SECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549
FORM 10-Q
For the quarterly period ended
OR
For the transition period from
Commission File Number 001-14157
(Exact name of registrant as specified in its charter)
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 ý No ¨
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.
TELEPHONE AND DATA SYSTEMS, INC.
2nd QUARTER REPORT ON FORM 10-Q
INDEX
PART I. FINANCIAL INFORMATIONITEM 1. FINANCIAL STATEMENTSTELEPHONE AND DATA SYSTEMS, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONSUnaudited
The accompanying notes to consolidated financial statements are an integral part of these statements.
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TELEPHONE AND DATA SYSTEMS, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWSUnaudited
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TELEPHONE AND DATA SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETSASSETSUnaudited
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TELEPHONE AND DATA SYSTEMS, INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETSLIABILITIES AND STOCKHOLDERS' EQUITYUnaudited
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TELEPHONE AND DATA SYSTEMS, INC. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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Consists of the TDS Corporate operations, TDS Telecom intercompany revenue and expense eliminations, TDS Corporate and TDS Telecom marketable equity securities and all other businesses not included in the U.S. Cellular or TDS Telecom segments.
Operating income before depreciation, amortization and accretion and Operating income before depreciation, amortization and accretion, loss on impairment of intangible assets and Loss on assets held for sale are measures of profit and loss used by the chief operating decision maker to review the operating performance of each reportable business segment and is reported above in accordance with SFAS No. 131, “Disclosure about Segments of an Enterprise and Related Information.”
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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF RESULTSOF OPERATIONS AND FINANCIAL CONDITION
TELEPHONE AND DATA SYSTEMS, INC. AND SUBSIDIARIES
Telephone and Data Systems, Inc. (“TDS”- AMEX symbol: TDS) is a diversified telecommunications company providing high-quality telecommunications services to approximately 5.8 million wireless telephone customers and wireline telephone equivalent access lines. TDS conducts substantially all of its wireless telephone operations through its 82.1%-owned subsidiary, United States Cellular Corporation (“U.S. Cellular”) and its incumbent local exchange carrier and competitive local exchange carrier wireline telephone operations through its wholly owned subsidiary, TDS Telecommunications Corporation (“TDS Telecom”).
The following discussion and analysis should be read in conjunction with TDS’s interim consolidated financial statements and footnotes included herein, and with TDS’s audited consolidated financial statements and footnotes and Management’s Discussion and Analysis of Results of Operations and Financial Condition included in TDS’s Annual Report on Form 10-K for the year ended December 31, 2003, as amended.
Wireless License Costs and Goodwill Restatements
On May 14, 2004 TDS restated its 2003 and 2002 financial statements relating to the implementation of Statement of Financial Accounting Standards (“SFAS”) No. 142 “Goodwill and Other Intangible Assets,” which was adopted on January 1, 2002. Prior to January 1, 2002, TDS allocated the excess of purchase price of wireless properties over tangible assets and liabilities acquired to wireless license costs and goodwill. At that time, the accounting treatment for the TDS’s wireless licenses and goodwill was the same for book purposes, with both asset classes amortized over an expected life of 40 years. However, no deferred taxes were provided on the amounts allocated to goodwill.
Based upon a subsequent review of goodwill, TDS restated the allocation of $138.9 million of purchase price recorded as goodwill to wireless license costs as of January 1, 2002, the date of the adoption of SFAS No. 142. In connection with this restatement, an additional deferred tax liability of $90.7 million was recorded as of January 1, 2002. The additional deferred tax liability recorded in conjunction with this restatement increased the carrying value of wireless license costs by a corresponding $90.7 million. Following these adjustments, TDS reperformed the impairment tests for its wireless license costs as of January 1, 2002, and recorded an impairment loss of $20.9 million, before an income tax benefit of $8.2 million and minority interest of $2.3 million. This impairment was recorded as a cumulative effect of an accounting change at January 1, 2002, the date of the adoption of SFAS 142.
In the first quarter of 2003, TDS had recorded a Loss on assets held for sale related to the pending disposition of certain wireless properties. The wireless license costs upon which the impairment was recorded in the first quarter of 2002 included the wireless license costs of these properties. As a result, a portion of the originally recognized Loss on assets held for sale in the first quarter of 2003 was recognized in the first quarter of 2002. Consequently, Loss on assets held for sale in 2003 has been reduced by $1.9 million, before an income tax benefit of $0.8 million and minority interest of $0.2 million.
In addition, as a result of the restatement discussed above, TDS also reperformed the annual impairment test for its wireless license costs for 2003, which was originally performed during the second quarter of 2003. This resulted in the recognition of an additional impairment loss of $49.6 million, before an income tax benefit of $19.6 million and minority interest of $5.4 million in the second quarter of 2003.
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Retention Reclassifications
Certain amounts reported in prior years have been reclassified to conform to the current period presentation. Prior to the fourth quarter of 2003, costs for equipment sold by U.S. Cellular to retain current customers were included in selling, general and administrative expense. These costs were partially offset by equipment sales revenues received from these customers. In the fourth quarter of 2003, TDS changed its policy for classifying retention costs and reclassified U.S. Cellular equipment sales revenue and cost of equipment sold related to the retention of current customers out of selling, general and administrative expense and into operating revenues and cost of services and products, respectively, for each period presented. These reclassifications have been reflected in the three and six months ended June 30, 2003. These reclassifications increased operating revenues for the three and six months ended June 30, 2003 by $6.1 million and $14.0 million, respectively, and increased cost of services and products by $22.2 million and $46.1 million, respectively, from the amounts originally reported. Selling, general and administrative expense was reduced by $16.1 million and $32.1 million, respectively, from the amounts originally reported in the results for the three and six months ended June 30, 2003 to reflect the amounts reclassified to operating revenues and cost of services and products. These reclassifications did not have any impact on income from operations, net income, earnings per share, financial position or cash flows of TDS for the three and six months ended June 30, 2003.
The following is a summary of certain selected information from the complete management discussion that follows the overview and does not contain all of the information that may be important. You should carefully read this entire management discussion and analysis and not rely solely on the overview.
U.S. Cellular — U.S. Cellular positions itself as a regional operator, focusing its efforts on providing wireless service to customers in the geographic areas where it has licenses to provide such service. U.S. Cellular differentiates itself from its competitors through a customer satisfaction strategy, reflecting broad product distribution, a customer service focus and a high-quality wireless network.
U.S. Cellular’s business development strategy is to operate controlling interests in wireless licenses in areas adjacent to or in proximity to its other wireless licenses, thereby building contiguous operating market areas. U.S. Cellular’s operating strategy is to strengthen the geographic areas where it can continue to build long-term operating synergies and to exit those areas where it does not have opportunities to build such synergies. In addition to the recent transactions disclosed in TDS’s Annual Report on Form 10-K for the year ended December 31, 2003, as amended, on February 18, 2004, U.S. Cellular completed the sale of certain of its wireless properties in southern Texas to AT&T Wireless Services, Inc. for $96.9 million in cash, including a working capital adjustment.
U.S. Cellular’s operating income in the six months ended June 30, 2004 increased $95.1 million to $94.2 million from an operating loss of $883,000 in 2003. The operating income (loss) margins (as a percent of service revenues) were 7.3% in 2004 and less than (1%) in 2003. U.S. Cellular’s 2003 operating loss and operating loss margin were significantly affected by the Loss on assets held for sale and Loss on impairment of intangible assets. Although operating income and margins improved in 2004, TDS expects that there will be pressure on U.S. Cellular operating income and margins in the next few years related to the following factors:
The effects of these factors are expected to be mitigated to some extent by the following factors:
See “U.S. Cellular Operations.”
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TDS Telecom — TDS Telecom provides high-quality telecommunication services, including full-service local exchange service, long distance telephone service and Internet access, to rural, suburban and selected small urban area communities. TDS Telecom’s business plan is designed to leverage TDS Telecom’s strength as an incumbent local exchange carrier into a full-service telecommunications company that includes competitive local exchange carrier operations. TDS Telecom is focused on achieving three central strategic objectives: growth, market leadership, and profitability. TDS Telecom’s strategy includes gaining additional market share and deepening penetration of vertical services within established markets. The strategy places primary emphasis on small and medium-sized commercial customers and on residential customers.
Both incumbent local exchange carriers and competitive local exchange carriers are faced with significant challenges, including the industry declines in long distance minutes of use and use of second lines by customers, growing competition from wireless and other communications providers, lack of access to and potentially uneconomic pricing of unbundled network elements, changes in regulation and new technologies such as Voice Over Internet Protocol. These challenges could have a material adverse effect on the financial condition, results of operations and cash flows of TDS Telecom.
TDS Telecom’s operating income in the six months ended June 30, 2004 increased $10.4 million to $89.5 million from $79.1 million in 2003. The operating income margins were 20.5% in 2004 and 18.7% in 2003. Despite the challenges faced in the industry, TDS Telecom was able to increase equivalent access lines in 2004 primarily through the increase in penetration of existing markets by its competitive local exchange operations. The incumbent local exchange carrier operations increased revenues $3.2 million or 1% in 2004 and the competitive local exchange carrier operations increased revenues by $9.6 million, or 9%. TDS Telecom continues to look for ways to control costs while increasing the penetration of its competitive local exchange carrier markets.
See “TDS Telecom Operations.”
TDS and its subsidiaries had Cash and cash equivalents totaling $1,381.4 million, $1,296.6 million of revolving credit facilities available for use and an additional $75 million of bank lines of credit as of June 30, 2004. TDS and its subsidiaries are also generating substantial internal funds from operations. Cash flows from operating activities totaled $325.5 million in the six months ended June 30, 2004. In addition, TDS and its subsidiaries may have access to public and private capital markets to help meet their long-term financing needs. TDS anticipates that it may require funding over the next few years for capital expenditures, for the development of new wireless markets at U.S. Cellular and to further its growth in all markets. Management believes that cash on hand, expected future cash flows from operations and existing sources of external financing provide substantial financial flexibility and are sufficient to permit TDS and its subsidiaries to finance their contractual obligations and anticipated capital expenditures. TDS is committed to maintaining a strong balance sheet and an investment grade rating.
As of June 17, 2004, U.S. Cellular issued $330 million in aggregate principal amount of 7.5% senior notes due 2034. The net proceeds from this offering, after deducting underwriting discounts, were approximately $319.6 million.
On June 28, 2004, U.S. Cellular issued $100 million in aggregate principal amount of 6.7% senior notes due 2033 priced to yield 7.21% to maturity. The net proceeds from this offering, after deducting underwriting discounts, were approximately $92.9 million. This is a further issuance of U.S. Cellular’s 6.7% notes that were issued on December 8, 2003 in the aggregate principal amount of $444 million.
On June 24, 2004, U.S. Cellular issued redemption notices to holders of U.S. Cellular’s subordinated 6% zero coupon convertible debentures (also known as Liquid Yield Option Notes) and on June 28, 2004 issued redemption notices to holders of U.S. Cellular’s 7.25% senior notes. Consequently, $162.4 million of Liquid Yield Option Notes and $250 million of 7.25% senior notes were reclassified to Current portion of long-term debt on the Balance Sheet.
The total net proceeds from the 7.5% and 6.7% senior note offerings, after deducting underwriting discounts, were approximately $412.5 million. Of this amount, $163.3 million was used to redeem U.S. Cellular’s Liquid Yield Option Notes, on July 26, 2004 at accreted value. The balance of the net proceeds, together with borrowings under the revolving credit agreement, is expected to be used to redeem all of U.S. Cellular’s 7.25% senior notes as of August 16, 2004.
See “Financial Resources” and “Liquidity and Capital Resources.”
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Operating Revenues increased $132.4 million, or 8%, to $1,805.1 million during the six months ended June 30, 2004 from $1,672.7 million during the six months ended June 30, 2003 primarily as a result of an 8% increase in customers and equivalent access lines served. U.S. Cellular’s operating revenues increased $120.2 million, or 10%, to $1,369.9 million in 2004 from $1,249.7 million in 2003 as customers served increased by 341,000, or 8%, since June 30, 2003, to 4,684,000. Of the 341,000 increase in customers, 540,000 were added through U.S. Cellular’s marketing channels while 199,000 net customers were subtracted as a result of acquisition and divestiture activities, primarily the divestitures to AT&T Wireless in August 2003 and February 2004. TDS Telecom operating revenues increased $12.2 million, or 3%, to $435.2 million in 2004 from $423.0 million in 2003 as equivalent access lines increased by 78,800 or 8%, since June 30, 2003 to 1,121,200, and due to $2.5 million in one-time adjustments to certain competitive local exchange carrier revenue accruals. An equivalent access line is derived by converting a high-capacity data line to an estimated equivalent number, in terms of capacity, of switched access lines.
Operating Expenses increased $27.1 million, or 2%, to $1,621.5 million in 2004 from $1,594.4 million in 2003 primarily reflecting growth in operations offset by losses recorded in 2003. U.S. Cellular’s operating expenses increased $25.1 million, or 2%, to $1,275.7 million in 2004 from $1,250.6 million in 2003 primarily reflecting costs associated with providing service to an expanding customer base. In 2003, operating expenses included a $49.6 million Loss on impairment of intangible assets and a $25.1 million Loss on assets held for sale related to the exchange of wireless properties in Georgia and Florida with AT&T Wireless in August 2003. TDS Telecom’s expenses increased $1.9 million, or less than 1%, to $345.7 million in 2004 from $343.8 million in 2003 primarily reflecting cost control measures.
Operating Income increased $105.3 million to $183.6 million in 2004 from $78.3 million in 2003. Operating margin increased to 10.2% in 2004 from 4.7% in 2003 on a consolidated basis. U.S. Cellular’s operating income increased to $94.2 million from an operating loss of $883,000 in 2003 and its operating income (loss) margin, as a percentage of service revenues, increased to 7.3% in 2004 from less than (1%) in 2003. TDS Telecom’s operating income increased $10.4 million, or 13%, to $89.5 million in 2004 from $79.1 million in 2003 and its operating margin rose to 20.5% in 2004 from 18.7% in 2003 due in part to one-time adjustments to certain competitive local exchange carrier revenue accruals that increased operating revenues and operating income by $2.5 million.
Investment and Other Income(Expense) primarily includes interest and dividend income, investment income, loss on investments and interest expense. Investment and other income (expense) totaled ($58.4) million in 2004 and ($77.5) million in 2003.
Investment income increased $6.9 million, or 26%, to $33.2 million in 2004 from $26.3 million in 2003. Investment income represents TDS’s share of income in unconsolidated entities in which TDS has a minority interest and follows the equity method of accounting. The aggregate net income of these entities increased significantly in 2004, resulting in a corresponding increase in investment income.
Interest and dividend incomedecreased $2.3 million, or 22%, to $8.1 million in 2004 from $10.4 million in 2003 primarily due to lower average interest rates and lower average cash balances in 2004 than 2003.
Loss on investmentstotaled $1.8 million in 2004 and $8.5 million in 2003. TDS recorded a $5.0 million impairment loss on a wireless investment held by TDS Telecom in the second quarter of 2003. A $3.5 million license impairment loss was recorded in the second quarter of 2003 related to a wireless investment in a non-operating market in Florida that remained with U.S. Cellular after the AT&T Wireless exchange. An additional impairment loss of $1.8 million was recorded in the second quarter of 2004 to reflect further impairment in the carrying value of this same wireless investment in Florida.
Interest (expense) increased $7.8 million, or 9%, to $95.2 million in 2004 from $87.4 million in 2003. The increase was primarily due to amounts related to the issuance of 30-year 6.7% Senior Notes ($15.4 million) by U.S. Cellular in December 2003 offset by a reduction of interest on U.S. Cellular short-term debt ($3.7 million) and on TDS Medium-term notes ($3.1 million). TDS paid down $70.5 million of Medium-term notes in June and July of 2003.
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Minority interest in income of subsidiary trust decreased $12.4 million in 2004. In September 2003, TDS redeemed all $300 million of Company-Obligated Mandatorily Redeemable Preferred Securities at par plus accrued and unpaid distributions. There was no gain or loss on this transaction.
Income Tax Expense increased $42.8 million to $51.4 million in 2004 from $8.6 million in 2003 primarily due to higher pretax income and the tax effects on the Loss on impairment of intangible assets and on the (Gain) loss on assets held for sale in 2003. Losses totaled $83.2 million ($46.8 million, net of a tax benefit of $27.2 million and minority interest of $9.2 million) in 2003. The effective tax rate was 41.0% in 2004 and was not meaningful in 2003 due to the effect of the losses. Excluding the tax on losses, the effective tax rate was 39.1% in 2004 and 42.8% in 2003. For a discussion of TDS’s effective tax rates in 2004 and 2003, see Note 4 – Income Taxes.
Minority Share of (Income) Loss includes the minority public shareholders’ share of U.S. Cellular’s net income, the minority shareholders’ or partners’ share of U.S. Cellular’s subsidiaries’ net income or loss and other minority interests. U.S. Cellular’s minority public shareholders’ share of income in 2003 was reduced by $9.2 million due to U.S. Cellular’s Loss on impairment of intangible assets, Loss on assets held for sale and Loss on investments.
Income (Loss) Before Cumulative Effect of Accounting Change totaled $61.1 million, or $1.06 per diluted share, in 2004 compared to $(9.2) million, or $(0.17) per diluted share, in 2003.
Cumulative Effect of Accounting Change. Effective January 1, 2003, TDS adopted SFAS No. 143, “Accounting for Asset Retirement Obligations” and recorded the initial liability for legal obligations associated with an asset retirement. The cumulative effect of the implementation of this accounting standard on periods prior to 2003 was recorded in the first quarter of 2003, decreasing net income by $11.8 million, net of tax and minority interest, or $0.20 per basic and diluted share.
Net Income (Loss) Available to Common totaled $61.0 million, or $1.06 per diluted share, in 2004 and $(21.2) million, or $(0.37) per diluted share, in 2003.
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TDS provides wireless telephone service through United States Cellular Corporation (“U.S. Cellular”), an 82.1%-owned subsidiary. U.S. Cellular owns, manages and invests in cellular markets throughout the United States. Growth in the customer base is the primary reason for the growth in U.S. Cellular’s revenues and expenses. The number of customers served increased by 341,000 or 8%, since June 30, 2003, to 4,684,000 due to customer additions from its marketing channels. Of the 341,000 increase in customers, 540,000 were added through U.S. Cellular’s marketing channels while 199,000 net customers were subtracted as a result of acquisition and divestiture activities, primarily from the transactions discussed below.
On August 1, 2003, U.S. Cellular completed the transfer of wireless assets and customers in ten 25 megahertz markets in Florida and Georgia to AT&T Wireless pursuant to an agreement entered into in March 2003. In exchange, U.S. Cellular received the following: a) rights to acquire controlling interests in 36 personal communication service licenses; b) approximately $34.0 million in cash; and c) minority interests in six markets in which it previously owned a controlling interest. In accordance with the agreement, U.S. Cellular has deferred the assignment and development of 21 licenses for a period of up to five years from the closing date. U.S. Cellular will take possession of the licenses in staggered closings over that five-year period to comply with service requirements of the Federal Communications Commission (“FCC”). The value of these licenses is recorded as Wireless license rights on the Balance Sheet.
An estimated loss of $25.1 million was recorded in the six months ended June 30, 2003 as a Loss on assets held for sale (included in operating expenses), representing the difference between the carrying value of the markets transferred to AT&T Wireless and the fair value of the consideration received or to be received in the transaction. The Florida and Georgia markets that were transferred to AT&T Wireless are included in consolidated operations for the three and six months ended June 30, 2003.
On February 18, 2004, U.S. Cellular completed the sale of certain of its wireless properties in southern Texas to AT&T Wireless for $96.9 million in cash, including a working capital adjustment. The U.S. Cellular markets sold to AT&T Wireless included wireless assets and customers in six 25 megahertz cellular markets. An aggregate loss of $21.3 million (including a $22.0 million estimate of the Loss on assets held for sale in the fourth quarter of 2003 and a $725,000 reduction of the loss in the six months ended June 30, 2004) was recorded as a Loss on assets held for sale (included in operating expenses), representing the difference between the carrying value of the markets sold to AT&T Wireless and the cash received in the transaction. The southern Texas markets sold to AT&T Wireless are included in results of operations from January 1, 2004 through February 17, 2004.
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Operating revenues increased $120.2 million, or 10%, to $1,369.9 million in 2004 from $1,249.7 million in 2003.
Service revenues increased $107.3 million, or 9%, to $1,282.0 million in 2004 from $1,174.7 million in 2003. Service revenues primarily consist of: (i) charges for access, airtime, roaming and value-added services provided to U.S. Cellular’s retail customers (“retail service”); (ii) charges to other wireless carriers whose customers use U.S. Cellular’s wireless systems when roaming (“inbound roaming”); and (iii) charges for long-distance calls made on U.S. Cellular’s systems. The increase was primarily due to the growing number of retail customers. Monthly service revenue per customer averaged $46.96 in the six months ended June 30, 2004, a 2% increase from an average of $46.24 in the first six months of 2003. The numerator of this calculation of average monthly revenues per customer for the six months ended June 2004 and 2003 consists of the revenue for the respective six month period divided by six. The denominator consists of the average number of customers. Average customers totaled 4,550,000 for the six months ended June 30, 2004 and 4,234,000 for the six months ended June 30, 2003.
Retail service revenuesincreased $133.4 million, or 14%, to $1,116.8 million in 2004 from $983.4 million in 2003. Growth in U.S. Cellular’s customer base and an increase in average monthly retail service revenue per customer were the primary reasons for the increase in retail service revenue. The number of customers increased 8% to 4,684,000 at June 30, 2004, from 4,343,000 at June 30, 2003. Of the 341,000 increase in customers, 540,000 were added through U.S. Cellular’s marketing channels while 199,000 net customers were subtracted as a result of acquisition and divestiture activities, primarily the divestitures to AT&T Wireless in August 2003 and February 2004. Average monthly retail service revenue per customer increased 6% to $40.91 in 2004 from $38.71 in 2003. The increase in average monthly retail service revenue per customer was primarily driven by the increase in minutes of use per customer and by growth in revenue from data products.
U.S. Cellular management anticipates that growth in the customer base in U.S. Cellular’s wireless markets will be slower in the future, primarily as a result of the increased competition in its markets and continued penetration of the consumer market. However, as U.S. Cellular expands its operations in Chicago and into its other recently acquired markets in future years, it anticipates adding customers and revenues in those markets.
Monthly local retail minutes of use per customer averaged 517 in 2004 and 401 in 2003. The increase in monthly local retail minutes of use was driven by U.S. Cellular’s focus on designing sales incentive programs and customer billing rate plans to stimulate overall usage. The impact on retail service revenue of this increase was partially offset by a decrease in average revenue per minute of use in 2004. The decrease in average revenue per minute of use reflects the effects of increasing competition, which has led to the inclusion of an increasing number of minutes in package pricing plans. U.S. Cellular management anticipates that U.S. Cellular’s average revenue per minute of use will continue to decline in the future, reflecting increased competition and penetration of the consumer market.
Inbound roaming revenuesdecreased $24.4 million, or 22%, to $87.0 million in 2004 from $111.4 million in 2003. The decrease in revenue primarily related to the decrease in revenue per roaming minute of use, partially offset by an increase in roaming minutes of use. In 2004, the increase in inbound roaming minutes of use was primarily driven by the overall growth in the number of customers throughout the wireless industry and strong customer growth for carriers who use Code Division Multiple Access (“CDMA”) digital radio technology, partially offset by the loss of minutes of use from the markets transferred and sold to AT&T Wireless. Contributing to the decrease in inbound roaming revenue in 2004 was the effect of the transfer of Florida and Georgia markets to AT&T Wireless in August 2003 and the sale of southern Texas markets to AT&T Wireless in February 2004; these markets had historically provided substantial amounts of inbound roaming revenue. The decline in revenue per minute of use is primarily due to the general downward trend in negotiated rates.
U.S. Cellular management anticipates that the rate of growth in inbound roaming minutes of use will continue to slow down due to these factors:
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U.S. Cellular management also anticipates that average inbound roaming revenue per minute of use will continue to decline, reflecting the continued general downward trend in negotiated rates.
Long-distance and other revenue decreased $1.6 million, or 2%, to $78.3 million in 2004 from $79.9 million in 2003, primarily related to price reductions related to long-distance charges on roaming minutes of use as well as U.S. Cellular’s increasing use of pricing plans for its retail customers which include long-distance calling at no additional charge, partially offset by an increase in the volume of long-distance calls billed by U.S. Cellular from inbound roamers using its systems to make long-distance calls.
Equipment sales revenuesincreased $12.8 million, or 17%, to $87.8 million in 2004 from $75.0 million in 2003. U.S. Cellular includes in its equipment sales revenues any handsets and related accessories sold to its customers, whether the customers are new to U.S. Cellular or are current customers who are changing handsets. U.S. Cellular also sells handsets to its agents at a price approximately equal to U.S. Cellular’s cost before applying any rebates. Selling handsets to agents enables U.S. Cellular to provide better control over handset quality, set roaming preferences and pass along quantity discounts. U.S. Cellular management anticipates that it will continue to sell handsets to agents in the future, and that it will continue to provide rebates to agents who provide handsets to new and current customers. Equipment sales revenues have grown less significantly than cost of equipment sold in the six months ended June 30, 2004 due to the continued substantial discounting of handsets. This trend is occurring throughout the wireless industry.
Equipment sales revenue from handset sales to agents is recognized upon delivery of the related products to the agents, net of any anticipated agent rebates. In most cases, the agents receive a rebate from U.S. Cellular at the time these agents provide handsets to sign up new customers or retain current customers.
Customers added to U.S. Cellular’s customer base through its marketing distribution channels (“gross customer activations”), the primary driver of equipment sales revenues, increased 10% in 2004. The higher percentage increase in revenues from handset sales than in gross customer activations was driven by an increase in sales of higher priced data-enabled handsets. These handsets were offered in conjunction with the launch of U.S. Cellular’s data services products, which began in the second half of 2003.
Operating expenses increased $25.1 million, or 2%, to $1,275.7 million in 2004 from $1,250.6 million in 2003.
System operations expenses (excluding depreciation) decreased $2.6 million, or less than (1%), to $282.4 million in 2004 from $285.0 million in 2003. System operations expenses include charges from landline telecommunications service providers for U.S. Cellular’s customers’ use of their facilities, costs related to local interconnection to the landline network, charges for maintenance of U.S. Cellular’s network, long-distance charges, outbound roaming expenses and payments to third-party data product and platform developers. The decrease in system operations expenses in 2004 was due to the following factors:
The effects of the above factors were partially offset by the following factors:
As a result of the above factors, the components of system operations expenses were affected as follows:
In 2004, roaming charges paid by U.S. Cellular to third parties when its customers roamed in the Chicago market declined compared to 2003. Continued integration of the Chicago market into U.S. Cellular’s operations in 2004 resulted in increased use of U.S. Cellular’s system by U.S. Cellular’s customers and a corresponding decrease in roaming by its customers on other systems in the Midwest.
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In total, U.S. Cellular management expects system operations expenses to increase over the next few years, driven by the following factors:
These factors are expected to be partially offset by anticipated decreases in the per-minute cost of usage both on U.S. Cellular’s systems and on other carriers’ networks. As the Chicago area has historically been U.S. Cellular’s customers’ most popular roaming destination, U.S. Cellular management anticipates that the continued integration of the Chicago market and other recently launched markets into its operations will result in a further increase in minutes of use by U.S. Cellular’s customers on its systems and a corresponding decrease in minutes of use by its customers on other systems, resulting in a lower overall increase in minutes of use by U.S. Cellular’s customers on other systems. Such a shift in minutes of use should reduce U.S. Cellular’s per-minute cost of usage in the future, to the extent that its customers use its systems rather than other carriers’ networks. Additionally, U.S. Cellular’s acquisition and subsequent buildout of licensed areas received in the AT&T Wireless exchange transaction may shift more minutes of use to U.S. Cellular’s systems, as many of these licensed areas are major roaming destinations for U.S. Cellular’s current customers.
Cost of equipment soldincreased $61.9 million, or 37%, to $230.1 million in 2004 from $168.2 million in 2003. The increase was due to the 10% increase in new customer activations as well as an increase in handsets sold to customers for retention purposes. Retention costs have increased as U.S. Cellular continued to focus on retaining customers by offering existing customers new handsets similar to those offered to new customers as the expiration dates of customers’ service contracts approached. In addition, the overall cost per handset increased in the first six months of 2004 as more customers purchased higher priced data-enabled handsets.
Selling, general and administrative expenses increased $19.4 million, or 4%, to $527.8 million in 2004 from $508.4 million in 2003. Selling, general and administrative expenses primarily consist of salaries, commissions and expenses of field sales and retail personnel and offices; agent commissions and related expenses; corporate marketing, merchandise management and telesales department salaries and expenses; advertising; and public relations expenses. Selling, general and administrative expenses also include the costs of operating U.S. Cellular’s customer care centers, the costs of serving customers and the majority of U.S. Cellular’s corporate expenses.
The increase in selling, general and administrative expenses in the first six months of 2004 is primarily due to the following factors:
The increase was also attributable to the rise in salaries and other employee-related expenses associated with acquiring, serving and retaining customers, primarily as a result of the increase in U.S. Cellular’s customer base.
These increases were partially offset by a $23.2 million decrease in billing-related expenses, primarily due to the expenses incurred in 2003 related to the maintenance of the Chicago market’s billing system and the transition to the system used in U.S. Cellular’s other operations in July 2003.
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Sales and marketing cost per gross customer activation increased 4% to $381 in 2004 from $367 in 2003, primarily due to increased handset subsidies. Sales and marketing cost per gross customer activation is not calculable using financial information derived directly from the statement of operations. The definition of sales and marketing cost per gross customer activation that U.S. Cellular uses as a measure of the cost to acquire additional customers through its marketing distribution channels may not be comparable to similarly titled measures that are reported by other companies. Below is a summary of sales and marketing cost per gross customer activation for each period:
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Monthly general and administrative expenses per customer, including the net costs related to the renewal or upgrade of service contracts of existing U.S. Cellular customers (“net customer retention costs”), increased 2% to $13.91 in 2004 from $13.65 in 2003. U.S. Cellular management uses this measurement to assess the cost of serving and retaining its customers on a per unit basis.
This measurement is reconciled to total selling, general and administrative expenses as follows:
Depreciation expense increased $29.4 million, or 16%, to $211.8 million in 2004 from $182.4 million in 2003. The increase primarily reflects rising average fixed asset balances, which increased 13% in 2004, as well as a change in the useful lives of certain asset categories, which increased depreciation expense $9.9 million in 2004. Also, certain Time Division Multiple Access (“TDMA”) digital radio equipment consigned to a third party for future sale was written down by $6.3 million prior to its consignment, increasing depreciation expense by that amount. This writedown was necessary to reduce the book value of the assets to be sold to their estimated proceeds from disposition. Increased fixed asset balances in 2004 resulted from the following factors:
In preparation for the implementation of a fixed asset management and tracking software system, including a bar code asset identification system, U.S. Cellular is conducting a physical inventory review of its cell site fixed assets. U.S. Cellular has commenced the cell site fixed asset inventory review and expects to complete the inventory in the fourth quarter of 2004. Based on the results of the review through June 30, 2004, U.S. Cellular estimates that the review, when completed, will result in a write-off of certain assets with a net book value of approximately $4.0 million, and charged $4.0 million to depreciation expense for the estimated write-off in the second quarter. To the extent the final results differ from the $4.0 million already charged to expense, an adjustment would be required.
In 2003, $5 million of depreciation expense was recorded related to the writeoff of certain assets.
See “Financial Resources” and “Liquidity and Capital Resources” for further discussions of U.S. Cellular’s capital expenditures.
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Amortization and accretion expensedecreased $7.5 million, or 24%, to $24.4 million in 2004 from $31.9 million in 2003, primarily representing decreased amortization related to the customer list intangible assets acquired in the Chicago market transaction during 2002. These customer list assets are amortized using the declining balance method, based on average customer retention periods of each customer list. Therefore, decreasing amounts of amortization expense will be recorded in each 12-month period following the establishment of each customer list asset. Amortization and accretion expense includes $2.4 million of accretion related to the asset retirement obligation in 2004, and $2.1 million in 2003.
Loss on impairment of intangible assets totaled $49.6 million in 2003. As discussed previously, U.S. Cellular restated 2003 and 2002 financial statements related to the implementation of Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets.” In connection with this restatement, U.S. Cellular reperformed the annual impairment test for its investment in licenses for 2003, which was originally performed during the second quarter of 2003. This resulted in the recognition of an additional impairment loss of $49.6 million, before an income tax benefit of $19.6 million.
The 2004 annual impairment tests for investments in licenses and goodwill were performed in the second quarter of 2004. Other than a license impairment loss recorded as a Loss on investments related to a non-operating market, no impairment losses resulted from the 2004 annual impairment tests.
(Gain) loss on assets held for sale totaled ($725,000) in 2004 and a loss of $25.1 million in 2003.
The amount recorded in 2004 was a reduction of a $22.0 million estimated loss recorded in the fourth quarter 2003 on the sale of U.S. Cellular markets in southern Texas to AT&T Wireless on February 17, 2004. The result was an aggregate loss of $21.3 million, representing the difference between the carrying value of the markets sold and the cash received in the transaction. The southern Texas markets sold to AT&T Wireless were included in consolidated operations from January 1, 2004 through February 17, 2004.
The $25.1 million loss in 2003 represents the difference between the fair value, as determined by an independent valuation, of the assets U.S. Cellular expected to receive in the AT&T Wireless exchange transaction which was completed in August 2003, and the recorded value of the assets it expected to transfer to AT&T Wireless.
Operating income (loss)totaled income of $94.2 million in 2004 and a loss of $883,000 in 2003. The operating income (loss) margins (as a percent of service revenues) were 7.3% in 2004 and less than (1%) in 2003. The increase in operating income and operating income margin in 2004 reflects the following:
These factors were partially offset by the following:
U.S. Cellular expects most of the above factors, except for those related to Loss on impairment of intangible assets and (Gain) loss on assets held for sale, to continue to have an effect on operating income and operating margins for the next several quarters. Any changes in the above factors, as well as the effects of other drivers of U.S. Cellular’s operating results, may cause operating income and operating margins to fluctuate over the next several quarters.
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U.S. Cellular plans to incur additional expenses during the remainder of 2004 as it competes in its established markets and in recently launched markets. Additionally, U.S. Cellular plans to build out its network into other as yet unserved portions of its licensed areas, and will begin sales and marketing operations in those areas in the second half of 2004 and in subsequent years. U.S. Cellular launched its brand of data-related wireless services in many of its markets in the second half of 2003, and expects to incur expenses related to its continued marketing of data-related wireless services in the next few years.
As a result, depending on the timing and effectiveness of these initiatives, U.S. Cellular anticipates that its operating income will range from $150 million to $190 million for the full year of 2004, including $500 million of anticipated depreciation, amortization and accretion expenses, compared to $119 million of operating income in 2003.
U.S. Cellular anticipates that service revenues will total approximately $2.6 billion for the full year of 2004, compared to service revenues of $2.4 billion in 2003. The anticipated service revenue growth in 2004 reflects the effects of the sale of properties to AT&T Wireless in February 2004, the markets transferred to AT&T Wireless in the exchange transaction completed in August 2003, the continued growth in U.S. Cellular’s customer base and the continued marketing of data-related wireless services in its markets.
Depending on the timing and effectiveness of its marketing efforts, U.S. Cellular anticipates that net customer activations from its marketing channels will total 560,000 to 610,000 for the full year of 2004. However, U.S. Cellular management anticipates that average monthly service revenue per customer will decrease slightly, as retail service revenue per minute of use and inbound roaming revenue per minute of use decline.
U.S. Cellular anticipates that its net costs associated with customer growth, service and retention, initiation of new services, launches in new markets and fixed asset additions will continue to grow. U.S. Cellular anticipates that its net customer retention costs will increase in the future as competitive pressures continue and as per unit handset costs increase. In addition, U.S. Cellular will continue to migrate its customer base to a single digital technology platform and certain customers will require new handsets, further increasing net customer retention costs in the future.
U.S. Cellular management believes there exists a seasonality in both service revenues, which tend to increase more slowly in the first and fourth quarters, and operating expenses, which tend to be higher in the fourth quarter due to increased marketing activities and customer growth, which may cause operating income to vary from quarter to quarter. U.S. Cellular management anticipates that the impact of such seasonality will decrease in the future, particularly as it relates to operating expenses, as the proportion of full year customer activations derived from fourth quarter holiday sales is expected to decline to reflect ongoing, rather than seasonal, promotions of U.S. Cellular’s products.
Effects of Competition on Operating Income
U.S. Cellular competes directly with several wireless communications services providers, including enhanced specialized mobile radio service providers, in each of its markets. In general, there are between five and seven competitors in each wireless market in which U.S. Cellular provides service. U.S. Cellular generally competes against each of the six near-nationwide wireless companies: Verizon Wireless, Sprint PCS (and affiliates), Cingular Wireless, AT&T Wireless, T-Mobile and Nextel. However, not all six competitors operate in all markets where U.S. Cellular does business. U.S. Cellular believes that these competitors have substantially greater financial, technical, marketing, sales, purchasing and distribution resources than it does. In addition, Cingular Wireless has agreed to acquire AT&T Wireless, which will increase this competitor’s financial, technical, marketing, sales, purchasing and distribution resources.
The use of national advertising and promotional programs by such national wireless operators may be a source of additional competitive and pricing pressures in all U.S. Cellular markets, even if those operators may not provide service in a particular market. U.S. Cellular provides wireless services comparable to the national competitors, but the other wireless companies operate in a wider geographic area and are able to offer no- or low-cost roaming and long-distance calling packages over a wider area on their own networks than U.S. Cellular can offer on its network. If U.S. Cellular offers the same calling area as one of these competitors, it will incur roaming charges for calls made in portions of the calling area that are not part of its network.
In the Midwest, U.S. Cellular’s largest contiguous service area, it can offer larger regional service packages without incurring significant roaming charges than it is able to offer in other parts of its network. U.S. Cellular also employs a customer satisfaction strategy throughout its markets which it believes has contributed to a relatively low customer churn rate.
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Some of U.S. Cellular’s competitors bundle other services, such as landline telephone service and internet access, with their wireless communications services, which U.S. Cellular either does not have the ability to offer or has chosen not to offer.
In addition, U.S. Cellular competes against both larger and smaller regional wireless companies in certain areas, including ALLTEL, Western Wireless and Rural Cellular Corporation, and against resellers of wireless services. Since each of these competitors operates on systems using spectrum licensed by the FCC and has comparable technology and facilities, competition for customers among these systems in each market is principally on the basis of quality of service, price, size of area covered, services offered and responsiveness of customer service.
Since U.S. Cellular’s competitors do not disclose their subscriber counts in specific regional service areas, market share for the competitors in each regional market cannot be accurately determined.
Effects of Wireless Number Portability on Operating Income
The FCC has adopted wireless number portability rules requiring wireless carriers to allow a customer to retain, subject to certain geographical limitations, their existing telephone number when switching from one telecommunications carrier to another. These rules became effective for all U.S. Cellular markets on or before May 24, 2004.
U.S. Cellular has been successful in facilitating number portability requests in a timely manner. The implementation of wireless number portability has not had a material effect on U.S. Cellular’ results of operations to date. However, U.S. Cellular is unable to predict the impact that the implementation of number portability will have in the future. The implementation of wireless number portability may increase churn rates for U.S. Cellular and other wireless companies, as the ability of customers to retain their wireless telephone numbers removes a significant barrier for customers who wish to change wireless carriers. However, to the extent U.S. Cellular loses customers, the effect may be offset to the extent it is able to obtain additional new customers who wish to change their service from other wireless carriers as a result of wireless number portability. The future volume of any porting requests, and the processing costs related thereto, may increase our operating costs in the future. Any of the above factors could have an adverse effect on U.S. Cellular’s competitive position, costs of obtaining new subscribers, liquidity, financial position and results of operations.
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TDS operates its wireline telephone operations through TDS Telecommunications Corporation (“TDS Telecom”), a wholly owned subsidiary. Total equivalent access lines served by TDS Telecom increased by 78,800 or 8%, since June 30, 2003 to 1,121,200. An equivalent access line is derived by converting a high-capacity data line to an estimated equivalent number, in terms of capacity, of switched access lines.
TDS Telecom’s incumbent local exchange carrier subsidiaries served 725,600 equivalent access lines at June 30, 2004, a 1% (6,800 equivalent access lines) increase from 718,800 equivalent access lines at June 30, 2003.
TDS Telecom’s competitive local exchange carrier subsidiaries served 395,600 equivalent access lines at June 30, 2004, a 22% (72,000 equivalent access lines) increase from 323,600 equivalent access lines served at June 30, 2003.
Operating income increased $10.4 million, or 13%, to $89.5 million in the six months ended June 30, 2004 from $79.1 million in 2003 reflecting improved operating results from competitive local exchange carrier operations due to one-time adjustments to certain competitive local exchange carrier revenue accruals that increased revenues and operating income by $2.5 million, savings from the early retirement program at the incumbent local exchange carriers and continued cost control throughout TDS Telecom.
TDS Telecom provided financial guidance for 2004 on February 4, 2004. The only change to this guidance is to reduce the upper and lower range of the estimate for competitive local exchange carrier operations revenue by $10 million to $20 million. Operating income guidance remains unchanged. For 2004, TDS Telecom expects modest revenue growth with revenues from the incumbent local exchange carrier operations in the range of $640 million to $650 million and revenues from the competitive local exchange carrier operations in the range of $230 million to $240 million. Operating income from the incumbent local exchange carrier is anticipated to range from $170 million to $180 million while competitive local exchange carrier operating losses are anticipated to range from $(30) million to $(20) million.
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Operating revenues increased $3.2 million, or 1%, to $322.6 million in the six months ended June 30, 2004 from $319.4 million in 2003.
Local service revenuesincreased $2.8 million, or 3%, to $101.6 million in 2004 from $98.8 million in 2003. Custom calling and advanced features and other miscellaneous revenues increased $1.9 million in 2004. Internal access line growth contributed approximately $0.9 million of the increase. Network access and long distance revenues decreased $0.4 million, or less than 1%, to $177.7 million in 2004 from $178.1 million in 2003. Compensation from state and national revenue pools for recovery of expenses of providing network access decreased $2.9 million as compared to 2003. Revenues from long distance service increased $1.8 million in 2004 reflecting increased long distance customers. As of June 30, 2004, TDS Telecom incumbent local exchange operations were providing long-distance service to 280,900 customers compared to 211,900 customers in 2003. Beginning January 1, 2004, the long distance customers reflect those lines from customers who have chosen TDS Telecom as their primary interexchange carrier. Prior to that, a count of customers was used.Miscellaneous revenues from Internet, digital subscriber line and other non-regulated lines of business increased $0.8 million, or 2%, to $43.3 million in 2004 from $42.5 million in 2003. As of June 30, 2004, TDS Telecom incumbent local exchange carrier operations were providing Internet service to 112,100 customers compared to 116,700 customers in 2003 and were providing digital subscriber line service to 31,500 customers compared to 16,200 customers 2003.
Operating expenses decreased by $5.7 million, or 2%, to $225.1 million in 2004 from $230.8 million in 2003, reflecting cost control measures. Cost of services and products decreased by $4.3 million, or 6%, to $73.7 million in 2004 from $78.0 million in 2003. The decrease was driven primarily by a one-time adjustment for long distance cost of goods sold recorded in the first quarter of 2004. In addition, network operation employee expenses decreased $1.2 million in 2004. Selling, general and administrative expenses decreased $0.6 million, or 1%, to $86.4 million from $87.0 million in 2003. Depreciation and amortization expenses decreased $0.7 million, or 1%, to $65.0 million in 2004 from $65.7 million in 2003.
Operating income increased $8.8 million, or 10%, to $97.5 million in 2004 from $88.7 million in 2003 primarily due to continued expense controls. Incumbent local exchange carriers are faced with significant challenges, including growing competition from wireless and other wireline providers, changes in regulation, and new technologies such as Voice Over Internet Protocol. Despite these challenges, TDS Telecom has successfully maintained customer levels and customer satisfaction while controlling expenses.
Operating revenues (revenue from the provision of local and long distance telephone service) increased $9.6 million, or 9%, to $114.5 million in 2004 from $104.9 million in 2003. Retail revenues increased $15.2 million, of which $12.7 million is due to customer growth, and $2.5 million is due to one-time adjustments to certain revenue accruals. In the second quarter of 2004, TDS Telecom undertook a comprehensive review of its competitive local exchange carrier accruals and, as a result, adjusted certain unbilled revenue accruals that on a net basis resulted in an increase in competitive local exchange carrier revenues of $2.5 million. Wholesale revenues, which represent charges to carriers, decreased $5.6 million in 2004 due primarily to access rate decreases.
Operating expensesincreased $8.1 million, or 7%, to $122.5 million in 2004 from $114.4 million in 2003. Cost of services and products increased $2.6 million, or 6%, to $43.6 million in 2004 from $41.0 million in 2003. Cost of services and products in 2003 included $2.3 million of one-time expense reductions relative to Regional Bell Operating Company payments for unsatisfactory service level performance. Selling, general and administrative expenses increased $2.9 million, or 5%, to $60.2 million in 2004 from $57.3 million in 2003 partially due to a $1.3 million increase in competitive local exchange carrier sales and marketing expenses associated with acquiring new customers.Depreciation and amortization expenses increased $2.6 million, or 16%, to $18.7 million in 2004 from $16.1 million in 2003 as a result of increases in fixed assets.
Operating loss decreased $1.5 million, or 16%, to $(8.0) million in 2004 from $(9.5) million in 2003. The amount of operating loss in 2004 was reduced by the $2.5 million one-time adjustments to certain revenue accruals, as discussed under Operating revenues. Excluding these one-time adjustments, the competitive local exchange carrier operating loss increased on a comparable basis due primarily to an increase in Depreciation and amortization expenses.
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Effects of Wireless Number Portability
The FCC has adopted wireless number portability rules requiring wireless carriers to allow a customer to retain, subject to certain geographical limitations, their existing telephone number when switching from one telecommunications carrier to another. Local exchange carriers in the largest 100 metropolitan statistical areas in the United States were required to be capable of facilitating wireless number portability as of November 24, 2003. On May 24, 2004, local exchange carriers outside such 100 areas were required to implement wireless number portability requirements on May 24, 2004 or within six months of the relevant request, whichever is later. However, local exchange carriers may seek waivers or extensions of these deadlines pursuant to the Communications Act and the FCC’s rules. TDS Telecom has established a schedule to implement local number portability. As of June 30, 2004, TDS Telecom has equipped 85% of its incumbent local exchange carrier physical access lines and will complete the remaining local number portability schedule by mid 2005. Through June 30, 2004, TDS Telecom has received 31 wireline to wireless port requests. TDS is unable to predict the impact that the implementation of wireless number portability will have on the business of TDS Telecom in the future.
Operating Revenues increased $77.2 million, or 9%, to $934.6 million during the second quarter of 2004 from $857.4 million in 2003 for reasons generally the same as the first six months.
U.S. Cellular revenues increased $66.3 million, or 10%, to $712.2 million in 2004 from $645.9 million in 2003. Retail service revenue increased $65.4 million, or 13%, to $576.5 million in 2004 from $511.1 million in 2003, while inbound roaming revenue decreased $12.3 million, or 22%, to $44.5 million in 2004 from $56.8 million in 2003. Average monthly service revenue per customer was $47.79 in the second quarter of 2004 and $47.38 in 2003. Average retail service revenue per customer increased to $41.58 from $39.69. The numerator of this calculation of average monthly revenues per customer for the three months ended June 2004 and 2003 consists of the revenue for the respective three month period divided by three. The denominator consists of the average number of customers. Average customers totaled 4,622,000 for the three months ended June 30, 2004 and 4,292,000 for the three months ended June 30, 2003. Equipment sales revenue increased $13.7 million, or 38%, to $49.5 million in 2004 from $35.8 million in 2003 primarily due to a 14% increase in gross customer activations as well as an increase in handsets sold to customers for retention purposes. In addition, the overall revenue per handset increased in the second quarter of 2004 as more customers purchased higher priced data-enabled handsets.
TDS Telecom revenues increased $10.9 million, or 5%, to $222.4 million in the second quarter of 2004 from $211.5 million in 2003 primarily due to a 14% growth in competitive local exchange carrier revenues and $2.5 million in one-time adjustments to certain competitive local exchange carrier revenue accruals. In the second quarter of 2004, TDS Telecom undertook a comprehensive review of its competitive local exchange carrier accruals and, as a result, adjusted certain unbilled revenue accruals that on a net basis resulted in an increase in competitive local exchange carrier revenues of $2.5 million. Competitive local exchange carrier access line equivalents increased 22% since June 30, 2003, while digital subscriber line customers increased 77%. Incumbent local exchange carrier revenues grew 2% in the second quarter of 2004 reflecting increases in additional services. Incumbent local exchange carrier digital subscriber line customers increased 94% since June 30, 2003. TDS Telecom continues to penetrate its wireline markets with successful promotion and sales of additional lines of business.
Operating Expenses increased $9.2 million, or 1%, to $824.1 million during the second quarter of 2004 from $814.9 million in 2003 for reasons generally the same as the first six months.
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U.S. Cellular expenses increased $3.9 million, or 1%, to $646.4 million in 2004 from $642.5 million in 2003. Cost of equipment sold increased $30.6 million, or 38%, to $110.2 million in 2004 from $79.6 million in 2003. The increase was due to the 14% increase in gross customer activations in 2004 as well as an increase in handsets sold to customers for retention purposes. In addition, the overall cost per handset increased in the second quarter of 2004 as more customers purchased higher priced data enabled handsets. Selling, general and administrative expenses increased $11.5 million, or 4%, to $269.6 million in 2004 from $258.1 million in 2003. Sales and marketing cost per gross customer addition increased to $392 in the second quarter of 2004 from $378 in 2003, primarily due to increased handset subsidies. Below is a summary of sales and marketing cost per gross customer activation for each period.
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Monthly general and administrative expenses per customer, including the net costs related to the renewal or upgrade of service contracts of existing U.S. Cellular customers (“net customer retention costs”), decreased 4% to $13.50 in 2004 from $14.09 in 2003. This measurement is reconciled to total selling, general and administrative expenses as follows:
Depreciation expense increased $22.8 million, or 26%, to $110.3 million in 2004 from $87.5 million in 2003 for reasons generally the same as for the first six months of 2004. In the second quarter of 2004, certain U.S. Cellular TDMA digital radio equipment consigned to a third party for future sale was written down by $6.3 million prior to its consignment, increasing depreciation expense by that amount. This writedown was necessary to reduce the book value of the assets to be sold to their estimated proceeds from disposition.
Amortization and accretion expense decreased $5.3 million, or 31%, to $11.9 million in 2004 from $17.2 million in 2003.
In 2004, U.S. Cellular’s operating expenses included a $582,000 reduction of Loss on assets held for sale previously recorded on the sale of wireless properties in southern Texas to AT&T Wireless in February 2004. In 2003, operating expenses included $3.5 million of additional Loss on assets held for sale related to the exchange of wireless properties in Georgia and Florida with AT&T Wireless in August 2003. As discussed previously, U.S. Cellular restated 2003 and 2002 financial statements related to the implementation of Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets.” In connection with this restatement, U.S. Cellular reperformed the annual impairment test for its investment in licenses for 2003, which was originally performed during the second quarter of 2003. This resulted in the recognition of an additional impairment loss of $49.6 million, before an income tax benefit of $19.6 million.
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TDS Telecom expenses increased $5.4 million, or 3%, to $177.8 million in 2004 from $172.4 million in 2003. Expenses from competitive local exchange carrier operations increased $7.4 million in 2004. As stated previously, expenses reflect the increase in the customer base. Incumbent local exchange carrier operation expenses decreased $1.9 million.
Operating Income increased $68.0 million to $110.5 million in the three months ending June 30, 2004 from $42.5 million in 2003. U.S. Cellular’s operating income increased $62.5 million while TDS Telecom’s operating income increased $5.5 million. The increase in U.S. Cellular’s operating income is primarily due to the $49.6 million Loss on impairment of intangible assets recorded in 2003 as discussed previously. The increase at TDS Telecom primarily reflects reduced expenses of the incumbent local exchange carriers and one-time adjustments to certain competitive local exchange carrier revenue accruals which increased operating revenue and operating income by $2.5 million.
Investment and Other Income (Expense) totaled $(28.6) million in 2004 and $(42.7) million in 2003.
Investment income increased $5.0 million, or 37%, to $18.5 million in 2004 from $13.5 million in 2003. Investment income represents TDS’s share of income in unconsolidated entities in which TDS has a minority interest and follows the equity method of accounting. The aggregate net income of these entities increased significantly in 2004, resulting in a corresponding increase in investment income.
Loss on investments totaled $1.8 million in 2004 reflecting an impairment in the carrying value of a U.S. Cellular investment in a non-operational market in Florida. In 2003, a $5.0 million impairment loss was recorded on a wireless investment held by TDS Telecom.
Interest (expense) increased $4.4 million, or 10%, to $48.4 million in 2004 from $44.0 million in 2003 for reasons generally the same as for the first six months.
Minority Interest in Income of Subsidiary Trust decreased $6.2 million in 2004. In September 2003, TDS redeemed all $300 million of Company-Obligated Mandatorily Redeemable Preferred Securities at par plus accrued and unpaid distributions. There was no gain or loss on this transaction.
Income Tax Expense increased $27.3 million to $31.3 million in 2004 from $4.0 million in 2003. The effective tax (benefit) rate excluding Loss on impairment, (Gain) loss on assets held for sale and Loss on investments was 38.3% in 2004 and 43.0% in 2003. For an analysis of TDS’s effective tax rates in the second quarter of 2004 and 2003, see Note 4 — Income Taxes.
Minority Share of (Income) Losstotaled $(9.2) million in 2004 compared to $(0.9) million in the second quarter of 2003. U.S. Cellular’s minority public shareholders’ share of income in 2003 was reduced by $5.8 million due to U.S. Cellular’s Loss on impairment of intangible assets and (Gain) loss on assets held for sale.
Net Income (Loss) Available to Common totaled $41.3 million, or $0.72 per diluted share, in 2004, compared to $(5.3) million, or $(0.09) per diluted share, in 2003.
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Mandatorily Redeemable Noncontrolling Interests
Under SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity,” certain minority interests in consolidated entities with finite lives may meet the standard’s definition of a mandatorily redeemable financial instrument and thus require reclassification as liabilities and remeasurement at the estimated amount of cash that would be due and payable to settle such minority interests under the applicable entity’s organization agreement assuming an orderly liquidation of the finite-lived entity, net of estimated liquidation costs (the “settlement value”). TDS’s consolidated financial statements include such minority interests that meet the standard’s definition of mandatorily redeemable financial instruments. These mandatorily redeemable minority interests represent interests held by third parties in consolidated partnerships and limited liability companies (“LLCs”), where the terms of the underlying partnership or LLC agreement provide for a defined termination date at which time the assets of the subsidiary are to be sold, the liabilities are to be extinguished and the remaining net proceeds are to be distributed to the minority interest holders and TDS in accordance with the respective partnership and LLC agreements. The termination dates of TDS’s mandatorily redeemable minority interests range from 2042 to 2100.
On November 7, 2003, the FASB issued FASB Staff Position (“FSP”) No. FAS 150-3, “Effective Date, Disclosures, and Transition for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests under FASB Statement No. 150.” The FSP indefinitely deferred the classification and measurement provisions of SFAS No. 150 related to the mandatorily redeemable minority interests associated with finite-lived subsidiaries, but retained the related disclosure provisions. The settlement value of TDS’s mandatorily redeemable minority interests is estimated to be $91.6 million at June 30, 2004. This represents the estimated amount of cash that would be due and payable to settle minority interests assuming an orderly liquidation of the finite-lived consolidated partnerships and LLCs on June 30, 2004, net of estimated liquidation costs. This amount is being disclosed pursuant to the requirements of FSP FAS 150-3; TDS has no current plans or intentions to liquidate any of the related partnerships or LLCs prior to their scheduled termination dates. The corresponding carrying value of the minority interests in finite-lived consolidated partnerships and LLCs at June 30, 2004 is $27.3 million, and is included in the balance sheet caption Minority interest in subsidiaries. The excess of the aggregate settlement value over the aggregate carrying value of the mandatorily redeemable minority interests of $64.3 million is primarily due to the unrecognized appreciation of the minority interest holders’ share of the underlying net assets in the consolidated partnerships and LLCs. Neither the minority interest holders’ share, nor TDS’s share, of the appreciation of the underlying net assets of these subsidiaries is reflected in the consolidated financial statements. The estimate of settlement value was based on certain factors and assumptions. Changes in those factors and assumptions could result in a materially larger or smaller settlement amount.
The FASB plans to reconsider certain implementation issues and perhaps the classification or measurement guidance for mandatorily redeemable minority interests during the deferral period. The outcome of their deliberations cannot be determined at this point. Accordingly, it is possible that the FASB could require the recognition and measurement of mandatorily redeemable minority interests at their settlement value at a later date.
Health Care Benefits
On December 8, 2003, the Medicare Prescription Drug, Improvement and Modernization Act of 2003 was enacted. The Act expands Medicare, primarily by adding a prescription drug benefit for Medicare-eligible participants starting in 2006. The Act provides employers currently sponsoring prescription drug programs for Medicare-eligible participants with a range of options for coordinating with the new government-sponsored program to potentially reduce program cost. These options include supplementing the government program on a secondary payor basis or accepting a direct subsidy from the government to support a portion of the cost of the employer’s program.
Pursuant to guidance from the FASB under FSP FAS 106-1, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003,” TDS has chosen to defer recognition of the potential effects of the Act. Therefore, the retiree health obligations and costs reported in these financial statements do not yet reflect any potential impact of the Act. The FASB published guidance on the accounting for the government subsidy in FSP 106-2, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003,” that is effective beginning July 1, 2004. The implementation of this guidance could require TDS to change previously reported information.
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In the months ahead, TDS intends to review its retiree health care strategy in light of the Act. As part of that review, TDS may consider amending its retiree health program to coordinate with the new Medicare prescription drug program or to receive the direct subsidy from the government. As a result, TDS anticipates that its retiree health obligations and costs could be reduced if such amendments are adopted.
Earnings per Share
In March 2004, the Emerging Issues Task Force (“EITF”) reached a consensus on EITF Issue No. 03-6, “Participating Securities and the Two-Class Method under FASB Statement No. 128, Earnings per Share.” EITF 03-6 clarifies what constitutes a participating security and provides further guidance in applying the two-class method of calculating earnings per share. The consensuses reached by the Task Force on EITF Issue No. 03-6 were ratified by the FASB on March 31, 2004, and are effective for reporting periods beginning after March 31, 2004. TDS has reviewed this Issue and concluded that it has no participating securities as defined by EITF Issue No. 03-6.
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The following table provides a summary of TDS’s cash flow activities in the six months ended June 30, 2004 and 2003:
Cash Flows from Operating ActivitiesTDS generates substantial internal funds from the operations of U.S. Cellular and TDS Telecom. Cash flows from operating activities totaled $325.5 million in the six months ended June 30, 2004 compared to $321.0 million in 2003.
The following table is a summary of the components of cash flows from operating activities:
Changes in working capital and other assets and liabilities required $100.6 million in 2004 and $54.6 million in 2003 reflecting timing differences in the payment of accounts payable, the receipt of accounts receivable, the change in accrued taxes and materials and supplies balances.
Cash Flows from Investing ActivitiesTDS makes substantial investments each year to acquire, construct, operate and upgrade modern high-quality communications networks and facilities as a basis for creating long-term value for shareowners. In recent years, rapid changes in technology and new opportunities have required substantial investments in revenue enhancing and cost reducing upgrades to TDS’s networks. Cash flows used for investing activities required $266.2 million in the first six months of 2004 compared to $345.9 million 2003.
Cash expenditures for capital additions required $325.1 million in the six months ended June 30, 2004 and $360.9 million in 2003. The primary purpose of TDS’s construction and expansion expenditures is to provide for significant customer growth, to upgrade service, and to take advantage of service-enhancing and cost-reducing technological developments in order to maintain competitive services. U.S. Cellular’s capital additions totaled $263.1 million in 2004 and $304.0 million in 2003 representing expenditures to construct cell sites, to replace retired assets, to improve business systems and to migrate to a single digital equipment platform — CDMA. TDS Telecom capital expenditures for its local telephone operations totaled $44.6 million in 2004 and $44.7 million in 2003 representing expenditures for switch modernization and outside plant facilities to maintain and enhance the quality of service and offer new revenue opportunities. TDS Telecom’s capital expenditures for competitive local exchange operations totaled $15.1 million in 2004 and $9.2 million in 2003 for switching and other network facilities. Corporate capital expenditures totaled $2.3 million in 2004 and $3.0 million in 2003.
The sale of wireless properties in southern Texas to AT&T Wireless provided $96.9 million in 2004 including working capital adjustments. Acquisitions of certain minority wireless interests in 2004 required $40.4 million. Distributions from unconsolidated investments provided $7.5 million in 2004 and $17.9 million in 2003.
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Cash Flows from Financing ActivitiesCash flows from financing activities provided $384.5 million in the six months ended June 30, and $15.6 million in 2003. Short term debt borrowings, net of repayments, provided $143.6 million in 2003. Issuances of long-term debt by U.S. Cellular provided $412.5 million in 2004. In 2003, U.S. Cellular repurchased and cancelled the remaining $45.2 million of 9% Series A Notes from PrimeCo for $40.7 million. The repurchase was financed using short-term debt. Cash received from short term borrowings on revolving lines of credit provided $270.0 million in 2004. Repayments of short term borrowings required $270.0 million, primarily paid with cash received from the U.S. Cellular long-term debt issuances. Cash received from long-term debt issuances was temporarily used to reduce short-term debt pending the redemption of long-term debt. See Liquidity and Capital Resources – Long-term Financing below. Treasury shares reissued for stock options exercised in 2004 provided $20.3 million and $2.5 million in 2003. Dividends paid on TDS Common and Preferred Shares, required $19.0 million in 2004 and $18.2 million in 2003.
During the six months ended June 30, 2004, cash required for the repurchase of TDS Common Shares totaled $14.9 million including commissions. An additional $5.6 million was paid in January 2004 to settle repurchases that occurred at the end of December 2003. In total, TDS repurchased 214,800 Common Shares for an average price of $69.16 per share including commissions.
During the six months ended June 30, 2003, cash required for the repurchase of TDS Common Shares totaled $56.5 million. In total, TDS repurchased 1,378,900 Common Shares for an average price of $40.99 per share including commissions.
Management believes that internal cash flow, existing cash and cash equivalents, and funds available from line of credit arrangements provide sufficient financial resources to finance its near-term capital, business development and expansion expenditures. TDS and its subsidiaries may have access to public and private capital markets to help meet their long-term financing needs. TDS and its subsidiaries anticipate accessing public and private capital markets to issue debt and equity securities when and if capital requirements, financial market conditions and other factors warrant.
However, the availability of financial resources is dependent on economic events, business developments, technological changes, financial conditions or other factors, many of which are not in TDS’s control. If at any time financing is not available on terms acceptable to TDS, TDS might be required to reduce its business development and capital expenditure plans, which could have a materially adverse effect on its business and financial condition. TDS does not believe that any circumstances that could materially adversely affect TDS’s liquidity or capital resources are currently reasonably likely to occur, but it cannot provide assurances that such circumstances will not occur or that they will not occur rapidly. Economic downturns, changes in financial markets or other factors could rapidly change the availability of TDS’s liquidity and capital resources. Uncertainty of access to capital for telecommunications companies, deterioration in the capital markets, other changes in market conditions or other factors could limit or restrict the availability of financing on terms and prices acceptable to TDS, which could require TDS to reduce its construction, development, acquisition and share repurchase programs.
TDS is generating substantial internal funds from the operations of U.S. Cellular and TDS Telecom. Cash flows from operating activities totaled $325.5 million in the first six months of 2004 compared to $321.0 million in 2003. TDS and its subsidiaries had cash and cash equivalents totaling $1,381.4 million at June 30, 2004.
TDS and its subsidiaries had $1,296.6 million of revolving credit facilities available for general corporate purposes as well as an additional $75 million in bank lines of credit as of June 30, 2004.
TDS has a $600 million revolving credit facility for general corporate purposes. At June 30, 2004, this credit facility had $596.8 million available for use, net of $3.2 million of outstanding letters of credit. This credit facility expires in January 2007. Borrowings bear interest at the London InterBank Offered Rate (“LIBOR”) plus a contractual spread based on TDS’s credit rating. The contractual spread was 30 basis points as of June 30, 2004 (for a rate of 1.67% based on the one month LIBOR rate at June 30, 2004).
TDS also has $75 million of additional bank lines of credit for general corporate purposes, all of which was unused at June 30, 2004. These line of credit agreements expire in less than one year and provide for borrowings at negotiated rates up to the prime rate (4.0% at June 30, 2004 and subsequently increased to 4.25% as of July 1, 2004).
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U.S. Cellular has a $700 million revolving credit facility for general corporate purposes. At June 30, 2004, this credit facility had $699.8 million available for use, net of outstanding letters of credit of $0.2 million. This credit facility expires in June 2007. Borrowings bear interest at the LIBOR rate plus a margin percentage, based on U.S. Cellular’s credit rating, which was 55 basis points as of June 30, 2004 (for a rate of 1.92% based on the one month LIBOR rate at June 30, 2004).
TDS’s and U.S. Cellular’s interest costs would increase if their credit rating goes down which would increase their cost of financing, but their credit facilities would not cease to be available solely as a result of a decline in their credit rating. A downgrade in TDS’s or U.S. Cellular’s credit ratings could adversely affect their ability to renew existing, or obtain access to new, credit facilities in the future. Certain of TDS’s and U.S. Cellular’s credit facilities would accelerate in the event of a change in control.
The continued availability of the revolving credit facilities requires TDS and U.S. Cellular to comply with certain negative and affirmative covenants, maintain certain financial ratios and provide representation on certain matters at the time of each borrowing. On May 14, 2004, TDS filed a Form 10-K/A to restate its financial statements for the years ended December 31, 2003 and 2002 and for the interim periods for such years. The restatements resulted in defaults under a revolving credit agreement between TDS and certain lenders and under a revolving credit agreement between U.S. Cellular and certain lenders. TDS and U.S. Cellular did not fail to make any scheduled payment of principal or interest under such revolving credit agreements. TDS and U.S. Cellular received waivers from the lenders under which the lenders agreed to waive any defaults that may have occurred as a result of the restatements. As of the date of filing of this Form 10-Q, TDS and U.S. Cellular are in compliance with all covenants and other requirements set forth in revolving credit agreements.
As of the date of filing of this Form 10-Q, TDS and subsidiaries are in compliance with all covenants and other requirements set forth in long-term debt indentures. TDS does not have any rating downgrade triggers that would accelerate the maturity dates of its long-term debt. However, a downgrade in TDS’s credit rating could adversely affect its ability to refinance existing, or obtain access to new, long-term debt in the future.
On May 25, 2004, U.S. Cellular filed with the SEC a shelf registration statement on Form S-3 to register the issuance from time to time of up to $500 million of senior debt securities. This registration statement became effective on June 2, 2004.
As of June 17, 2004, U.S. Cellular issued $330 million in aggregate principal amount of unsecured 7.5% senior notes due June 15, 2034 under this registration statement. The net proceeds from this offering, after deducting underwriting discounts, were approximately $319.6 million.
Also, on June 28, 2004, U.S. Cellular issued $100 million in aggregate principal amount of unsecured 6.7% senior notes due December 15, 2033 priced to yield 7.21% to maturity under this registration statement. The net proceeds from this offering, after deducting underwriting discounts, were approximately $92.9 million. This is a further issuance of U.S. Cellular’s 6.7% notes that were issued on December 8, 2003 in the aggregate principal amount of $444 million.
On June 24, 2004, U.S. Cellular issued redemption notices to holders of U.S. Cellular’s Liquid Yield Option Notes and on June 28, 2004 issued redemption notices to holders of U.S. Cellular’s 7.25% senior notes. Consequently, $162.4 million of Liquid Yield Option Notes and $250 million of 7.25% senior notes were reclassified to Current portion of long-term debt on the Balance Sheet.
The total net proceeds from the 7.5% and 6.7% senior note offerings, after deducting underwriting discounts, were approximately $412.5 million. Of this amount, $163.3 million was used to redeem U.S. Cellular’s Liquid Yield Option Notes on July 26, 2004 at accreted value. The balance of the net proceeds, together with borrowings under the revolving credit agreement, is expected to be used to redeem all of U.S. Cellular’s 7.25% senior notes as of August 16, 2004. No gain or loss is expected to be recognized as a result of such redemptions. However, U.S. Cellular expects to charge $3.6 million of deferred debt expenses to the Statement of Operations related to the redemption of long-term debt.
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TDS and its subsidiaries hold a substantial amount of marketable equity securities that are publicly traded and can have volatile share prices. TDS and its subsidiaries do not make direct investments in publicly traded companies and all of these interests were acquired as a result of sales, trades or reorganizations of other assets. The investment in Deutsche Telekom AG (“Deutsche Telekom”) resulted from TDS’s disposition of its over 80%-owned personal communications services operating subsidiary, Aerial Communications, Inc., to VoiceStream Wireless Corporation (“VoiceStream”) in exchange for stock of VoiceStream, which was then acquired by Deutsche Telekom in exchange for Deutsche Telekom stock. The investment in Vodafone Group Plc (“Vodafone”) resulted from certain dispositions of non-strategic cellular investments to or settlements with AirTouch Communications, Inc. (“AirTouch”) in exchange for stock of AirTouch, which was then acquired by Vodafone whereby TDS and its subsidiaries received American Depository Receipts representing Vodafone stock. The investment in Rural Cellular Corporation (“Rural Cellular”) is the result of a consolidation of several cellular partnerships in which TDS subsidiaries held interests into Rural Cellular, and the distribution of Rural Cellular stock in exchange for these interests. The investment in VeriSign, Inc. (“VeriSign”) is the result of the acquisition by VeriSign of Illuminet, Inc., a telecommunications entity in which several TDS subsidiaries held interests. A contributing factor in TDS’s decision not to dispose of the investments is that their tax basis is significantly lower when compared to current stock prices, and therefore would trigger a substantial taxable gain upon disposition.
Subsidiaries of TDS and U.S. Cellular have entered into a number of variable prepaid forward contracts (“forward contracts”) with counterparties related to the marketable equity securities that they hold. The forward contracts mature from May 2007 to August 2008 and, at TDS’s and U.S. Cellular’s option, may be settled in shares of the respective securities or cash. TDS and U.S. Cellular have provided guarantees to the counterparties which provide assurance that all principal and interest amounts will be paid upon settlement of the contracts by their subsidiaries. If shares are delivered in the settlement of the forward contract, TDS and U.S. Cellular would incur a current tax liability at the time of delivery based on the difference between the tax basis of the marketable equity securities delivered and the net amount realized through maturity. Deferred taxes have been provided for the difference between the book basis and the tax basis of the marketable equity securities and are included in deferred tax liabilities on the balance sheet. As of June 30, 2004, such deferred tax liabilities totaled $989.2 million.
TDS and U.S. Cellular are required to comply with certain covenants under the forward contracts. On May 14, 2004, TDS filed a Form 10-K/A to restate its financial statements for the years ended December 31, 2003 and 2002 and for the interim periods for such years. The restatements resulted in defaults under certain of the forward contracts with one counterparty. TDS and U.S. Cellular did not fail to make any scheduled payments under any of the forward contracts. TDS and U.S. Cellular received waivers from the counterparty to such forward contracts, as required, under which the counterparty agreed to waive any defaults that may have occurred as a result of the restatements.
As of the date of filing of this Form 10-Q, TDS and U.S. Cellular are in compliance with all covenants and other requirements set forth in the forward contracts.
U.S. Cellular’s anticipated capital expenditures for 2004 primarily reflect U.S. Cellular’s plans for construction, system expansion, the buildout of certain of its licensed areas and additional expenditures related to its plans to migrate to a single digital equipment platform. U.S. Cellular plans to finance its construction program using internally generated cash and short-term and long-term financing. U.S. Cellular’s estimated capital spending for 2004 is $655 million to $695 million. U.S. Cellular’s capital expenditures for the six months ended June 30, 2004 totaled $263.1 million.
U.S. Cellular’s 2004 capital expenditures will primarily address the following needs:
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U.S. Cellular’s overlay of existing technologies with CDMA is largely completed, and when the project is fully completed in 2004 it anticipates total expenditures related to the project to be no more than $300 million. U.S. Cellular will utilize CDMA technology in building out the licenses it has acquired and expects to acquire in the future from AT&T Wireless.
U.S. Cellular expects capital expenditures related to the buildout of the licensed areas it acquired in 2001 through 2003, including those in the AT&T Wireless exchange transaction, to be substantial. U.S. Cellular plans to build networks to serve these licensed areas and launch commercial service in these areas over the next several years. Approximately $100 million of the estimated capital spending for 2004 is allocated to the buildout of certain of these licenses, and U.S. Cellular expects a significant portion of its capital spending over the next few years to be related to the buildout of its wireless licensed areas.
TDS Telecom’s estimated capital spending for 2004 approximates $150 million. The incumbent local telephone companies are expected to spend approximately $105 million to provide for normal growth and to upgrade plant and equipment to provide enhanced services. The competitive local exchange companies are expected to spend approximately $45 million to build switching and other network facilities to meet the needs of a growing customer base. TDS Telecom’s incumbent local exchange carriers capital expenditures totaled $44.6 million and the competitive local exchange carriers capital expenditures totaled $15.1 million for the six months ended June 30, 2004. TDS Telecom plans to finance its construction program using primarily internally generated cash.
In July 2004, TDS Telecom was granted a franchise to provide cable television services to the residents of the Town of Farragut, Tennessee. Under the terms of the franchise agreement, TDS has 36 months to complete the buildout of the system and to begin providing service to customers. As a pilot project, TDS expects to begin providing service to some residents of Farragut during the summer of 2005. The capital spending guidance provided above does not include the impact of this buildout. TDS Telecom is currently developing the detailed plans and related required capital for this project.
TDS assesses its holdings on an ongoing basis in order to maximize the benefits derived from its operations. TDS reviews attractive opportunities to acquire additional telecommunications companies and wireless spectrum, which add value to the business.
2004 Activity
On February 18, 2004, U.S. Cellular completed the sale of certain of its wireless properties in southern Texas to AT&T Wireless for $96.9 million in cash, including a working capital adjustment. The U.S. Cellular markets sold to AT&T Wireless included wireless assets and customers in six 25 megahertz cellular markets. An aggregate loss of $21.3 million (including a $22.0 million estimate of the Loss on assets held for sale in the fourth quarter of 2003 and a $725,000 reduction of the loss in the six months ended June 30, 2004) was recorded as a Loss on assets held for sale (included in operating expenses), representing the difference between the carrying value of the markets sold to AT&T Wireless and the cash received in the transaction.
In addition, in 2004 U.S. Cellular purchased certain minority interests in several wireless markets in which it already owned a controlling interest for $40.4 million in cash. These acquisitions increased investment in licenses, goodwill and customer lists by $2.7 million, $3.6 million and $12.9 million, respectively.
Subsequent Event
On August 4, 2004, TDS announced that U.S. Cellular and TDS Telecom had entered into definitive agreements with ALLTEL Coommunications, Inc. ("ALLTEL") to sell certain wireless properties. TDS subsidiaries will sell three consolidated properties and six minority interests to ALLTEL for $143 million in cash, including repayment of debt and working capital that is subject to adjustment at closing. The transactions are subject to regulatory approvals. The closing of the transactions is expected to occur in the fourth quarter of 2004.
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The following table summarizes the recorded value of the assets and liabilities of the properties that TDS subsidiaries will be transferring:
TDS expects to record a gain related to these transactions for the excess of the cash received over the book value of the net assets given up, subject to a working capital adjustment. As a result of signing the definitive agreements for these transactions, TDS will reclassify the net assets of the properties to be transferred as assets held for sale in the third quarter of 2004.
2003 Activity
On August 1, 2003, U.S. Cellular completed the transfer of wireless assets and customers in ten 25 megahertz markets in Florida and Georgia to AT&T Wireless pursuant to an agreement entered into in March 2003. In return, U.S. Cellular received the following: a) rights to acquire controlling interests in 36 personal communication service licenses contiguous to and that overlap existing U.S. Cellular properties in 13 states in the Midwest and the Northeast; b) approximately $34 million in cash; and c) minority interests in six markets in which it previously owned a controlling interest. In accordance with the agreement, U.S. Cellular has deferred the assignment and development of 21 licenses for a period of up to five years from the closing date. U.S. Cellular will take possession of the licenses in staggered closings over that five-year period to comply with service requirements of the Federal Communications Commission (“FCC”). The value of these licenses is recorded as Wireless license rights on the Balance Sheet.
The acquisition of the licenses in the exchange was accounted for as a purchase by U.S. Cellular and the transfer of the properties by U.S. Cellular to AT&T Wireless was accounted for as a sale. An estimated loss of $25.1 million was recorded in the six months ended June 30, 2003 as a Loss on assets held for sale (included in operating expenses), representing the difference between the carrying value of the markets transferred to AT&T Wireless and the fair value of the consideration received or to be received in the transaction.
As market conditions warrant, TDS and U.S. Cellular may repurchase their common shares on the open market or at negotiated prices in private transactions. In 2003, the TDS Board of Directors authorized the repurchase of up to 3.0 million TDS Common Shares through February 2006. In the first six months of 2004 TDS repurchased 214,800 TDS Common Shares for $14.9 million including commissions. TDS has 824,300 common shares remaining available for repurchase under the authorization. Share repurchases may be made from time to time on the open market or private transactions, at prices approximating then existing market prices.
U.S. Cellular has no current plans to repurchase a significant number of its Common Shares, and it did not repurchase any Common Shares in the first six months of 2004 or 2003. U.S. Cellular’s primary repurchase program expired in December 2003. However, U.S. Cellular has an ongoing authorization to repurchase a limited amount of additional Common Shares on a quarterly basis, primarily for use in employee benefit plans.
TDS paid total dividends on its common and preferred stock of $19.0 million in the first six months of 2004 and $18.2 million in 2003. TDS has no current plans to change its policy of paying dividends. TDS paid quarterly dividends per share of $.165 in 2004 and $.155 in 2003.
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Except as described below, there has been no material change in the resources required for scheduled repayment of contractual obligations from the table of Contractual Obligations included in Management’s Discussion and Analysis of Results of Operations and Financial Condition included in TDS’s Annual Report on Form 10-K for the year ended December 31, 2003, as amended.
Subsequent to December 31, 2003, U.S. Cellular issued $330 million in aggregate principal amount of unsecured 7.5% senior notes due 2034 and an additional $100 million of its unsecured 6.7% senior notes due 2033 in June 2004. The total net proceeds from these offerings, after deducting underwriting discounts, were approximately $412.5 million. Of this amount, approximately $163.3 million was used to redeem U.S. Cellular’s Liquid Yield Option Notes on July 26, 2004. The balance of the net proceeds, together with borrowings under the revolving credit agreement, is expected to be used to redeem all of U.S. Cellular’s 7.25% senior notes as of August 16, 2004.
The following table shows the increases and decreases in contractual obligations, as presented in the Annual Report on Form 10-K for the year ended December 31, 2003, as amended, as a result of the debt transactions described above:
TDS has no transactions, agreements or contractual arrangements with unconsolidated entities involving “off-balance sheet arrangements,” as defined by SEC rules, that have or are reasonably likely to have a material current or future effect on financial condition, changes in financial condition, results of operations, liquidity, capital expenditures, capital resources, revenues or expenses.
TDS has certain variable interests in investments in unconsolidated entities where TDS holds a minority interest. The investments in unconsolidated entities totaled $234.2 million as of June 30, 2004 and are accounted for using either the equity or cost method. TDS’s maximum loss exposure for these variable interests is limited to the aggregate carrying amount of the investments.
TDS enters into agreements in the normal course of business that provide for indemnification of counterparties. These include certain asset sales and financings with other parties. The term of the indemnification varies by agreement. The events or circumstances that would require TDS to perform under these indemnities are transaction specific; however these agreements may require TDS to indemnify the counterparty for costs and losses incurred from litigation or claims arising from the underlying transaction. TDS is unable to estimate the maximum potential liability for these types of indemnifications as the amounts are dependent on the outcome of future events, the nature and likelihood of which cannot be determined at this time. Historically, TDS has not made any significant indemnification payments under such agreements.
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TDS prepares its consolidated financial statement in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”). TDS’s significant accounting policies are discussed in detail in Note 1 to the consolidated financial statements included in its Annual Report on Form 10-K for the year ended December 31, 2003, as amended.
The preparation of financial statements in accordance with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Management bases its estimates on historical experience and on various other assumptions and information that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from estimates under different assumptions or conditions.
Management believes the following critical accounting estimates reflect its more significant judgments and estimates used in the preparation of its consolidated financial statements. TDS’s senior management has discussed the development and selection of each of the following accounting estimates and the following disclosures with the audit committee of TDS’s board of directors.
TDS reported $1,192.8 million and $1,189.3 million of wireless license costs and $890.9 million and $887.9 million of goodwill, at June 30, 2004 and December 31, 2003, respectively, as a result of the acquisitions of wireless licenses and markets, and the acquisition of operating telephone companies. In addition, at the end of both periods, TDS reported $42.0 million of Wireless license rights related to the licenses that will be received when the AT&T Wireless exchange transaction is fully completed.
Wireless licenses and goodwill must be reviewed for impairment annually, or more frequently if events or changes in circumstances indicate that the asset might be impaired. TDS performs the annual impairment review on wireless licenses cost and goodwill during the second quarter. There can be no assurance that upon review at a later date material impairment charges will not be required.
The intangible asset impairment test consists of comparing the fair value of the intangible asset to the carrying amount of the intangible asset. If the carrying amount exceeds the fair value, an impairment loss is recognized for the difference. The goodwill impairment test is a two-step process. The first step compares the fair value of the reporting unit, as identified in accordance with SFAS No. 142, to its carrying value. If the carrying amount exceeds the fair value, the second step of the test is performed to measure the amount of impairment loss, if any. The second step compares the implied fair value of reporting unit goodwill with the carrying amount of that goodwill. To calculate the implied fair value of goodwill, an enterprise allocates the fair value of the reporting unit to all of the assets and liabilities of that reporting unit (including any unrecognized intangible assets) as if the reporting unit had been acquired in a business combination and the fair value was the price paid to acquire the reporting unit. The excess of the fair value of the reporting unit over the amounts assigned to the assets and liabilities of the reporting unit is the implied fair value of goodwill. If the carrying amount exceeds the implied fair value, an impairment loss is recognized for that difference.
The fair value of an intangible asset and reporting unit goodwill is the amount at which that asset or reporting unit could be bought or sold in a current transaction between willing parties. Therefore, quoted market prices in active markets are the best evidence of fair value and should be used when available. If quoted market prices are not available, the estimate of fair value is based on the best information available, including prices for similar assets and the use of other valuation techniques. Other valuation techniques include present value analysis, multiples of earnings or revenue or a similar performance measure. The use of these techniques involve assumptions by management about factors that are highly uncertain including future cash flows, the appropriate discount rate, and other inputs. Different assumptions for these inputs or different valuation methodologies could create materially different results.
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U.S. Cellular tests goodwill for impairment at the level of reporting referred to as a reporting unit. Following the divestiture of its southern Texas markets, which in the aggregate represented an entire reporting unit, in February 2004, U.S. Cellular has identified six reporting units pursuant to paragraph 30 of SFAS No. 142. The six reporting units represent six geographic groupings of FCC licenses, constituting six geographic service areas. U.S. Cellular combines its FCC licenses into six units of accounting for purposes of testing the licenses for impairment pursuant to Emerging Issues Task Force Statement 02-7 “Unit of Accounting for Testing Impairment of Indefinite-Lived Intangible Assets” (“EITF 02-7”) and SFAS No. 142, using the same geographic groupings as its reporting units.
In 2004 and 2003, U.S. Cellular retained a third-party valuation firm to prepare valuations of each of the reporting units for purposes of goodwill impairment testing. A discounted cash flow approach was used to value each of the reporting units, using value drivers and risks specific to each individual geographic region. The cash flow estimates incorporate assumptions that market participants would use in their estimates of fair value. Key assumptions made in this process were the selection of a discount rate, estimated future cash flow levels, projected capital expenditures, and selection of terminal values.
U.S. Cellular also retained a third-party valuation firm to prepare valuations of the similar groupings of FCC licenses (units of accounting pursuant to EITF 02-7). The valuations were prepared using an excess earnings methodology, through the use of a discounted cash flow approach. This excess earnings methodology estimates the fair value of the intangible assets (FCC license units of accounting) by measuring the future cash flows of the license groups, reduced by charges for contributory assets such as working capital, trademarks, existing subscribers, fixed assets, assembled workforce and goodwill.
TDS Telecom has recorded goodwill primarily as a result of the acquisition of operating telephone companies. TDS Telecom has assigned goodwill to its incumbent local exchange carrier reporting unit ($397.3 million), its competitive local exchange carrier reporting units ($29.4 million), and a wireless investment reporting unit ($30.9 million). The incumbent local exchange carrier reporting unit was valued using a multiple of cash flow valuation technique. The competitive local exchange carrier unit was valued using a discounted cash flow analysis. The wireless investment reporting unit was also valued using a discounted cash flow analysis. However, in the event TDS Telecom receives a bona fide offer for any reporting unit, that information will be incorporated into the valuation of that unit.
In the second quarter of 2004, U.S. Cellular recorded an additional $1.8 million impairment loss on its investment in a non-operating wireless market in Florida. No other impairment losses were identified during the annual impairment testing in the second quarter of 2004.
In the first quarter of 2003, TDS recorded a $3.5 million license cost impairment loss related to U.S. Cellular’s investment in a non-operating wireless market in Florida remaining after the AT&T Wireless exchange was completed. In the second quarter of 2003, U.S. Cellular recorded an impairment loss on its wireless licenses totaling $49.6 million related to the impairment of two reporting units. Also in the second quarter of 2003, TDS recorded a $5.0 million impairment loss on goodwill related to a cellular investment held at TDS Telecom.
SFAS No. 143, “Accounting for Asset Retirement Obligations,” became effective for TDS beginning January 1, 2003. SFAS No. 143 requires entities to record the fair value of a liability for legal obligations associated with an asset retirement in the period in which the obligations are incurred. When the liability is initially recorded, the entity capitalizes the cost of the asset retirement obligation by increasing the carrying amount of the related long-lived asset. Over time, the liability is accreted to its present value each period, and the capitalized cost is depreciated over the useful life of the related asset. Upon settlement of the obligation, any difference between the cost to retire the asset and the liability recorded is recognized in the statement of operations as a gain or loss.
The calculation of the asset retirement obligation for TDS is a critical accounting estimate because changing the factors used in calculating the obligation could result in larger or smaller estimated obligations that could have a significant impact on TDS’s results of operations and financial condition. Such factors may include probabilities or likelihood of remediation, cost estimates, lease renewals and salvage values. Actual results may differ materially from estimates under different assumptions or conditions.
U.S. Cellular is subject to asset retirement obligations associated primarily with its cell sites, retail sites and office locations. Asset retirement obligations include costs to remediate leased land on which U.S. Cellular’s cell sites and switching offices are located. U.S. Cellular is also required to return lease retail store premises and office space to their pre-existing conditions.
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U.S. Cellular determined that it had an obligation to remove long-lived assets in its cell sites, retail sites and office locations as described by SFAS 143, and has recorded a $64.5 million liability at December 31, 2003 and $66.3 million at June 30, 2004.
TDS Telecom’s incumbent local telephone companies follow the provisions of SFAS No. 71, and therefore conform to the regulatory accounting principles as prescribed by the respective state public utility commissions and the FCC, and where applicable, accounting principles generally accepted in the United States of America. TDS Telecom’s incumbent local telephone carriers have recorded an asset retirement obligation in accordance with the requirements of SFAS No. 143 and a regulatory liability for the amounts of costs of removal that state public utility commissions have required to be recorded for regulatory accounting purposes which are in excess of the amounts required to be recorded in accordance with SFAS No. 143. The regulatory liability included in asset retirement obligation at December 31, 2003 and at June 30, 2004 was $28.2 million and $29.9 million, respectively. The asset retirement obligation calculated in accordance with the provisions of SFAS No. 143 at December 31, 2003 and at June 30, 2004 was $31.8 million and $32.6 million, respectively.
TDS Telecom’s competitive local telephone companies adopted SFAS No. 143 effective January 1, 2003. TDS Telecom determined that its competitive local telephone companies do not have a material legal obligation to remove long-lived assets as described by SFAS 143, and accordingly, adoption of SFAS 143 did not have a material impact on the competitive local telephone companies.
The table below summarizes the changes in asset retirement obligations during the first six months of 2004.
The accounting for income taxes, the amounts of income tax assets and liabilities and the related income tax provision are critical accounting estimates because such amounts are significant to TDS’s financial condition, changes in financial condition and results of operations.
The preparation of the consolidated financial statements requires TDS to calculate a provision for income taxes. This process involves estimating the actual current income tax liability together with assessing temporary differences resulting from the different treatment of items, such as depreciation expense, for tax and accounting purposes. These temporary differences result in deferred tax assets and liabilities, which are included within the consolidated balance sheet. TDS must then assess the likelihood that deferred tax assets will be recovered from future taxable income and to the extent management believes that recovery is not likely, establish a valuation allowance. Management judgment is required in determining the provision for income taxes, deferred tax assets and liabilities and any valuation allowance recorded against deferred tax assets. TDS’s current net deferred tax asset was $19.4 million as of June 30, 2004, representing primarily the deferred tax effects of the allowance for doubtful accounts on accounts receivable, and is included in Other current assets on the balance sheet.
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The temporary differences that gave rise to the noncurrent deferred tax assets and liabilities as of June 30, 2004 are as follows:
The valuation allowance relates to state net operating loss carry forwards and the federal net operating loss carryforwards for those subsidiaries not included in the consolidated federal income tax return since it is more likely than not a portion will expire before such carryforwards can be utilized.
The deferred income tax liability relating to marketable equity securities of $989.2 million at June 30, 2004 represents deferred income taxes calculated on the difference between the book basis and the tax basis of the marketable equity securities. Income taxes will be payable when TDS disposes of the marketable equity securities.
TDS is routinely subject to examination of its income tax returns by the Internal Revenue Service (“IRS”) and other tax authorities. TDS periodically assesses the likelihood of adjustments to its tax liabilities resulting from these examinations to determine the adequacy of its provision for income taxes, including related interest. Management judgment is required in assessing the eventual outcome of these examinations. Changes to such assessments affect the calculation of TDS’s income tax expense. The IRS has completed audits of TDS’s federal income tax returns for tax years through 1996.
In the event of an increase in the value of tax assets or a decrease in tax liabilities, TDS would decrease the income tax expense or increase the income tax benefit by an equivalent amount. In the event of a decrease in the value of tax assets or an increase in tax liabilities, TDS would increase the income tax expense or decrease the income tax benefit by an equivalent amount.
U.S. Cellular and TDS Telecom’s competitive local exchange carrier operations provide for depreciation using the straight-line method over the estimated useful lives of the assets. TDS Telecom’s incumbent local exchange carrier operations provide for depreciation on a group basis according to depreciable rates approved by state public utility commissions. Annually, U.S. Cellular and TDS Telecom review its property, plant and equipment lives to ensure that the estimated useful lives are appropriate. The estimated useful lives of property, plant and equipment is a critical accounting estimate because changing the lives of assets can result in larger or smaller charges for depreciation expense. Factors used in determining useful lives include technology changes, regulatory requirements, obsolescence and type of use.
In the first quarter of 2004, U.S. Cellular adjusted the useful lives of TDMA radio equipment, switch software and antenna equipment. TDMA radio equipment lives were adjusted to be fully depreciated by the end of 2008, which is the latest date the wireless industry will be required by regulation to support analog service. U.S. Cellular currently uses TDMA radio equipment to support analog service, and expects to have its digital radio network fully migrated to CDMA 1XRTT or some future generation of CDMA technology by that time. The useful lives for certain switch software were reduced to one year from three years and antenna equipment lives were reduced from eight years to seven years in order to better align the useful lives with the actual length of time the assets are in use. These changes increased depreciation by $2.5 million and $9.9 million for the three and six months ended June 30, 2004, respectively, and is estimated to increase depreciation by $14.9 million for the full year 2004. The change in useful lives reduced net income by $1.2 million, or $0.02 per share, in the three months ended June 30, 2004 and by $4.9 million, or $0.09 per share, in the six months ended June 30, 2004.
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TDS Telecom did not change the useful lives of its property, plant and equipment in the six months ended June 30, 2004.
In the second quarter of 2004, certain U.S. Cellular TDMA digital radio equipment consigned to a third party for future sale was written down by $6.3 million prior to its consignment, increasing depreciation expense by that amount. This writedown was necessary to reduce the book value of the assets to be sold to their estimated proceeds from disposition.
The following persons are partners of Sidley Austin Brown & Wood LLP, the principal law firm of TDS and its subsidiaries: Walter C.D. Carlson, a trustee and beneficiary of a voting trust that controls TDS, the non-executive chairman of the board and member of the board of directors of TDS and a director of U.S. Cellular, a subsidiary of TDS; William S. DeCarlo, the General Counsel of TDS and an Assistant Secretary of TDS and certain subsidiaries of TDS; and Stephen P. Fitzell, the General Counsel of U.S. Cellular and TDS Telecom and an Assistant Secretary of certain subsidiaries of TDS. Walter C.D. Carlson does not provide legal services to TDS or its subsidiaries.
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PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995SAFE HARBOR CAUTIONARY STATEMENT
This Management’s Discussion and Analysis of Results of Operations and Financial Condition and other sections of this Quarterly Report contain statements that are not based on historical fact, including the words “believes”, “anticipates”, “intends”, “expects”, and similar words. These statements constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, events or developments to be significantly different from any future results, events or developments expressed or implied by such forward-looking statements. Such factors include the following:
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TDS undertakes no obligation to update publicly any forward-looking statements whether as a result of new information, future events or otherwise. Readers should evaluate any statements in light of these important factors.
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
TDS is subject to market risks due to fluctuations in interest rates. The majority of TDS’s debt, excluding long-term debt related to the forward contracts, is in the form of long-term, fixed-rate notes and convertible debt with original maturities ranging up to 40 years. The long-term debt related to the forward contracts consists of both variable-rate debt and fixed-rate zero coupon debt. Accordingly, fluctuations in interest rates can lead to significant fluctuations in the fair value of such instruments. As of June 30, 2004, TDS had not entered into any significant financial derivatives to reduce its exposure to interest rate risks.
Reference is made to the disclosure under Market Risk – Long Term Debt in TDS’s Annual Report on Form 10-K for the year ended December 31, 2003, as amended, for additional information about the annual requirements of principal payments, the average interest rates, and the estimated fair values of long-term debt.
In June 2004, U.S. Cellular issued $330 million in aggregate principal amount of unsecured 7.5% senior notes due 2034 and $100 million of unsecured 6.7% senior notes due 2033 in June 2004. The total net proceeds from these offerings, after deducting underwriting discounts, were approximately $412.5 million. Of this amount, $163.3 million was used to redeem U.S. Cellular’s Liquid Yield Option Notes on July 26, 2004 at accreted value. The balance of the net proceeds, together with borrowings under the revolving credit agreement, is expected to be used to redeem all of U.S. Cellular’s 7.25% senior notes as of August 16, 2004.
The following shows the annual requirements for principal payments on such long-term debt transactions:
TDS maintains a portfolio of available-for-sale marketable equity securities, the majority of which are the result of sales or trades of non-strategic assets. The market value of these investments aggregated $2,652.1 million at June 30, 2004. As of June 30, 2004, the net unrealized holding gain, net of tax included in accumulated other comprehensive income totaled $668.3 million.
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Subsidiaries of TDS and U.S. Cellular have entered into forward contracts related to the marketable equity securities that they hold. TDS and U.S. Cellular have provided guarantees to the counterparties which provide assurance to the counterparties that all principal and interest amounts are paid upon settlement of the contracts by such subsidiaries. The risk management objective of the forward contracts is to hedge the value of the marketable equity securities from losses due to decreases in the market prices of the securities (“downside limit”) while retaining a share of gains from increases in the market prices of such securities (“upside potential”). The downside limit is hedged at or above the cost basis thereby eliminating the risk of an other than temporary loss being recorded on these contracted securities.
Under the terms of the forward contracts, TDS and U.S. Cellular continue to own the contracted shares and will receive dividends paid on such contracted shares, if any. The forward contracts mature from May 2007 to August 2008 and, at TDS’s and U.S. Cellular’s option, may be settled in shares of the respective security or in cash, pursuant to formulas that “collar” the price of the shares. The collars effectively limit downside risk and upside potential on the contracted shares. The collars are typically adjusted for any changes in dividends on the contracted shares. If TDS and U.S. Cellular elect to settle in shares, they will be required to deliver the number of shares of the contracted security determined pursuant to the formula. If shares are delivered in the settlement of the forward contract, TDS and U.S. Cellular would incur a current tax liability at the time of delivery based on the difference between the tax basis of the marketable equity securities delivered and the net amount realized through maturity. If TDS and U.S. Cellular elect to settle in cash they will be required to pay an amount in cash equal to the fair market value of the number of shares determined pursuant to the formula. If cash is delivered in the settlement of the forward contract, TDS and U.S. Cellular would incur a current tax liability or a deferred tax benefit, based on the difference between the amount of cash paid in the settlement and the net amount realized through maturity.
Deferred taxes have been provided for the difference between the carrying value and the income tax basis of the marketable equity securities and are included in deferred tax liabilities on the balance sheet. Such deferred tax liabilities totaled $989.2 million at June 30, 2004.
The following table summarizes certain details surrounding the contracted securities as of June 30, 2004.
The following analysis presents the hypothetical change in the fair value of marketable equity securities and derivative instruments at June 30, 2004, using the Black-Scholes model, assuming hypothetical price fluctuations of plus and minus 10%, 20% and 30%. The table presents hypothetical information as required by SEC rules. Such information should not be inferred to suggest that TDS has any intention of selling any marketable equity securities or canceling any derivative instruments.
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ITEM 4. CONTROLS AND PROCEDURES
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PART II. OTHER INFORMATION
Item 1. Legal Proceedings.
TDS is involved in a number of legal proceedings before the FCC and various state and federal courts. Management does not believe that any such proceeding should have a material adverse impact on the financial position or results of operations of TDS.
Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities.
The following table provides certain information with respect to all purchases made by or on behalf of TDS, or any “affiliated purchaser” (as defined by the SEC) of TDS, of TDS Common Shares during the quarter covered by this Form 10-Q.
TDS PURCHASES OF COMMON SHARES (1)
The following is additional information with respect to TDS’s publicly announced Common Share repurchase program:
The date the program was announced was February 28, 2003 by press release.
The share amount originally approved was 3,000,000 Common Shares (representing a reauthorization of 1,009,746 unpurchased shares under a program that was scheduled to expire in April 2003, plus 1,990,254 shares under a new authorization).
The expiration date of the program is February 28, 2006.
No stock repurchase program has expired during the quarter covered by this Form 10-Q.
TDS has not determined to terminate the foregoing stock repurchase program prior to expiration, or to cease making further purchases thereunder, during the quarter covered by this Form 10-Q.
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Item 4. Submission of Matters to a Vote of Security-Holders
At the Annual Meeting of Shareholders of TDS, held on June 29, 2004, the following number of votes were cast for the matters indicated:
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Item 6. Exhibits and Reports on Form 8-K.
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SIGNATURES
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.
TELEPHONE AND DATA SYSTEMS, INC. (Registrant)
Signature page for the TDS 2004 Second Quarter Form 10-Q