USF mandated contributions and annual fees to regulatory agencies. We routinely review our operations, personnel and facilities to achieve greater efficiencies. These reviews may result in reductions in personnel and an increase in severance costs. Taxes other than income taxes for the three and nine months ended September 30, 2005 increased $3.2 million, or 16%, and $2.4 million, or 3%, respectively, as compared with the prior year periods primarily due to higher gross receipts (which are generally passed through to our customers) and property taxes in the ILEC sector. 30
Sales and marketing expenses for the three and nine months ended September 30, 2005 increased $2.5 million, or 9%, and $2.6 million, or 3%, respectively, as compared with the prior year periods primarily due to competition for customers and the launch of new products. As our markets become more competitive and we launch new products, we expect that our marketing costs will increase. Included in operating expenses is stock compensation expense. Stock compensation expense was $6.4 million and $7.8 million for the first nine months of 2005 and 2004, respectively. In 2006, we expect to begin expensing the cost of the unvested portion of outstanding stock options pursuant to SFAS No. 123R. We expect to recognize approximately $2.8 million of stock option expense for the year ended December 31, 2006. Included in operating expenses is pension expense. In future periods, if the value of our pension assets or interest rates decline and/or projected benefit costs increase, we may have increased pension expenses. Based on current assumptions and plan asset values, we estimate that our pension expense will be approximately $1.8 million in 2005 (it was $3.6 million in 2004). In addition, as medical costs increase the costs of our postretirement benefit costs also increase. Our retiree medical costs for 2004 were $16.6 million and our current estimate for 2005 is approximately $17.0 million. <TABLE> <CAPTION> DEPRECIATION AND AMORTIZATION EXPENSE ($ in thousands) For the three months ended September 30, For the nine months ended September 30, ---------------------------------------------- ----------------------------------------------- 2005 2004 $ Change % Change 2005 2004 $ Change % Change ----------- ----------- ----------- ----------------------- ----------- ------------ ---------- <S> <C> <C> <C> <C> <C> <C> <C> <C> Depreciation expense $ 102,732 $ 109,278 $ (6,546) -6% $ 317,206 $ 333,301 $ (16,095) -5% Amortization expense 31,595 31,630 (35) 0% 94,784 94,890 (106) 0% ----------- ----------- ----------- ----------- ----------- ------------ $ 134,327 $ 140,908 $ (6,581) -5% $ 411,990 $ 428,191 $ (16,201) -4% =========== =========== =========== =========== =========== ============ </TABLE> Depreciation expense for the three and nine months ended September 30, 2005 decreased $6.6 million, or 6%, and $16.1 million, or 5%, respectively, as compared with the prior year periods due to a declining asset base. <TABLE> <CAPTION> MANAGEMENT SUCCESSION AND STRATEGIC ALTERNATIVES EXPENSES ($ in thousands) For the three months ended September 30, For the nine months ended September 30, ---------------------------------------------- ----------------------------------------------- 2005 2004 $ Change % Change 2005 2004 $ Change % Change ----------- ----------- ----------- ---------- ----------- ----------- ------------ ---------- Strategic alternatives and <S> <C> <C> <C> <C> <C> <C> <C> <C> management succession expenses $ - $ 75,858 $ (75,858) -100% $ - $ 90,632 $ (90,632) -100% </TABLE> Management succession and strategic alternatives expenses in 2004 include a mix of cash retention payments, equity awards and severance agreements. <TABLE> <CAPTION> INVESTMENT AND OTHER INCOME (LOSS) / INTEREST EXPENSE / INCOME TAX EXPENSE (BENEFIT) ($ in thousands) For the three months ended September 30, For the nine months ended September 30, ---------------------------------------------- ----------------------------------------------- 2005 2004 $ Change % Change 2005 2004 $ Change % Change ----------- ----------- ----------- ---------- ---------- ---------- ----------- ---------- Investment and <S> <C> <C> <C> <C> <C> <C> <C> <C> other income (loss) $ 6,768 $ (13,654) $ 20,422 150% $ 12,749 $ 16,849 $ (4,100) -24% Interest expense $85,228 $ 90,863 $ (5,635) -6% $253,096 $286,296 $(33,200) -12% Income tax expense (benefit) $24,781 $ (21,934) $ 46,715 213% $ 69,892 $ 12,869 $ 57,023 443% </TABLE> Investment and other income for the three months ended September 30, 2005 increased $20.4 million as compared with the prior year period primarily due to higher income from money market balances and short-term investments of $5.7 million and a $1.3 million gain on forward rate agreements in 2005, and premiums paid in 2004 to repurchase debt of $20.4 million, partially offset by a $10.7 million gain on the sales of non-strategic investments in 2004. Investment and other income for the nine months ended September 30, 2005 decreased $4.1 million, or 24%, as compared with the prior year period. The decrease is primarily due to $25.3 million of income from the expiration of certain retained liabilities at less than face value, which are associated with 31
customer advances for construction from our disposed water properties and a gain of $9.4 million on the sales of non-strategic investments, partially offset by the $20.4 million of premiums paid to repurchase debt in 2004. These decreases were partially offset in 2005 by higher income from money market balances and short-term investments of $6.3 million and the $1.3 million gain on forward rate agreements, partially offset by a $3.2 million loss on the exchange of debt during the second quarter of 2005. Interest expense for the three months ended September 30, 2005 decreased $5.6 million, or 6%, as compared with the prior year period primarily due to conversions and refinancing of debt. Our composite average borrowing rate for the three months ended September 30, 2005 as compared with the prior year period was 7 basis points lower, decreasing from 8.0% to 7.93%. Interest expense for the nine months ended September 30, 2005 decreased $33.2 million, or 12%, as compared with the prior year period primarily due to conversions and refinancing of debt. Our composite average borrowing rate for the nine months ended September 30, 2005 as compared with the prior year period was 16 basis points lower, decreasing from 8.06% to 7.90%. Income taxes for the three and nine months ended September 30, 2005 increased $46.7 million and $57.0 million, respectively, as compared with the prior year periods primarily due to changes in taxable income and the effective tax rate. The effective tax rate for the first nine months of 2005 was 36.2% as compared with 20.0% for the first nine months of 2004. <TABLE> <CAPTION> DISCONTINUED OPERATIONS ($ in thousands) For the three months ended September 30, For the nine months ended September 30, ---------------------------------------------- ----------------------------------------------- 2005 2004 $ Change % Change 2005 2004 $ Change % Change ----------- ----------- ----------------------- ----------- ----------- ------------ ---------- <S> <C> <C> <C> <C> <C> <C> <C> <C> Revenue $ - $ 6,205 $ (6,205) -100% $ 4,607 $ 18,657 $(14,050) -75% Operating income $ - $ 1,869 $ (1,869) -100% $ 1,489 $ 6,241 $ (4,752) -76% Income from discontinued operations, net of tax $ - $ 1,206 $ (1,206) -100% $ 1,040 $ 3,987 $ (2,947) -74% Gain on disposal of CCUSA, net of tax $ - $ - $ - - $ 1,167 $ - $ 1,167 100% </TABLE> On March 15, 2005, we completed the sale of CCUSA for $43.6 million in cash, subject to adjustments under the terms of the agreement. The pre-tax gain on the sale of CCUSA was $14.1 million. Our after-tax gain was $1.2 million. The book income taxes recorded upon sale are primarily attributable to a low tax basis in the assets sold. 32
Item 3. Quantitative and Qualitative Disclosures about Market Risk ---------------------------------------------------------- Disclosure of primary market risks and how they are managed We are exposed to market risk in the normal course of our business operations due to ongoing investing and funding activities. Market risk refers to the potential change in fair value of a financial instrument as a result of fluctuations in interest rates and equity and commodity prices. We do not hold or issue derivative instruments, derivative commodity instruments or other financial instruments for trading purposes. As a result, we do not undertake any specific actions to cover our exposure to market risks and we are not party to any market risk management agreements other than in the normal course of business or to hedge long-term interest rate risk. Our primary market risk exposures are interest rate risk and equity and commodity price risk as follows: Interest Rate Exposure Our exposure to market risk for changes in interest rates relates primarily to the interest-bearing portion of our investment portfolio and interest on our long-term debt and capital lease obligations. The long term debt and capital lease obligations include various instruments with various maturities and weighted average interest rates. Our objectives in managing our interest rate risk are to limit the impact of interest rate changes on earnings and cash flows and to lower our overall borrowing costs. To achieve these objectives, a majority of our borrowings have fixed interest rates. Consequently, we have limited material future earnings or cash flow exposures from changes in interest rates on our long-term debt and capital lease obligations. A hypothetical 10% adverse change in interest rates would increase the amount that we pay on our variable obligations and could result in fluctuations in the fair value of our fixed rate obligations. Based upon our overall interest rate exposure at September 30, 2005, a near-term change in interest rates would not materially affect our consolidated financial position, results of operations or cash flows. In order to manage our interest rate risk exposure, we have entered into interest rate swap and forward rate agreements. Under the terms of the swap agreements, we make semi-annual, floating rate interest payments based on six month LIBOR and receive a fixed rate on the notional amount. The forward rate agreements fix the underlying variable rate component of some of our swaps at the market rate as of the date of execution for certain future rate-setting dates. At September 30, 2005, the rates obtained under these forward rate agreements were currently below market rates. Sensitivity analysis of interest rate exposure At September 30, 2005, the fair value of our long-term debt and capital lease obligations was estimated to be approximately $4.1 billion, based on our overall weighted average rate of 7.97% and our overall weighted maturity of 12 years. There has been no material change in the weighted average maturity applicable to our obligations since December 31, 2004. The overall weighted average interest rate on our long-term debt and capital lease obligations increased approximately 14 basis points during the first nine months of 2005. A hypothetical increase of 80 basis points (10% of our overall weighted average borrowing rate) would result in an approximate $216.3 million decrease in the fair value of our fixed rate obligations. However, the interest rates on most of our debt are fixed and therefore changes in market interest rates have little near-term impact on our results of operations. Equity Price Exposure Our exposure to market risks for changes in equity prices as of September 30, 2005 is limited and relates to our investment in Adelphia, and our pension assets. As of September 30, 2005 and December 31, 2004, we owned 3,059,000 shares of Adelphia common stock. The stock price of Adelphia was $0.09 and $0.39 at September 30, 2005 and December 31, 2004, respectively. Sensitivity analysis of equity price exposure At September 30, 2005, the fair value of the equity portion of our investment portfolio was estimated to be $0.3 million. A hypothetical 10% decrease in quoted market prices would result in an approximate $28,000 decrease in the fair value of the equity portion of our investment portfolio. 33
Disclosure of limitations of sensitivity analysis Certain shortcomings are inherent in the method of analysis presented in the computation of fair value of financial instruments. Actual values may differ from those presented should market conditions vary from assumptions used in the calculation of the fair value. This analysis incorporates only those exposures that exist as of September 30, 2005. It does not consider those exposures or positions, which could arise after that date. As a result, our ultimate exposure with respect to our market risks will depend on the exposures that arise during the period and the fluctuation of interest rates and quoted market prices. Item 4. Controls and Procedures ----------------------- (a) Evaluation of disclosure controls and procedures We carried out an evaluation, under the supervision and with the participation of our management, regarding the effectiveness of the design and operation of our disclosure controls and procedures. Based upon this evaluation, our principal executive officer and principal financial officer concluded, as of the end of the period covered by this report, September 30, 2005, that our disclosure controls and procedures are effective. (b) Changes in internal control over financial reporting We reviewed our internal control over financial reporting at September 30, 2005. There have been no changes in our internal control over financial reporting identified in an evaluation thereof that occurred during the third fiscal quarter of 2005, that materially affected or are reasonably likely to materially affect our internal control over financial reporting. 34
PART II. OTHER INFORMATION CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES Item 1. Legal Proceedings ----------------- There have been no material changes to our legal proceedings from the information provided in Item 3. Legal Proceedings included in our Annual Report on Form 10-K for the year ended December 31, 2004. We are party to other legal proceedings arising in the normal course of our business. The outcome of individual matters is not predictable. However, we believe that the ultimate resolution of all such matters, after considering insurance coverage, will not have a material adverse effect on our financial position, results of operations, or our cash flows. Item 2. Unregistered Sales of Equity Securities and Use of Proceeds, Issuer ----------------------------------------------------------------------- Purchases of Equity Securities ------------------------------ There have been no unregistered sales or purchases of equity securities. <TABLE> <CAPTION> ISSUER PURCHASES OF EQUITY SECURITIES ------------------------------------- (d) Maximum Approximate (c) Total Number Dollar Value of of Shares Shares that (a) Total Purchased as Part May Yet be Number of (b) Average of Publicly Purchased Shares Price Paid per Announced Plans Under the Plans Period Purchased Share or Programs or Programs - ----------------------------------------------------------------------------------------------------------- July 1, 2005 to July 31, 2005 <S> <C> <C> <C> Share Repurchase Program (1) - $ - - $231,400,000 Employee Transactions (2) - - - N/A August 1, 2005 to August 31, 2005 Share Repurchase Program (1) 6,576,100 $ 13.68 6,576,100 $141,500,000 Employee Transactions (2) - - N/A N/A September 1, 2005 to September 30, 2005 Share Repurchase Program (1) 4,680,400 $ 13.56 4,680,400 $ 78,000,000 Employee Transactions (2) 629 $ 13.51 N/A N/A Totals July 1, 2005 to September 30, 2005 Share Repurchase Program (1) 11,256,500 $ 13.62 11,256,500 $ 78,000,000 Employee Transactions (2) 629 $ 13.51 N/A N/A </TABLE> (1) On May 25, 2005, our Board of Directors authorized the Company to repurchase over the following twelve-month period, up to $250.0 million of the Company's common stock, either in the open market or through negotiated transactions. This share repurchase program commenced on June 13, 2005. (2) Includes restricted shares withheld (under the terms of grants under employee stock compensation plans) to offset tax withholding obligations that occur upon the vesting of restricted shares. The Company's stock compensation plans provide that the value of shares withheld shall be the average of the high and low price of the Company's common stock on the date the relevant transaction occurs. Item 6. Exhibits -------- a) Exhibits: 10.19.3 Summary of Non-Employee Directors' Compensation Arrangements Outside of Formal Plans as amended, effective July 1, 2005. 35
10.24 Separation Agreement between Citizens Communications Company and L. Russell Mitten dated July 13, 2005. 10.24.1 Amendment to the Separation Agreement between Citizens Communications Company and L. Russell Mitten dated August 31, 2005. 31.1 Certification of Principal Executive Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934. 31.2 Certification of Principal Financial Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934. 32.1 Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.2 Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 36
CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. CITIZENS COMMUNICATIONS COMPANY (Registrant) By: /s/ Robert J. Larson --------------------------------------- Robert J. Larson Senior Vice President and Chief Accounting Officer Date: November 2, 2005 37