Table of Contents
UNITED STATESSECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
FORM 10-Q
Commission File No. 001-15577
QWEST COMMUNICATIONS INTERNATIONAL INC. (Exact name of registrant as specified in its charter)
(303) 992-1400 (Registrant's telephone number, including area code)
N/A (Former name, former address and former fiscal year, if changed since last report)
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No ý
On April 27, 2009, 1,720,192,626 shares of common stock were outstanding.
QWEST COMMUNICATIONS INTERNATIONAL INC.
TABLE OF CONTENTS
Glossary of Terms
PART I—FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Statements of Operations—Three months ended March 31, 2009 and 2008 (unaudited)
Condensed Consolidated Balance Sheets—March 31, 2009 and December 31, 2008 (unaudited)
Condensed Consolidated Statements of Cash Flows—Three months ended March 31, 2009 and 2008 (unaudited)
Notes to Condensed Consolidated Financial Statements (unaudited)
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Item 4. Controls and Procedures
PART II—OTHER INFORMATION
Item 1. Legal Proceedings
Item 1A. Risk Factors
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Item 6. Exhibits
Signature
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GLOSSARY OF TERMS
Our industry uses many terms and acronyms that may not be familiar to you. To assist you in reading this document and other documents we file with the Securities and Exchange Commission, we have provided below definitions of some of these terms.
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PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
QWEST COMMUNICATIONS INTERNATIONAL INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
Operating revenue
Operating expenses:
Cost of sales (exclusive of depreciation and amortization)
Selling
General, administrative and other operating
Depreciation and amortization
Total operating expenses
Other expense (income)—net:
Interest expense on long-term borrowings and capital leases—net
Other—net
Total other expense (income)—net
Income before income taxes
Income tax expense
Net income
Earnings per common share:
Basic
Diluted
Weighted average common shares outstanding:
The accompanying notes are an integral part of these condensed consolidated financial statements.
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QWEST COMMUNICATIONS INTERNATIONAL INC. CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)
ASSETS
Current assets:
Cash and cash equivalents
Accounts receivable—net of allowance of $136 and $129, respectively
Deferred income taxes—net
Prepaid expenses and other
Total current assets
Property, plant and equipment—net
Capitalized software—net
Other
Total assets
LIABILITIES AND STOCKHOLDERS' DEFICIT
Current liabilities:
Current portion of long-term borrowings
Accounts payable
Accrued expenses and other
Deferred revenue and advance billings
Total current liabilities
Long-term borrowings—net of unamortized debt discount and other of $253 and $270, respectively
Post-retirement and other post-employment benefits obligations—net
Pension obligations—net
Deferred revenue
Total liabilities
Commitments and contingencies (Note 12)
Stockholders' deficit:
Preferred stock—$1.00 par value, 200 million shares authorized; none issued or outstanding
Common stock—$0.01 par value, 5 billion shares authorized; 1,726,954 and 1,713,521 shares issued, respectively
Additional paid-in capital
Treasury stock—7,645 and 6,767 shares, respectively (including 62 shares held in rabbi trust at both dates)
Accumulated deficit
Accumulated other comprehensive loss
Total stockholders' deficit
Total liabilities and stockholders' deficit
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QWEST COMMUNICATIONS INTERNATIONAL INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
Operating activities:
Adjustments to reconcile net income to net cash provided by operating activities:
Deferred income taxes
Provision for bad debt—net
Other non-cash charges—net
Changes in operating assets and liabilities:
Accounts receivable
Prepaid expenses and other current assets
Accounts payable and accrued expenses and other current liabilities
Other non-current assets and liabilities
Cash provided by operating activities
Investing activities:
Expenditures for property, plant and equipment and capitalized software
Proceeds from sale of investment securities
Cash used for investing activities
Financing activities:
Repayments of long-term borrowings, including current maturities
Proceeds from issuances of common stock
Dividends paid
Repurchases of common stock
Cash used for financing activities
Cash and cash equivalents:
Decrease in cash and cash equivalents
Beginning balance
Ending balance
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QWEST COMMUNICATIONS INTERNATIONAL INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS For the Three Months Ended March 31, 2009(Unaudited)
Unless the context requires otherwise, references in this report to "Qwest," "we," "us," the "Company" and "our" refer to Qwest Communications International Inc. and its consolidated subsidiaries, and references to "QCII" refer to Qwest Communications International Inc. on an unconsolidated, stand-alone basis.
Note 1: Basis of Presentation
The condensed consolidated balance sheet as of December 31, 2008, which was derived from audited financial statements, and the unaudited interim condensed consolidated financial statements as of and for the three months ended March 31, 2009 have been prepared in accordance with the instructions for Form 10-Q. In compliance with those instructions, certain information and footnote disclosures normally included in consolidated financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted. We believe that the disclosures made are adequate such that the information presented is not misleading. We have reclassified certain prior year revenue and expense amounts presented in our Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2008 to conform to the current period presentation and to the presentation of the full year 2008 results of operations included in our Annual Report on Form 10-K for the year ended December 31, 2008.
In the opinion of management, these statements include all normal recurring adjustments necessary to fairly present our condensed consolidated results of operations, financial position and cash flows as of March 31, 2009 and for all periods presented. These condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2008.
The condensed consolidated results of operations and the condensed consolidated statement of cash flows for the three months ended March 31, 2009 are not necessarily indicative of the results or cash flows expected for the full year.
Use of Estimates
Our condensed consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles. These accounting principles require us to make certain estimates, judgments and assumptions. We believe that the estimates, judgments and assumptions we made when accounting for items and matters such as, but not limited to, investments, long-term contracts, customer retention patterns, allowance for doubtful accounts, depreciation, amortization, asset valuations, internal labor capitalization rates, recoverability of assets (including deferred tax assets), impairment assessments, pension and post-retirement benefits, taxes, reserves and other provisions and contingencies are reasonable, based on information available at the time they were made. These estimates, judgments and assumptions can affect the reported amounts of assets, liabilities and components of equity as of the dates of the condensed consolidated balance sheets, as well as the reported amounts of revenue, expenses and components of cash flows during the periods presented in our condensed consolidated statements of operations and our condensed consolidated statements of cash flows. We also make estimates in our assessments of potential losses in relation to threatened or
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
For the Three Months Ended March 31, 2009(Unaudited)
Note 1: Basis of Presentation (Continued)
pending tax and legal matters. See Note 9—Tax Matters and Note 12—Commitments and Contingencies for additional information.
For all of these and other matters, actual results could differ from our estimates.
Universal Service Funds (USF), Gross Receipts Taxes and Other Surcharges
Our revenue and general, administrative and other operating expenses included taxes and surcharges accounted for on a gross basis of $82 million and $94 million for the three months ended March 31, 2009 and 2008, respectively.
Depreciation and Amortization
Property, plant and equipment is shown net of accumulated depreciation on our condensed consolidated balance sheets. Accumulated depreciation was $33.808 billion and $33.725 billion as of March 31, 2009 and December 31, 2008, respectively.
Capitalized software is shown net of accumulated amortization on our condensed consolidated balance sheets. Accumulated amortization was $1.532 billion and $1.497 billion as of March 31, 2009 and December 31, 2008, respectively.
Effective January 1, 2009, we changed our estimates of the average remaining lives of certain copper cable and telecommunications equipment assets. These changes resulted in additional depreciation expense of approximately $10 million for the three months ended March 31, 2009 when compared to the three months ended March 31, 2008 and will result in additional depreciation expense of approximately $38 million for the full year ending December 31, 2009 when compared to the year ended December 31, 2008.
We made a decision in June 2008 to discontinue certain product offerings and as a result we changed our estimates of the remaining economic lives of certain assets used in providing those services, which resulted in the acceleration of depreciation of those assets. This change also resulted in additional depreciation expense of approximately $10 million for the three months ended March 31, 2009 when compared to the three months ended March 31, 2008 and will result in additional
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depreciation expense of approximately $19 million for the full year ending December 31, 2009 when compared to the year ended December 31, 2008.
The additional depreciation for both of the changes described above, net of deferred taxes, reduced net income by approximately $12 million, or less than $0.01 per basic and diluted common share, for the three months ended March 31, 2009 and will reduce net income by approximately $35 million, or approximately $0.02 per basic and diluted common share, for the full year ending December 31, 2009.
Recently Adopted Accounting Pronouncements
Effective January 1, 2009, we adopted FASB Staff Position ("FSP") APB 14-1, "Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement)" ("FSP APB 14-1"). This FSP requires issuers of convertible debt that may be settled fully or partially in cash upon conversion to account separately for the liability and equity components of the convertible debt. The liability component is measured so that the effective interest expense associated with the convertible debt reflects our borrowing rate at the date of issuance for similar debt instruments without the conversion feature. This FSP applies to our 3.50% Convertible Senior Notes due 2025 (the "3.50% Convertible Senior Notes"). We applied this FSP retrospectively to all periods presented in our condensed consolidated financial statements. The adoption of this FSP resulted in a decrease in net income of $8 million, or less than $0.01 per basic and diluted common share, and $7 million, or less than $0.01 per basic and diluted common share, for the three months ended March 31, 2009 and 2008, respectively. Interest expense increased $13 million and $11 million for the three months ended March 31, 2009 and 2008, respectively. Additionally, the adoption resulted in a decrease to borrowings of $104 million, a decrease to deferred taxes of $40 million and a decrease to stockholders' deficit of $63 million at December 31, 2008 as compared to the balances previously reported in our Annual Report on Form 10-K for the year then ended. For additional information, see Note 5—Borrowings.
Effective January 1, 2009, we adopted FSP EITF 03-6-1, "Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities." This FSP states that unvested share-based payment awards that contain non-forfeitable rights to dividends are participating securities and must be included in the computation of earnings per share pursuant to the two-class method. Under this FSP, our unvested restricted stock grants are now considered participating securities. The two-class method requires earnings to be allocated between common shareholders and holders of unvested restricted stock grants. Upon adoption, we retrospectively recomputed earnings per common share for all periods presented, but the modified calculation resulted in an immaterial change to the earnings per common share we have reported historically. The changes in the earnings per common share presented in these financial statements as compared to amounts previously presented are the result of the adoption of FSP APB 14-1.
Effective January 1, 2009, we adopted FSP FAS 157-4, "Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly." This FSP provides guidelines for ensuring that fair value measurements are consistent with the principles presented in Statement of Financial Accounting
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Standards ("SFAS") No. 157, "Fair Value Measurements" ("SFAS No. 157"). The adoption of this FSP has not had a material effect on our financial position or results of operations.
Effective January 1, 2009, we adopted FSP FAS 115-2 and FAS 124-2, "Recognition and Presentation of Other-Than-Temporary Impairments." This FSP provides additional guidance designed to create greater clarity and consistency in accounting for and presenting impairment losses on securities. The adoption of this FSP has not had a material effect on our financial position or results of operations.
Note 2: Earnings Per Common Share
Basic earnings per common share excludes dilution and is computed by dividing net income allocated to common stockholders by the weighted average number of shares of common stock outstanding for the period. Diluted earnings per common share reflects the potential dilution that could occur if certain outstanding stock options are exercised and certain performance shares require payout in common stock.
The following is a reconciliation of the number of shares used in the basic and diluted earnings per common share computations for the three months ended March 31, 2009 and 2008:
Net income allocated to common shareholders
Basic weighted average shares outstanding
Dilutive effect of options with strike prices equal to or less than the average price of our common stock during the period, calculated using the treasury stock method
Dilutive effect of performance shares
Diluted weighted average shares outstanding
We had weighted average unvested restricted stock grants outstanding of approximately 9 million shares and 6 million shares during the three months ended March 31, 2009 and 2008, respectively. The grants are treated as participating securities in the calculation of our earnings per common share and were allocated net income of approximately $1 million for basic and diluted earnings per share for the three months ended March 31, 2009 and 2008.
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Note 2: Earnings Per Common Share (Continued)
The following is a summary of the securities that could potentially dilute basic earnings per common share, but have been excluded from the computations of diluted earnings per common share for the three months ended March 31, 2009 and 2008:
Outstanding options to purchase common stock excluded because the strike prices of the options exceeded the average price of common stock during the period
Outstanding options to purchase common stock because the market-based vesting conditions have not been met
Other outstanding instruments excluded because the impact would have been antidilutive
The above table does not include the potential dilutive effects of the equity premium on our 3.50% Convertible Senior Notes, which were not convertible as of March 31, 2009. The number of shares we would have to issue upon conversion of this debt is determined by a formula that uses our stock price as a major input.
Note 3: Fair Value of Financial Instruments
Our financial instruments consist of cash and cash equivalents, certain of our current and non-current investments (consisting of auction rate securities and an investment fund), accounts receivable, accounts payable, interest rate hedges and long-term notes including the current portion. The carrying values of cash and cash equivalents, accounts receivable and accounts payable, interest rate hedges, the investment fund, and auction rate securities approximate their fair values.
SFAS No. 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The fair value hierarchy established by SFAS No. 157 prioritizes the inputs into valuation techniques used to measure fair value. Accordingly, we use valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs when determining fair value.
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Note 3: Fair Value of Financial Instruments (Continued)
The table below presents the fair values for certain of our current and non-current investments, interest rate hedges and long-term notes including the current portion, as well as the input levels used to determine these fair values as of March 31, 2009 and December 31, 2008:
Assets:
Auction rate securities
Investment fund
Liabilities:
Long-term notes, including the current portion
Interest rate hedges
The three levels of the hierarchy are as follows:
We determined the fair value of our auction rate securities using a discounted cash flow model that takes into consideration the interest rate of the securities, the probability that we will be able to sell the securities in an auction or that the securities will be redeemed early, the probability that a default will occur and its severity, a discount rate and other factors.
We determined the fair value of our investment fund based on the asset values of the securities underlying the fund.
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We determined the fair value of our interest rate hedges using projected future cash flows, discounted at the mid-market implied forward London Interbank Offered Rate ("LIBOR"). We valued the debt underlying the fair value hedges using projected future cash flows, discounted at mid-market implied forward LIBOR, plus a constant spread above LIBOR determined at the inception of the hedging relationship. We determined these valuations excluding accrued interest. For additional information on our derivative financial instruments, see Note 6—Derivative Financial Instruments.
We determined the fair values of our long-term notes including the current portion based on quoted market prices where available or, if not available, based on discounted future cash flows using current market interest rates. Unlike the items listed above, our long-term notes including the current portion are reflected on our condensed consolidated balance sheets at original cost net of unamortized discounts and premiums. The carrying value of our long-term notes including the current portion was $13.250 billion as of March 31, 2009. For additional information, see Note 5—Borrowings.
The table below presents a rollforward of the instruments valued using SFAS No. 157 Level 3 inputs for the three months ended March 31, 2009:
Balance at January 1
Transfers into (out of) Level 3
Additions
Dispositions
Realized and unrealized losses:
Included in other (expense) income—net
Included in other comprehensive loss
Balance at March 31
Note 4: Investments
As of March 31, 2009 and December 31, 2008, our investments included auction rate securities of $86 million and $90 million, respectively, which are classified as non-current, available-for-sale investments and are included in other non-current assets at their estimated fair value on our condensed consolidated balance sheets. Auction rate securities are generally long-term debt instruments that provide liquidity through a Dutch auction process that resets the applicable interest rate at pre-determined calendar intervals, generally every 28 days. This mechanism generally allows existing investors to rollover their holdings and continue to own their respective securities or liquidate their holdings by selling their securities at par value. Prior to August 2007, we invested in these securities for short periods of time as part of our cash management program. However, the uncertainties in the
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Note 4: Investments (Continued)
credit markets have prevented us and other investors from liquidating holdings of these securities in auctions since the third quarter of 2007. These securities:
We recorded unrealized losses, net of deferred income taxes, on these auction rate securities of $2 million and $4 million for the three months ended March 31, 2009 and 2008, respectively. The cumulative unrealized losses, net of deferred income taxes, related to these securities were $19 million and $17 million as of March 31, 2009 and December 31, 2008, respectively. These unrealized losses were recorded in accumulated other comprehensive income on our condensed consolidated balance sheets. The cost basis of these securities was $117 million as of both March 31, 2009 and December 31, 2008. We consider the decline in fair value to be a temporary impairment because we believe it is more likely than not that we will ultimately recover the entire $117 million cost basis, in part because the securities are rated investment grade, the securities are fully collateralized and the issuers continue to make required interest payments. At some point in the future, we may determine that the decline in fair value is other than temporary if, among other factors, the issuers cease making required interest payments or if we believe it is more likely than not that we will be required to sell these securities before their values recover; we would then recognize the portion of the other than temporary decline in fair value that is due to credit loss in other expense (income)—net in our condensed consolidated statements of operations. Because we are uncertain as to when the liquidity issues relating to these investments will improve, we continued to classify these securities as non-current as of March 31, 2009.
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Note 5: Borrowings
As of March 31, 2009 and December 31, 2008, our long-term borrowings, net of unamortized discounts and premiums, consisted of the following:
Current portion of long-term borrowings:
Long-term notes
Long-term capital lease and other obligations
Total current portion of long-term borrowings
Long-term borrowings:
Total long-term borrowings—net
Total long-term borrowings—net, including current portion
We were in compliance with all provisions and covenants of our borrowings as of March 31, 2009.
Effective January 1, 2009, we adopted FSP APB 14-1. This FSP requires issuers of convertible debt that may be settled fully or partially in cash upon conversion to account separately for the liability and equity components of the convertible debt. The carrying amount of the equity component of the 3.50% Convertible Senior Notes was $164 million as of March 31, 2009 and December 31, 2008. At March 31, 2009 and December 31, 2008, the liability component of the notes had: a principal amount of $1.265 billion; an unamortized discount value of $91 million and $104 million, respectively; and a net carrying amount of $1.174 billion and $1.161 billion, respectively. The remaining discount will be amortized over the next 19 months. The effective interest rate on the 3.50% Convertible Senior Notes is 8.77%. The interest cost, inclusive of the 3.50% coupon and amortization of the discount, recognized for the three months ended March 31, 2009 and 2008 was $25 million and $24 million, respectively.
The holders of our 3.50% Convertible Senior Notes have the option to require us to repurchase their notes for cash every five years on November 15, beginning in 2010, and receive cash from us equal to the par value of the notes. We believe that, if the trading price of our common stock is below the conversion price on November 15, 2010, the likelihood of holders requiring us to repurchase their notes will increase the more the conversion price exceeds the trading price of our common stock. The conversion value of the notes as of March 31, 2009 was calculated by using the current conversion rate of 187.6836 per $1,000 in principal amount of the notes or a conversion price of $5.33, adjusted for certain events, including the payment of dividends, as described in the indenture governing the notes.
Repayment
On January 2, 2009, we redeemed $230 million aggregate principal amount of QCII's Floating Rate Senior Notes due 2009.
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Note 5: Borrowings (Continued)
New Issuance
In April 2009, our wholly owned subsidiary, Qwest Corporation ("QC"), issued approximately $811 million of 8.375% Senior Notes due 2016. QC intends to use the net proceeds of $738 million for general corporate purposes, including repayment of indebtedness and funding and refinancing investments in its telecommunication assets.
Credit Facility
In April 2009, in connection with the addition of a new lender to our revolving credit facility (referred to as the Credit Facility), the amount available to us under the Credit Facility increased from $850 million to $910 million. The Credit Facility is currently undrawn and expires in October 2010. Any amounts drawn on the Credit Facility are guaranteed by our wholly owned subsidiary, Qwest Services Corporation ("QSC"), and are secured by a senior lien on the stock of QC.
Note 6: Derivative Financial Instruments
We sometimes use derivative financial instruments, specifically interest rate swap contracts, to manage interest rate risks. We execute these instruments with financial institutions we deem creditworthy and monitor our exposure to these counterparties. An interest rate hedge is generally designated as either a cash flow hedge or a fair value hedge. In a cash flow hedge, a borrower of variable interest debt agrees with another party to make fixed payments equivalent to paying fixed rate interest on debt in exchange for receiving payments from the other party equivalent to receiving variable rate interest on debt, the effect of which is to eliminate some portion of the variability in the borrower's overall cash flows. In a fair value hedge, a borrower of fixed rate debt agrees with another party to make variable payments equivalent to paying variable rate interest on the debt in exchange for receiving fixed payments from the other party equivalent to receiving fixed rate interest on debt, the effect of which is to eliminate some portion of the variability in the fair value of the borrower's overall debt portfolio.
We recognize all derivatives on our condensed consolidated balance sheets at fair value. We generally designate the derivative as either a cash flow hedge or a fair value hedge on the date on which we enter into the derivative instrument.
For a derivative that is designated as and meets all of the required criteria for a cash flow hedge, we record in accumulated other comprehensive income on our condensed consolidated balance sheets any changes in the fair value of the derivative. We then reclassify these amounts into earnings as the underlying hedged item affects earnings. In addition, if there are any changes in the fair value of the derivative arising from ineffectiveness of the cash flow hedging relationship, we record those amounts immediately in other expense (income)—net in our condensed consolidated statements of operations. For a derivative that is designated as and meets all of the required criteria for a fair value hedge, we record in other expense (income)—net in our condensed consolidated statements of operations the changes in fair value of the derivative and the underlying hedged item.
We assess quarterly whether each derivative is highly effective in offsetting changes in fair values or cash flows of the hedged item. If we determine that a derivative is not highly effective as a hedge, or
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Note 6: Derivative Financial Instruments (Continued)
if a derivative ceases to be a highly effective hedge, we discontinue hedge accounting with respect to that derivative prospectively. We record immediately in earnings, changes in the fair value of derivatives that are not designated as hedges.
Interest Rate Hedges
During 2008, we entered into the interest rate hedges described below as part of our short-term and long-term debt strategies. One objective of our short-term debt strategy is to take advantage of favorable interest rates by swapping floating rate debt to fixed rate debt using cash flow hedges. One objective of our long-term debt strategy is to achieve a more balanced ratio of fixed rate to floating rate debt by swapping a portion of our fixed interest rate debt to floating rate debt through fair value hedges. This decreases our exposure to changes in the fair value of our fixed interest rate debt due to changes in interest rates.
We evaluate counterparty credit risk before entering into any hedge transaction. During 2008, one of our counterparties merged into a large bank. We evaluated the new counterparty credit risk and found it to be acceptable. We will continue to closely monitor the financial market and the risk that our counterparties will default on their obligations to us. We are prepared to unwind these hedge transactions if our counterparties' credit risk becomes unacceptable to us.
In March 2008, QC entered into interest rate hedges on $500 million of the outstanding $750 million aggregate principal amount of its Floating Rate Notes due 2013. The notes bear interest at a rate per year equal to LIBOR plus 3.25%. These hedges had the economic effect of converting QC's floating interest rate to fixed interest rates of approximately 6.0% for a term of approximately two years. QC designated these interest rate swaps as cash flow hedges. We did not recognize any gain or loss in earnings for hedge ineffectiveness for the three months ended March 31, 2009.
In March 2008, QC also entered into interest rate hedges on the outstanding $500 million aggregate principal amount of its 6.5% Notes due 2017. These hedges had the economic effect of converting QC's fixed interest rate to a floating interest rate until these notes mature in 2017. QC designated these interest rate swaps as fair value hedges. QC terminated these hedges in the fourth quarter of 2008.
The cash flow and fair value hedges were valued using projected future cash flows, discounted at mid-market implied forward LIBOR. The debt underlying the fair value hedges was valued using projected future cash flows, discounted at mid-market implied forward LIBOR, plus a constant spread above LIBOR determined at the inception of the hedging relationship. These valuations were determined excluding accrued interest. For additional information on the fair value of our financial instruments, see Note 3—Fair Value of Financial Instruments.
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The fair value of derivative instruments designated as hedging instruments as of March 31, 2009 is described below:
Cash Flow Hedging Contracts
The fair value of derivative instruments designated as hedging instruments as of December 31, 2008 is described below:
The following table presents the effect of derivative instruments on our condensed consolidated statement of operations for the three months ended March 31, 2009 and our condensed consolidated balance sheet as of March 31, 2009:
Interest rate contracts:
Amount of loss recognized in other comprehensive income on derivative during the three months ended March 31, 2009 (effective portion), net of deferred taxes of $1
Location of amount reclassified from accumulated other comprehensive income into income (effective portion)
Amount of gain reclassified from accumulated other comprehensive income into interest expense (effective portion), net of deferred taxes of $1
Location of amount recognized in income on derivative (ineffective portion and amount excluded from effectiveness testing)
Amount recognized in income on derivative (ineffective portion and amount excluded from effectiveness testing)
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Note 7: Severance and Restructuring
Severance
For the three months ended March 31, 2009 and 2008, we recorded severance expenses of $23 million and $45 million, respectively. A portion of our severance charges is included in each of cost of sales, selling expenses and general, administrative and other operating expenses in our condensed consolidated statements of operations. We have not included any severance charges in our segment expenses. As of March 31, 2009 and December 31, 2008, our severance liability was $59 million and $56 million, respectively. We expect to pay substantially all of the accrued severance charges in the remainder of 2009.
Restructuring
During 2004 and previous years, as part of our ongoing efforts to evaluate our operating costs, we established restructuring programs, which included workforce reductions, consolidation of excess facilities, and restructuring of certain business functions. As of March 31, 2009, the remaining restructuring reserve for these programs related to leases for real estate that we ceased using in prior periods and consisted of our estimates of amounts to be paid for these leases in excess of our estimates of any sublease revenue we may collect. We expect this reserve will be used over the remaining lease terms, which range from 0.8 to 16.8 years, with a weighted average of 12.8 years.
The remaining reserve balances are included on our condensed consolidated balance sheets in accrued expenses and other current liabilities for the current portion and other long-term liabilities for the long-term portion. The charges, reversals, and adjustments are included in general, administrative and other expenses in our condensed consolidated statements of operations. We have not included any restructuring charges in our segment expenses.
The following table presents the details of our real estate restructuring reserves for the three months ended March 31, 2009.
Balance December 31, 2008
Provisions
Utilization
Reversals and adjustments
Balance March 31, 2009
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Note 8: Employee Benefits
The components of net periodic benefits expense for our pension, non-qualified pension and post-retirement benefit plans for the three months ended March 31, 2009 and 2008 are detailed below:
Net periodic benefits expense:
Service cost
Interest cost
Expected return on plan assets
Recognized prior service cost
Recognized net actuarial loss
Total net periodic benefits expense
The net periodic benefits expense for our pension, non-qualified pension and post-retirement benefit plans is recorded in general, administrative and other operating expenses in our condensed consolidated statements of operations. The measurement date used to determine pension, non-qualified pension and post-retirement benefits is December 31.
Note 9: Tax Matters
The balance of unrecognized tax benefits as of March 31, 2009 was $400 million, which was a decrease of $34 million from the balance as of December 31, 2008, due mainly to $22 million in reductions from prior year tax positions and $12 million in settlements. As of March 31, 2009, approximately $287 million of the unrecognized tax benefits could affect our income tax provision and effective tax rate. During the three months ended March 31, 2009 and 2008, reductions from prior year tax positions and settlements affected the calculation of our effective tax rate by approximately $22 million and $0, respectively.
Note 10: Comprehensive Income
Comprehensive income includes the amortization of actuarial gains and losses and prior service costs for our pension and post-retirement benefit plans, changes in the fair value of certain financial derivative instruments (which qualify for hedge accounting) and unrealized gains and losses on certain
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Note 10: Comprehensive Income (Continued)
investments. The components of comprehensive income for the three months ended March 31, 2009 and 2008 are detailed below:
Other comprehensive loss—net of deferred taxes:
Post-retirement benefit plans—net
Pension—net
Unrealized gain (loss) on derivative instruments—net
Unrealized loss on auction rate securities and other—net
Total other comprehensive loss—net of deferred taxes
Comprehensive income
Note 11: Segment Information
Our operating revenue is generated from our business markets, mass markets and wholesale markets segments. Our Chief Operating Decision Maker ("CODM") regularly reviews information for each of our segments to evaluate performance and to allocate resources. The accounting principles used to determine segment results are the same as those used in our condensed consolidated financial statements.
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Note 11: Segment Information (Continued)
Segment income consists of each segment's revenue and expenses. The following table summarizes segment information for the three months ended March 31, 2009 and 2008:
Total segment revenue
Total segment expense
Total segment income
Total margin percentage
Business markets:
Revenue
Expense
Income
Margin percentage
Mass markets:
Wholesale markets:
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The following table reconciles segment income to net income for the three months ended March 31, 2009 and 2008:
Other revenue (primarily USF surcharges)
Unassigned expenses (primarily general and administrative)
Total other expense—net
The following table summarizes revenue derived from external customers for our major products and services for the three months ended March 31, 2009 and 2008:
Operating revenue by products and services:
Segment revenue:
Data, Internet and video services
Voice services
Wireless products and services
Total operating revenue
Note 12: Commitments and Contingencies
Throughout this note, when we refer to a class action as "putative" it is because a class has been alleged, but not certified in that matter. Until and unless a class has been certified by the court, it has not been established that the named plaintiffs represent the class of plaintiffs they purport to represent. Settlement classes have been certified in connection with the settlements of certain of the putative class actions described below where the courts held that the named plaintiffs represented the settlement class they purported to represent.
To the extent appropriate, we have provided reserves for each of the matters described below.
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Note 12: Commitments and Contingencies (Continued)
The terms and conditions of applicable bylaws, certificates or articles of incorporation, agreements or applicable law may obligate us to indemnify our former directors, officers and employees with respect to certain of the matters described below, and we have been advancing legal fees and costs to many former directors, officers and employees in connection with certain matters described below.
Settlement of Consolidated Securities Action
Twelve putative class actions purportedly brought on behalf of purchasers of our publicly traded securities between May 24, 1999 and February 14, 2002 were consolidated into a consolidated securities action pending in federal district court in Colorado against us and various other defendants. The first of these actions was filed on July 27, 2001. Plaintiffs alleged, among other things, that defendants issued false and misleading financial results and made false statements about our business and investments, including materially false statements in certain of our registration statements. The most recent complaint in this matter sought unspecified compensatory damages and other relief. However, counsel for plaintiffs indicated that the putative class would seek damages in the tens of billions of dollars.
In November 2005, we, certain other defendants, and the putative class representatives entered into, and filed with the federal district court in Colorado, a Stipulation of Partial Settlement that, if implemented, will settle the consolidated securities action against us and certain other defendants (the "Qwest settlement"). No parties admit any wrongdoing as part of the Qwest settlement. Pursuant to the Qwest settlement, we deposited approximately $400 million in cash into a settlement fund. In connection with the Qwest settlement, we received $10 million from Arthur Andersen LLP. As part of the Qwest settlement, the class representatives and the settlement class they represent are also releasing Arthur Andersen. If the Qwest settlement is not implemented, we will be repaid the $400 million plus interest, less certain expenses, and we will repay the $10 million to Arthur Andersen.
If implemented, the Qwest settlement will resolve and release the individual claims of the class representatives and the claims of the settlement class they represent against us and all defendants except Joseph Nacchio, our former chief executive officer, and Robert Woodruff, our former chief financial officer. In September 2006, the federal district court in Colorado issued an order approving the proposed Qwest settlement on behalf of purchasers of our publicly traded securities between May 24, 1999 and July 28, 2002, over the objections of Messrs. Nacchio and Woodruff. Messrs. Nacchio and Woodruff then appealed that order to the United States Court of Appeals for the Tenth Circuit. In addressing that appeal, the Tenth Circuit held that the federal district court order overruling Nacchio and Woodruff's objections to the Qwest settlement was not sufficiently specific, and it remanded the case to the district court with instructions to consider certain issues and to provide a more detailed explanation for its earlier decision overruling those objections. Subsequent to the remand, a proposed settlement was reached involving the claims of the putative class against Messrs. Nacchio and Woodruff as described below that, if implemented, will also result in the implementation of the Qwest settlement.
On August 4, 2008, we, Messrs. Nacchio and Woodruff, and the putative class representatives entered into a Stipulation of Settlement (the "Nacchio/Woodruff settlement"). The court preliminarily approved the Nacchio/Woodruff settlement, certified a class for settlement purposes of purchasers of our publicly traded securities between May 24, 1999 and July 28, 2002, and conducted a hearing to
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consider final approval of the Nacchio/Woodruff settlement. If implemented, the settlement will, among other things, (i) settle the individual claims of the class representatives and the class they represent against Messrs. Nacchio and Woodruff, and (ii) result in the withdrawal by Messrs. Nacchio and Woodruff of their objections to the Qwest settlement and the resolution of their indemnification dispute with us arising from the Qwest settlement. Under the proposed Nacchio/Woodruff settlement, we have contributed $40 million, and, if implemented, Messrs. Nacchio and Woodruff will contribute a total of $5 million of insurance proceeds. Although the Nacchio/Woodruff settlement remains subject to final court approval, the court has indicated that it plans to issue such approval. No parties admit any wrongdoing as a part of the Nacchio/Woodruff settlement.
Certain investment companies managed by Munder Capital Management ("Munder Funds") requested to be excluded from the Nacchio/Woodruff settlement class and filed suit against Messrs. Nacchio and Woodruff on January 28, 2009. As a result, Munder Funds' claims will not be released by any court order finally approving the Nacchio/Woodruff settlement, in the event that such an order is entered. Munder Funds have alleged that Messrs. Nacchio and Woodruff violated federal securities laws by issuing false and misleading financial reports and statements, falsely inflating revenue and decreasing expenses, creating false perceptions of revenue and growth prospects and employing improper accounting practices. Munder Funds contend that they have incurred losses resulting from their investment in our securities of approximately $110 million, and they seek compensatory and rescissionary damages, pre- and post-judgment interest, costs and attorneys' fees.
KPNQwest Litigation/Investigation
On January 27, 2009, the trustees in the Dutch bankruptcy proceeding for KPNQwest, N.V. (of which we were a major shareholder) filed a lawsuit in the federal district court for the District of Colorado alleging violations of the Racketeer Influenced and Corrupt Organizations Act and breach of duty and mismanagement under Dutch law. We are a defendant in this lawsuit along with Joseph Nacchio, Robert S. Woodruff and John McMaster, the former president and chief executive officer of KPNQwest. Plaintiffs allege, among other things, that defendants' actions were a cause of the bankruptcy of KPNQwest, and they seek damages for the bankruptcy deficit of KPNQwest of approximately $2.4 billion. Plaintiffs also seek treble and punitive damages as well as an award of plaintiffs' attorneys' fees and costs. A lawsuit asserting the same claims that was previously filed in the federal district court for the District of New Jersey was dismissed without prejudice, and that dismissal was affirmed on appeal.
On September 13, 2006, Cargill Financial Markets, Plc and Citibank, N.A. filed a lawsuit in the District Court of Amsterdam, located in the Netherlands, against us, KPN Telecom B.V., Koninklijke KPN N.V. ("KPN"), Joseph Nacchio, John McMaster, and other former employees or supervisory board members of us, KPNQwest or KPN. The lawsuit alleges that defendants misrepresented KPNQwest's financial and business condition in connection with the origination of a credit facility and wrongfully allowed KPNQwest to borrow funds under that facility. Plaintiffs allege damages of approximately €219 million (or approximately $290 million based on the exchange rate on March 31, 2009).
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On October 31, 2002, Richard and Marcia Grand, co-trustees of the R.M. Grand Revocable Living Trust, dated January 25, 1991, filed a lawsuit in Arizona Superior Court. As amended and following the appeal of a partial summary judgment against plaintiffs which was affirmed in part and reversed in part, plaintiffs allege, among other things, that defendants violated state securities laws in connection with plaintiffs' investments in KPNQwest securities. We are a defendant in this lawsuit along with Qwest B.V. (one of our subsidiaries), Joseph Nacchio and John McMaster. The Arizona Superior Court dismissed most of plaintiffs' claims, and plaintiffs voluntarily dismissed the remainder of their claims. Plaintiffs have appealed the court's decision to the Arizona Court of Appeals. Plaintiffs claim to have lost approximately $9 million in their investments in KPNQwest, and are also seeking interest and attorneys' fees.
On August 23, 2005, the Dutch Shareholders Association (Vereniging van Effectenbezitters, or VEB) filed a petition for inquiry with the Enterprise Chamber of the Amsterdam Court of Appeals, located in the Netherlands, with regard to KPNQwest. VEB sought an inquiry into the policies and course of business at KPNQwest that are alleged to have caused the bankruptcy of KPNQwest in May 2002, and an investigation into alleged mismanagement of KPNQwest by its executive management, supervisory board members, joint venture entities (us and KPN), and KPNQwest's outside auditors and accountants. On December 28, 2006, the Enterprise Chamber ordered an inquiry into the management and conduct of affairs of KPNQwest for the period January 1 through May 23, 2002. We and others have appealed that order to the Netherlands Supreme Court. On December 5, 2008, the Enterprise Chamber appointed investigators to conduct the inquiry.
We will continue to defend against the pending KPNQwest litigation matters vigorously.
Other Matters
Several putative class actions relating to the installation of fiber optic cable in certain rights-of-way were filed against us on behalf of landowners on various dates and in various courts in California, Colorado, Georgia, Illinois, Indiana, Kansas, Massachusetts, Mississippi, Missouri, Oregon, South Carolina, Tennessee and Texas. For the most part, the complaints challenge our right to install our fiber optic cable in railroad rights-of-way. Complaints in Colorado, Illinois and Texas, also challenge our right to install fiber optic cable in utility and pipeline rights-of-way. The complaints allege that the railroads, utilities and pipeline companies own the right-of-way as an easement that did not include the right to permit us to install our fiber optic cable in the right-of-way without the plaintiffs' consent. Most actions (California, Colorado, Georgia, Kansas, Mississippi, Missouri, Oregon, South Carolina, Tennessee and Texas) purport to be brought on behalf of state-wide classes in the named plaintiffs' respective states. The Massachusetts action purports to be on behalf of state-wide classes in all states in which Qwest has fiber optic cable in railroad rights-of-way (other than Louisiana and Tennessee), and also on behalf of two classes of landowners whose properties adjoin railroad rights-of-way originally derived from federal land grants. Several actions purport to be brought on behalf of multi-state classes. The Illinois state court action purports to be on behalf of landowners in Illinois, Iowa, Kentucky, Michigan, Minnesota, Nebraska, Ohio and Wisconsin. The Illinois federal court action purports to be on behalf of landowners in Arkansas, California, Florida, Illinois, Indiana, Missouri, Nevada, New Mexico, Montana and Oregon. The Indiana action purports to be on behalf of a national class of landowners adjacent to railroad rights-of-way over which our network passes. The complaints seek
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damages on theories of trespass and unjust enrichment, as well as punitive damages. On July 18, 2008, a federal district court in Massachusetts entered an order preliminarily approving a settlement of all of the actions described above, except the action pending in Tennessee. On November 18, 2008, the court held a hearing to consider final approval of the proposed settlement and the parties are awaiting the court's decision.
Qwest Communications Company, LLC ("QCC") is a defendant in litigation filed by several billing agents for the owners of payphones seeking compensation for coinless calls made from payphones. The matter is pending in the United States District Court for the District of Columbia. Generally, the payphone owners claim that QCC underpaid the amount of compensation due to them under Federal Communications Commission ("FCC") regulations for coinless calls placed from their phones onto QCC's network. The claim seeks compensation for calls, as well as interest and attorneys' fees. QCC will vigorously defend against this action.
A putative class action filed on behalf of certain of our retirees was brought against us, the Qwest Life Insurance Plan and other related entities in federal district court in Colorado in connection with our decision to reduce the life insurance benefit for these retirees to a $10,000 benefit. The action was filed on March 30, 2007. The plaintiffs allege, among other things, that we and other defendants were obligated to continue their life insurance benefit at the levels in place before we decided to reduce them. Plaintiffs seek restoration of the life insurance benefit to previous levels and certain equitable relief. The district court ruled in our favor on the central issue of whether we properly reserved our right to reduce the life insurance benefit under applicable law and plan documents. The plaintiffs subsequently amended their complaint to assert additional claims. The court has since dismissed or granted summary judgment to us on five of the eight claims asserted by plaintiffs. We believe the three remaining claims are without merit, and we have moved for summary judgment on those claims.
Note 13: Dividend
On April 15, 2009, our Board of Directors declared a quarterly dividend of $0.08 per share totaling approximately $138 million. The dividend is payable on June 12, 2009 to shareholders of record as of May 22, 2009.
Note 14: Financial Statements of Guarantors
QCII and two of its subsidiaries, Qwest Capital Funding, Inc. ("QCF") and Qwest Services Corporation ("QSC"), guarantee the payment of certain of each other's registered debt securities. As of March 31, 2009, QCII had outstanding a total of $1.825 billion aggregate principal amount of senior notes that were issued in February 2004 and June 2005 and that are guaranteed by QCF and QSC (the "QCII Guaranteed Notes"). These notes are guaranteed through their respective maturity dates, the latest of which is in February 2014. Each series of QCF's outstanding notes totaling $2.747 billion in aggregate principal amount is guaranteed on a senior unsecured basis by QCII (the "QCF Guaranteed Notes"). These notes are guaranteed through their respective maturity dates, the latest of which is in February 2031. The guarantees are full and unconditional and joint and several. A significant amount of QCII's and QSC's income and cash flow are generated by their subsidiaries. As a result, the funds
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Note 14: Financial Statements of Guarantors (Continued)
necessary to meet their debt service or guarantee obligations are provided in large part by distributions or advances from their subsidiaries.
The following information sets forth our condensed consolidating statements of operations for the three months ended March 31, 2009 and 2008, our condensed consolidating balance sheets as of March 31, 2009 and December 31, 2008, and our condensed consolidating statements of cash flows for the three months ended March 31, 2009 and 2008. The information for QCII is presented on a stand-alone basis, information for QSC and QCF is presented on a combined basis and information for all of our other subsidiaries is presented on a combined basis. Each entity's investments in its subsidiaries, if any, are presented under the equity method. The condensed consolidating statements of operations and balance sheets include the effects of consolidating adjustments to our subsidiaries' tax provisions and the related income tax assets and liabilities in the QSC and QCII results. Both QSC and QCF are 100% owned by QCII, and QCF is a finance subsidiary of QCII. Other than as already described in this note, the accounting principles used to determine the amounts reported in this note are the same as those used in our condensed consolidated financial statements.
The effects of our adoption of FSP APB 14-1, which relates to the accounting for convertible debt, are reflected in all columns except for the "Subsidiary Non-Guarantors" column in the financial statements below.
We periodically restructure our internal debt based on the needs of our business.
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QWEST COMMUNICATIONS INTERNATIONAL INC. CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS THREE MONTHS ENDED MARCH 31, 2009 (UNAUDITED)
Operating revenue:
Operating revenue—affiliates
Affiliates
Interest expense—net
Interest expense—affiliates
Interest income—affiliates
(Income) loss from equity investments in subsidiaries
Total other (income) expense—net
Income tax benefit (expense)
Net income (loss)
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QWEST COMMUNICATIONS INTERNATIONAL INC. CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS THREE MONTHS ENDED MARCH 31, 2008 (UNAUDITED)
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QWEST COMMUNICATIONS INTERNATIONAL INC. CONDENSED CONSOLIDATING BALANCE SHEETS MARCH 31, 2009 (UNAUDITED)
Accounts receivable—net
Accounts receivable—affiliates
Notes receivable—affiliates
Investments in subsidiaries
Prepaid pension and post-retirement and other post-employment benefits—net—affiliate
LIABILITIES AND STOCKHOLDERS' (DEFICIT) EQUITY
Current borrowings—affiliates
Accounts payable—affiliates
Accrued expenses and other—affiliates
Long-term borrowings—net
Pension and post-retirement and other post-employment benefits obligations—net
Pension and post-retirement and other post-employment benefits obligations and other—affiliate
Stockholders' (deficit) equity
Total liabilities and stockholders' (deficit) equity
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QWEST COMMUNICATIONS INTERNATIONAL INC. CONDENSED CONSOLIDATING BALANCE SHEETS DECEMBER 31, 2008 (UNAUDITED)
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QWEST COMMUNICATIONS INTERNATIONAL INC. CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS THREE MONTHS ENDED MARCH 31, 2009 (UNAUDITED)
Cash (used for) provided by operating activities
Changes in interest in investments managed by QSC
Net (increase) decrease in short-term affiliate loans
Dividends received from subsidiaries
Cash (used for) provided by investing activities
Net proceeds from (repayments of) short-term affiliate borrowings
Dividends paid to parent
Cash provided by (used for) financing activities
(Decrease) increase in cash and cash equivalents
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QWEST COMMUNICATIONS INTERNATIONAL INC. CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS THREE MONTHS ENDED MARCH 31, 2008 (UNAUDITED)
Cash infusion to subsidiaries
Cash provided by (used for) investing activities
Equity infusion from parent
Cash (used for) provided by financing activities
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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Certain statements in this report constitute forward-looking statements. See "Special Note Regarding Forward-Looking Statements" at the end of this Item 2 for additional factors relating to these statements, and see "Risk Factors" in Item 1A of Part II of this report for a discussion of certain risk factors applicable to our business, financial condition and results of operations.
Business Overview and Presentation
We provide data, Internet, video and voice services nationwide and globally. We generate the majority of our revenue from services provided in the 14-state region of Arizona, Colorado, Idaho, Iowa, Minnesota, Montana, Nebraska, New Mexico, North Dakota, Oregon, South Dakota, Utah, Washington and Wyoming. We refer to this region as our local service area.
Our analysis presented below is organized to provide the information we believe will be useful for understanding the relevant trends going forward. However, this discussion should be read in conjunction with our condensed consolidated financial statements and the notes thereto in Item 1 of Part I of this report.
Our operating revenue is generated from our business markets, mass markets and wholesale markets segments. Segment results presented in this Item 2 and in Note 11—Segment Information to our condensed consolidated financial statements in Item 1 of Part I of this report are not necessarily indicative of the results of operations these segments would have achieved had they operated as stand-alone entities during the periods presented. We have reclassified certain prior year revenue, expense and access lines amounts presented in our Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2008 to conform to the current period presentation and to the presentation for the full year 2008 results of operations included in our Annual Report on Form 10-K for the year ended December 31, 2008.
Business Trends
Our financial results were impacted by several significant trends, which are listed below. We expect that these trends will continue to affect our future results of operations, cash flows or financial position. Most of these trends also impact our segment results, and therefore we provide a detailed discussion of those trends under the heading "Segment Results" below. Because we do not allocate our pension and post-retirement benefit expenses to our segments, the related trend does not impact any of our segments. Instead, we provide a detailed discussion of this trend under the heading "Liquidity and Capital Resources—Long-Term View" below.
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While these trends are important to understanding and evaluating our financial results, the other transactions, events and trends discussed in "Risk Factors" in Item 1A of Part II of this report may also materially impact our business operations and financial results.
Results of Operations
Overview
The following table summarizes some of our key financial and operational measures for the three months ended March 31, 2009 and 2008:
Segment revenue
Voice Services
Operating expenses
Other expense (income)—net
Employees (as of March 31)
Total broadband subscribers
Total video subscribers
Total wireless subscribers
Total access lines
Operating Revenue
Operating revenue decreased due to continued access line losses, decreased long-distance volumes and fewer wireless subscribers as we transition to selling Verizon Wireless services. We recognize revenue from services provided under our Verizon Wireless arrangement on a net basis, whereas we recognize revenues from services provided under a pre-existing arrangement that we have with a different provider on a gross basis. The decrease in revenue was partially offset by increasing revenue associated with our data and Internet growth products and services which has outpaced the declining revenue from our traditional data, Internet and video services.
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Operating Expenses
The following table provides further detail regarding our total operating expenses for the three months ended March 31, 2009 and 2008:
Cost of sales (exclusive of depreciation and amortization):
Facility costs
Employee-related costs
Equipment sales costs
Total cost of sales
Selling:
Marketing, advertising and external commissions
Total selling
General, administrative and other operating:
Taxes and fees
Real estate and occupancy costs
Total general, administrative and other operating
Cost of Sales (exclusive of depreciation and amortization)
Facility costs decreased primarily due to improvements that we have made in the profitability structure for our wholesale long-distance service, which resulted in an improved wholesale long-distance margin percentage, and lower wholesale long-distance volumes and revenue. In addition, facility costs decreased due to the migration of our wireless customers to Verizon Wireless. As previously discussed, we record revenue net of expenses under our wireless services arrangement with Verizon Wireless. Lower sales of certain business markets data and Internet services, such as our traditional WAN services, also favorably impacted our facility costs; however, this decrease was more than offset by the increased facility costs associated with the growth in Qwest iQ Networking® revenue.
Employee-related costs decreased primarily due to workforce reductions and higher severance charges in the first quarter of 2008 as we continued to adjust our workforce to reflect our workload in our network operations.
Equipment sales costs decreased primarily due to our transition to selling Verizon Wireless products and services.
Selling Expenses
Employee-related costs remained flat as decreased costs due to 2008 workforce reductions were offset by approximately $20 million in severance charges recorded in the first quarter of 2009.
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Marketing, advertising and external commissions decreased primarily due to lower marketing and advertising costs to promote product bundling in our mass markets segment.
Other selling costs increased due to expenses for litigation related losses and adjustments made to our bad debt reserve.
General, Administrative and Other Operating Expenses
Employee-related costs increased primarily due to increased pension and post-retirement benefits expenses. These expenses are calculated annually based on several assumptions, including among other things, discount rates and expected rates of return on plan assets that are set at the beginning of each year. In 2008, we recognized combined net periodic income, as pension income exceeded post-retirement benefit expense for the year. However, during 2008 we experienced significant losses on our pension and post-retirement benefit plan assets, which have significantly impacted the pension and post-retirement benefits expenses we are recording in 2009.
We expect to recognize approximately $188 million in non-cash combined net periodic benefits expense for 2009 as compared to combined net periodic benefits income of $14 million for 2008. Changes to the assumptions at the end of 2009 may further increase or decrease our expected combined net periodic benefits expenses beyond 2009. For additional information on our pension and post-retirement benefit plans, see Note 8—Employee Benefits to our condensed consolidated financial statements in Item 1 of Part I of this report.
Taxes and fees decreased due to lower property and real estate taxes, lower gross receipts taxes related to our transition to selling Verizon Wireless products and services and a favorable rate change in USF fees.
Real estate and occupancy costs decreased primarily due to lower fuel costs, lower overall fuel use for fleet vehicles and lower rent expense.
The following table provides detail regarding depreciation and amortization expense:
Depreciation and amortization:
Depreciation
Amortization
Total depreciation and amortization
Depreciation expense decreased due to lower capital expenditures and the changing mix of our investment in property, plant and equipment since 2002. If our capital investment program remains approximately the same and we do not significantly shorten our estimates of the useful lives of our assets, we expect that our depreciation expense will continue to decrease for the foreseeable future. Amortization expense was higher for the three months ended March 31, 2009 compared to the three months ended March 31, 2008 due to the increase in internally developed capitalized software used to support our operations.
Effective January 1, 2009, we changed our estimates of the average remaining lives of certain copper cable and telecommunications equipment assets. These changes resulted in additional depreciation expense of approximately $10 million for the three months ended March 31, 2009 when
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compared to the three months ended March 31, 2008, and will result in additional depreciation expense of approximately $38 million for the year ending December 31, 2009 when compared to the year ended December 31, 2008.
We made a decision in June 2008 to discontinue certain product offerings and as a result we changed our estimates of the remaining economic lives of certain assets used in providing those services, which resulted in the acceleration of depreciation of those assets. This change also resulted in additional depreciation expense of approximately $10 million for the three months ended March 31, 2009 when compared to the three months ended March 31, 2008, and will result in additional depreciation expense of approximately $19 million for the full year ending December 31, 2009 when compared to the year ended December 31, 2008.
The additional depreciation for both of the changes described above, net of deferred taxes, reduced net income by approximately $12 million, or less than $0.01 per basic and diluted common share for the three months ended March 31, 2009 and will reduce net income by approximately $35 million, or approximately $0.02 per basic and diluted common share, for the year ending December 31, 2009.
Other Consolidated Results
The following table provides detail regarding other expense (income)—net and income tax expense:
nm—Percentages greater than 200% and comparisons between positive and negative values or to/from zero values are considered not meaningful.
Other Expense (Income)—Net
Interest expense on long-term borrowings and capital leases—net decreased due to declining debt levels as a result of maturities and early retirement of debt as well as decreasing rates on floating rate debt.
Other—net includes, among other things, interest income, income tax penalties, other interest expense (such as interest on income taxes), gains or losses related to fair value interest rate hedges and underlying debt and gains or losses on investments. The decrease in other—net was due to lower interest expense on income taxes resulting from the reversal of accrued interest related to uncertain tax positions.
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Income Tax Expense
The effective income tax rate is the provision for income taxes as a percentage of income before income taxes. Our effective income tax rate decreased to 31% for the three months ended March 31, 2009 from 39% for the same period in 2008 due to the reversal of reserves for uncertain tax positions.
Segment Results
The following table summarizes our segment results for the three months ended March 31, 2009 and 2008:
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Business Markets
The following table summarizes some of the key financial and operational measures for our business markets segment as of and for the three months ended March 31, 2009 and 2008:
Revenue:
Data and Internet services
Total revenue
Expenses:
Direct segment expenses
Assigned facility, network and other expenses
Total expenses
Access lines
The financial results for our business markets segment continue to be impacted by several significant trends, which are described below.
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our business markets customers in improving the effectiveness and efficiency of their operations. This gives us an opportunity to form stronger bonds with these customers.
Data and Internet services revenue increased primarily due to increased volumes in Qwest iQ Networking® and hosting services. The growth in Qwest iQ Networking® revenue outpaced the decreases in revenue from traditional WAN products. In addition, private line services revenue increased due to higher volumes, partially offset by lower rates. Data and Internet revenue growth offset voice services revenue declines in most of the business markets customer groups.
Voice services revenue decreased primarily due to lower local voice services revenue resulting from customer migration to data and Internet products and continued intense competition in the industry.
Expenses
Direct segment expenses increased due to increases in salaries, professional fees and other expenses.
Assigned facility, network and other expenses decreased primarily due to a decrease in network expenses.
Margin percentage expanded from 38% in the three months ended March 31, 2008 to 39% for the three months ended March 31, 2009 as we continued to execute on operating initiatives that improved our overall cost efficiency. As a result of our continued focus on higher margin products and managing costs, we were able to grow income by 6% and expand our margin percentage by 100 basis points.
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Mass Markets
The following table summarizes some of the key financial and operational measures for our mass markets segment as of and for the three months ended March 31, 2009 and 2008:
Wireless services
Broadband subscribers(1)
Video subscribers
Wireless subscribers(1)
The financial results for our mass markets segment continue to be impacted by several significant trends, which are described below.
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Data, Internet and video services revenue increased primarily due to an increase in broadband subscribers and, to a lesser extent, an increase in video subscribers as of March 31, 2009 compared to March 31, 2008. The increase in revenue due to additional broadband subscribers was partially offset by rate discounts.
Voice services revenue decreased primarily due to lower local voice services revenue, which was driven by access line losses resulting from the competitive pressures described above. In addition, long-distance voice services revenue decreased due to lower volumes and rates.
Wireless services revenue decreased as we transition to selling Verizon Wireless products and services, the revenue from which we record in voice services.
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Direct segment expenses decreased primarily due to lower equipment sales costs reflecting fewer handsets sold as we transition to our new wireless service arrangement, lower marketing and advertising costs and lower employee-related costs primarily due to workforce reductions in 2008.
Assigned facility, network and other expenses decreased primarily due to lower facility costs as we transition to selling Verizon Wireless products and services and lower network costs related to employee reductions in our network operations in 2008 as we continued to adjust our workforce to reflect our workload.
Expense reductions due to a reduced workforce, network cost efficiencies and our transition to selling Verizon Wireless products and services improved our margin percentage by 600 basis points to 55% when compared to the same period in 2008.
Wholesale Markets
The following table summarizes some of the key financial and operational measures for our wholesale markets segment as of and for the three months ended March 31, 2009 and 2008:
The financial results for our wholesale markets segment continue to be impacted by several significant trends, which are described below.
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network to offer their services. We expect these factors will continue to impact our wholesale markets segment for the remainder of 2009.
Data and Internet services revenue was flat primarily due to increased volumes in private line services, mostly offset by decreases in traditional WAN products and services driven by customer migration to more advanced technology services and industry consolidation.
Voice services revenue decreased primarily due to a 28% decline in long-distance services revenue due to lower volumes as we continued our focus on improving the profitability structure of this service and the impacts of industry consolidation. In addition, local voice services revenue decreased due to declining demand for UNEs and access services revenue decreased primarily due to a decline in volume for the three months ended March 31, 2009 compared to the same period in 2008.
Direct segment expenses increased due to higher bad debt expense as compared to the three months ended March 31, 2008.
Assigned facility, network and other expenses decreased primarily due to lower facility costs, largely resulting from the long-distance volume decline noted above, coupled with lower long-distance rates. The long-distance volume declines driving the lower facilities expenses were a direct result of the improvements to our profitability structure we executed in the last half of 2008.
Driven by profitability structure improvements relating to our long-distance services, our margin percentage increased 600 basis points and we held our income to a 2% reduction. We continue to experience income pressure as a result of decreased access and local voice services and the continued shift to data and Internet products and services. Price compression on data and Internet services continues to impact our income and the industry in general; however, as we execute on our operating initiatives (thereby improving our overall cost efficiency), we expect income to stabilize.
Liquidity and Capital Resources
Near-Term View
At March 31, 2009, we held cash and cash equivalents totaling $541 million, and we have $910 million available under our currently undrawn revolving credit facility (referred to as the Credit Facility). We expect that our cash on hand and expected net cash generated by operating activities will exceed our cash needs over the next 12 months.
During the 12 months ended March 31, 2009, our net cash generated by operating activities totaled $3.200 billion. Although our revenue has been decreasing, we believe that we will be able to continue to control costs to keep them aligned with revenue and therefore expect that we will continue to generate cash from operating activities sufficient to fund our financing and investing activities. For the coming 12 months, our expected financing and investing cash needs include capital expenditures (anticipated to be approximately $1.8 billion or less in 2009), $562 million of debt maturing in August 2009 and quarterly dividends on our common stock of approximately $140 million per quarter.
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We have significant discretion in how we use our cash to pay for capital expenditures and for other costs of our business, as only a moderate portion of our capital expenditures is dedicated to preservation activities or government mandates. We evaluate capital expenditure projects based on expected strategic impacts (such as forecasted revenue growth or productivity, expense and service impacts) and our expected return on investment. If we are not successful in maintaining or increasing our net cash generated by operating activities in the near term, we expect that we would use this discretion to decrease our capital expenditures, which may impact future years' operating results and cash flows.
At March 31, 2009, our current liabilities exceeded our current assets by $344 million. This working capital deficit decreased as compared to our working capital deficit at December 31, 2008 due to earnings before depreciation and amortization partially offset by capital expenditures.
We continue to look for opportunities to improve our capital structure by reducing debt and interest expense. We expect that at any time we deem conditions favorable we will also attempt to improve our liquidity position by accessing debt or other markets in a manner designed to create positive economic value. In April 2009, our QC subsidiary completed a debt offering for net proceeds of $738 million. Due to recent turmoil in the credit markets and the continued decline in the economy, our ability to refinance maturing debt at terms that are as favorable as those from which we previously benefited or at terms that are acceptable to us may be impaired.
As of March 31, 2009, we also had $193 million in stock repurchases remaining under the $2 billion stock repurchase program that our Board of Directors authorized in October 2006. In light of current credit market conditions, the Board of Directors has extended the timeframe to complete these repurchases, which were originally scheduled to be completed in 2008. We have not repurchased any stock under this program in 2009.
Long-Term View
We believe that cash provided by operations and our currently undrawn Credit Facility, combined with our current cash position and the likelihood that we will continue to have access to capital markets to refinance our debt as it matures, should allow us to meet our cash requirements for the foreseeable future. Our general policy is to refinance debt maturities of our QC subsidiary and to not refinance all other debt maturities except for our convertible debt.
Debt
We have a significant amount of debt maturing in the next several years, including $2.168 billion maturing in 2010, $2.151 billion maturing in 2011 and $1.500 billion maturing in 2012. The $2.168 billion maturing in 2010 includes $1.265 billion of 3.50% Convertible Senior Notes discussed below. In general, we expect that we will refinance this convertible debt and debt issued by our QC subsidiary (including $500 million maturing in 2010, $825 million maturing in 2011 and $1.500 billion maturing in 2012); we intend to pay all other maturing debt with cash generated by operating activities.
In addition, although our 3.50% Convertible Senior Notes have a stated maturity of 2025, we treat these notes as maturing in November 2010 because they contain put and call provisions that first apply in November 2010. As such, we are preparing for the possibility that we will need $1.265 billion of cash in November 2010 to repurchase these notes. Our preparations may include borrowing additional amounts in anticipation of these repurchases. Even if we are not required to repurchase these notes in November 2010, we may still choose to call the notes at that time. You can find additional information about these notes in Note 5—Borrowings to our condensed consolidated financial statements in Item 1 of Part I of this report.
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We believe that we will continue to have access to capital markets to refinance our debt as discussed above. However, as demonstrated by recent turmoil in the credit markets, our ability to refinance maturing debt at terms that are as favorable as those from which we previously benefited or at terms that are acceptable to us may be impaired.
The Credit Facility makes available to us $910 million of additional credit subject to certain restrictions as described below, is currently undrawn and expires in October 2010. The Credit Facility has 13 lenders with commitments ranging from $15 million to $160 million. This facility has a cross payment default provision, and this facility and certain other debt issues also have cross acceleration provisions. When present, these provisions could have a wider impact on liquidity than might otherwise arise from a default or acceleration of a single debt instrument. These provisions generally provide that a cross default under these debt instruments could occur if:
Upon a cross default, the creditors of a material amount of our debt may elect to declare that a default has occurred under their debt instruments and to accelerate the principal amounts due to those creditors. Cross acceleration provisions are similar to cross default provisions, but permit a default in a second debt instrument to be declared only if in addition to a default occurring under the first debt instrument, the indebtedness due under the first debt instrument is actually accelerated.
The Credit Facility also contains various limitations, including a restriction on using any proceeds from the facility to pay settlements or judgments relating to the securities-related actions discussed in Note 12—Commitments and Contingencies to our condensed consolidated financial statements in Item 1 of Part I of this report. In addition, to the extent that our earnings before interest, taxes, depreciation and amortization, or EBITDA (as defined in our debt covenants), is reduced by cash settlements or judgments relating to the matters discussed in that note, our debt to consolidated EBITDA ratios under certain debt agreements will be adversely affected. This could reduce our liquidity and flexibility due to potential restrictions on drawing on our Credit Facility and potential restrictions on incurring additional debt under certain provisions of our debt agreements.
We may also need to obtain additional financing or investigate other methods to generate cash (such as further cost reductions or the sale of assets) if:
Pension Plan
Benefits paid by our pension plan are paid through a trust. This pension plan is measured annually at December 31. The accounting unfunded status of our pension plan was $745 million at
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December 31, 2008. Cash funding requirements are significantly impacted by earnings on investments, the applicable discount rate at the end of each year and funding laws and regulations. As a result, it is difficult to determine future funding requirements with a high level of precision. Based on elections we will make in 2010 relating to, among other things, the method of determining discount rates, and subject to any changes in funding laws and regulations, we may be required to make cash contributions to the plan in the range of $0 to $300 million. If the elections that we make do not require a contribution in 2010, it is highly likely that a contribution will be required in 2011. The amount of any required contribution in 2011 will be dependant upon earnings on investments, discount rates and funding laws and regulations. If a contribution is made in 2010, it may reduce required contributions after 2010.
Post-Retirement Benefits
Certain of our post-retirement health care and life insurance benefits plans are unfunded. However, a trust has been established to help cover the health care costs of retirees who are former occupational employees. As of December 31, 2008, the fair value of the trust assets was $915 million and we believed that the trust assets would be adequate to provide continuing reimbursements for our occupational post-retirement health care costs for approximately five years assuming that the trust's current asset allocation remains the same and the assets earn an expected long-term rate of return of 8.5%. Thereafter, covered benefits for our eligible retirees who are former occupational employees will be paid directly by us. This five year period could be substantially shorter depending on returns on plan assets, projected benefit payments and future changes in benefit obligations; for instance, if we assume that the rate of return on trust assets is zero and benefit reimbursements remain at projected levels the trust would still be exhausted in approximately five years, but if we assume that the rate of return on trust assets were zero and benefit reimbursements increase by 20%, the trust assets could be exhausted in three years.
Income Tax Payments
During the past three years, our income tax payments have predominantly related to prior years' income tax issues; in 2008 and 2006, we made payments (including penalties and interest) of $102 million and $130 million, respectively, related to prior years' federal income tax issues. In 2007, we paid immaterial amounts for income taxes.
We currently make some payments for income taxes; however, in most jurisdictions where we are subject to income tax those taxes are largely eliminated because we have significant net operating loss carryforwards ("NOLs"). As of December 31, 2008, we had NOLs of $6.2 billion and we expect to fully use these NOLs as an offset against future taxable income. We do not expect to pay a significant amount of income taxes until all of these NOLs have been used; however, the timing of that use will depend upon future earnings and upon our future tax circumstances. We currently expect to be able to use the NOLs to reduce tax payments for several years.
Once our NOLs are fully utilized, we expect to make significant income tax payments. The amounts of those payments will also depend upon future earnings and upon our future tax circumstances and cannot be accurately estimated at this time.
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Historical View
The following table summarizes cash flow activities for the three months ended March 31, 2009 and 2008:
Cash flows:
Provided by operating activities
Used for investing activities
Used for financing activities
Operating Activities
Cash provided by operating activities increased primarily due to payments for securities-related legal matters in 2008, lower long-distance services volumes, and lower wireless volumes and equipment costs as we transition to selling Verizon Wireless products and services.
Investing Activities
Cash used for investing activities decreased primarily due to lower capital expenditures.
Financing Activities
In the first quarter of 2009, we paid $137 million in dividends and $239 million in repayments of our long-term borrowings, including current maturities. In the first quarter of 2008, we paid $142 million in dividends and $169 million for purchases of our common stock under our stock repurchase program.
Letters of Credit
We maintain letter of credit arrangements with various financial institutions for up to $125 million. As of March 31, 2009, we had outstanding letters of credit of approximately $81 million.
Risk Management
We are exposed to market risks arising from changes in interest rates. The objective of our interest rate risk management program is to manage the level and volatility of our interest expense. We currently use derivative financial instruments to manage our interest rate risk exposure and we may continue to employ them in the future.
Near-Term Maturities
As of March 31, 2009, we had approximately $562 million of long-term notes maturing in the subsequent 12 months. Although we do not currently intend to refinance any of this maturing debt as it comes due, we would be exposed to changes in interest rates at any time that we choose to refinance any of this debt. A hypothetical increase of 100 basis points in the interest rate on a refinancing of the entire current portion of long-term notes would decrease quarterly pre-tax earnings by approximately $1 million.
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Floating-Rate Debt
One objective of our short-term debt strategy is to take advantage of favorable interest rates by effectively converting floating rate debt to fixed rate debt using interest rate swaps. As of March 31, 2009 and December 31, 2008, we had $750 million and $980 million of floating-rate debt outstanding, of which $250 million and $480 million, respectively, was exposed to changes in interest rates. This exposure is linked to the London Interbank Offered Rate, or LIBOR. A hypothetical increase of 100 basis points in LIBOR relative to the $250 million of floating-rate debt that is exposed to changes in interest rates would decrease quarterly pre-tax earnings by less than $1 million.
Convertible Debt
Under the terms of our 3.50% Convertible Senior Notes, upon conversion at a time at which the market-based conversion provisions described in "Long-Term View" are satisfied, we must pay the converting holders cash equal to at least the par value of the 3.50% Convertible Senior Notes. As of March 31, 2009, $1.265 billion of these notes were outstanding. While these notes were not convertible as of March 31, 2009 because specified, market-based conversion provisions were not met as of that date, these notes would be available for immediate conversion if those provisions are met during certain subsequent periods. In addition, even if these provisions are not met, holders have the option to require us to repurchase the notes for cash every five years on November 15, beginning in 2010, and receive cash from us equal to the par value of the notes. We would also be exposed to changes in interest rates at any time that we choose to refinance any portion of this debt. A hypothetical increase of 100 basis points in the interest rate on the refinancing of the entire $1.265 billion would decrease quarterly pre-tax earnings by approximately $3 million. See "Long-Term View" above for additional information about the conversion provisions relating to these notes.
Investments
As of March 31, 2009, we had $464 million invested in highly liquid cash-equivalent instruments, $86 million invested in auction rate securities and $14 million in an investment fund. As interest rates change, so will the interest income derived from these instruments. Assuming that these investment balances were to remain constant, a hypothetical decrease of 100 basis points in interest rates would decrease quarterly pre-tax earnings by approximately $1 million.
Combined Impacts
The table below summarizes our consolidated interest expense on long-term borrowings and capital leases and consolidated other income for the three months ended March 31, 2009 and provides a sensitivity analysis of these expense and income items, as well as net income, assuming 100-basis-point upward and downward shifts in market interest rates over the entire year. This sensitivity analysis reflects only the impact from the borrowings and investments that were outstanding and hedges that were in effect as of March 31, 2009. It does not reflect the impact of long-term notes maturing in the subsequent 12 months or convertible borrowings because they would not have been affected by changes in market interest rates during the periods presented.
Three months ended March 31, 2009:
Other income—net
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Off-Balance Sheet Arrangements
We have no special purpose or limited purpose entities that provide off-balance sheet financing, liquidity, or market or credit risk support, and we do not engage in leasing, hedging, research and development services or other relationships that expose us to any significant liabilities that are not reflected on the face of the condensed consolidated financial statements. There were no substantial changes to our off-balance sheet arrangements or contractual commitments in the three months ended March 31, 2009, when compared to the disclosures provided in our Annual Report on Form 10-K for the year ended December 31, 2008.
Website Access and Important Investor Information
Our website address is www.qwest.com, and we routinely post important investor information in the "Investor Relations" section of our website at www.qwest.com/about/investor. The information contained on, or that may be accessed through, our website is not part of this report.
Special Note Regarding Forward-Looking Statements
This Form 10-Q contains or incorporates by reference forward-looking statements about our financial condition, operating results and business. These statements include, among others:
These statements may be made expressly in this document or may be incorporated by reference to other documents we have filed or will file with the Securities and Exchange Commission, or SEC. You can find many of these statements by looking for words such as "may," "would," "could," "should," "plan," "believes," "expects," "anticipates," "estimates," or similar expressions used in this document or in documents incorporated by reference in this document.
These forward-looking statements are subject to numerous assumptions, risks and uncertainties that may cause our actual results to be materially different from any future results expressed or implied by us in those statements. Some of these risks are described in Item 1A of Part II of this report.
These risk factors should be considered in connection with any written or oral forward-looking statements that we or persons acting on our behalf may issue. Given these uncertainties, we caution investors not to unduly rely on our forward-looking statements. We do not undertake any obligation to review or confirm analysts' expectations or estimates or to release publicly any revisions to any forward-looking statements to reflect events or circumstances after the date of this document or to reflect the occurrence of unanticipated events. Further, the information about our intentions contained in this document is a statement of our intentions as of the date of this document and is based upon, among other things, the existing regulatory environment, industry conditions, market conditions and prices, the economy in general and our assumptions as of such date. We may change our intentions, at any time and without notice, based upon any changes in such factors, in our assumptions or otherwise.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The information under the heading "Risk Management" in Item 2 of Part I of this report is incorporated herein by reference.
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ITEM 4. CONTROLS AND PROCEDURES
The effectiveness of our or any system of disclosure controls and procedures is subject to certain limitations, including the exercise of judgment in designing, implementing and evaluating the controls and procedures, the assumptions used in identifying the likelihood of future events and the inability to eliminate misconduct completely. As a result, there can be no assurance that our disclosure controls and procedures will detect all errors or fraud. By their nature, our or any system of disclosure controls and procedures can provide only reasonable assurance regarding management's control objectives.
Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we evaluated the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, or the "Exchange Act") as of March 31, 2009. On the basis of this review, our management, including our Chief Executive Officer and Chief Financial Officer, concluded that our disclosure controls and procedures are designed, and are effective, to give reasonable assurance that the information required to be disclosed by us in reports that we file under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC and to ensure that information required to be disclosed in the reports filed or submitted under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, in a manner that allows timely decisions regarding required disclosure.
There were no changes in our internal control over financial reporting that occurred in the first quarter of 2009 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
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ITEM 1. LEGAL PROCEEDINGS
The information contained in Note 12—Commitments and Contingencies to our condensed consolidated financial statements in Item 1 of Part I of this report is incorporated herein by reference.
ITEM 1A. RISK FACTORS
Risks Affecting Our Business
Increasing competition, including product substitution, continues to cause access line losses, which has adversely affected and could continue to adversely affect our operating results and financial condition.
We compete in a rapidly evolving and highly competitive market, and we expect competition to continue to intensify. We are facing greater competition from cable companies, wireless providers, resellers and sales agents (including ourselves) and facilities-based providers using their own networks as well as those leasing parts of our network. In addition, regulatory developments over the past several years have generally increased competitive pressures on our business. Due to some of these and other factors, we continue to lose access lines.
We are continually evaluating our responses to these competitive pressures. Some of our more recent responses are product bundling and packaging and our continuing focus on customer service. However, we may not be successful in these efforts. We may not be able to distinguish our service levels from those of our competitors, and we may not be successful in integrating our product offerings, especially products for which we act as a reseller or sales agent, such as wireless services and video services. If these initiatives are unsuccessful or insufficient, we are otherwise unable to sufficiently stem or offset our continuing access line losses and our revenue declines significantly without corresponding cost reductions, this would adversely affect our operating results and financial condition, as well as our ability to service debt, pay other obligations and enhance shareholder returns.
Unfavorable general economic conditions in the United States could negatively impact our operating results and financial condition.
Unfavorable general economic conditions, including the current recession in the United States and the recent financial crisis affecting the banking system and financial markets, could negatively affect our business. While it is often difficult for us to predict the impact of general economic conditions on our business, these conditions could adversely affect the affordability of and consumer demand for some of our products and services and could cause customers to shift to lower priced products and services or to delay or forgo purchases of our products and services. One or more of these circumstances could cause our revenue to decline. Also, our customers may not be able to obtain adequate access to credit, which could affect their ability to make timely payments to us. If that were to occur, we could be required to increase our allowance for doubtful accounts, and the number of days outstanding for our accounts receivable could increase. In addition, as discussed below under the heading "Risks Affecting our Liquidity," due to recent turmoil in the credit markets and the continued decline in the economy, we may not be able to refinance maturing debt at terms that are as favorable as those from which we previously benefited, at terms that are acceptable to us or at all. For these reasons, among others, if the current economic conditions persist or decline, this could adversely affect our operating results and financial condition, as well as our ability to service debt, pay other obligations and enhance shareholder returns.
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Consolidation among participants in the telecommunications industry may allow our competitors to compete more effectively against us, which could adversely affect our operating results and financial condition.
The telecommunications industry has experienced some consolidation, and several of our competitors have consolidated with other telecommunications providers. This consolidation results in competitors that are larger and better financed and affords our competitors increased resources and greater geographical reach, thereby enabling those competitors to compete more effectively against us. We have experienced and expect further increased pressures as a result of this consolidation and in turn have been and may continue to be forced to respond with lower profit margin product offerings and pricing plans in an effort to retain and attract customers. These pressures could adversely affect our operating results and financial condition, as well as our ability to service debt, pay other obligations and enhance shareholder returns.
Rapid changes in technology and markets could require substantial expenditure of financial and other resources in excess of contemplated levels, and any inability to respond to those changes could reduce our market share and adversely affect our operating results and financial condition.
The telecommunications industry is experiencing significant technological changes, and our ability to execute our business plans and compete depends upon our ability to develop and deploy new products and services, such as broadband, wireless, video and VoIP services. The development and deployment of new products and services could also require substantial expenditure of financial and other resources in excess of contemplated levels. If we are not able to develop new products and services to keep pace with technological advances, or if those products and services are not widely accepted by customers, our ability to compete could be adversely affected and our market share could decline. Any inability to keep up with changes in technology and markets could also adversely affect our operating results and financial condition, as well as our ability to service debt, pay other obligations and enhance shareholder returns.
Our reseller and sales agency arrangements expose us to a number of risks, one or more of which may adversely affect our business and operating results.
We rely on reseller and sales agency arrangements with other companies to provide some of the services that we sell to our customers, including video services and wireless products and services. If we fail to extend or renegotiate these arrangements as they expire from time to time or if these other companies fail to fulfill their contractual obligations to us or our customers, we may have difficulty finding alternative arrangements and our customers may experience disruptions to their services. In addition, as a reseller or sales agent, we do not control the availability, retail price, design, function, quality, reliability, customer service or branding of these products and services, nor do we directly control all of the marketing and promotion of these products and services. To the extent that these other companies make decisions that negatively impact our ability to market and sell their products and services, our business plans and goals and our reputation could be negatively impacted. If these reseller and sales agency arrangements are unsuccessful due to one or more of these risks, our business and operating results may be adversely affected.
Third parties may claim we infringe upon their intellectual property rights, and defending against these claims could adversely affect our profit margins and our ability to conduct business.
From time to time, we receive notices from third parties or are named in lawsuits filed by third parties claiming we have infringed or are infringing upon their intellectual property rights. We may receive similar notices or be involved in similar lawsuits in the future. Responding to these claims may require us to expend significant time and money defending our use of affected technology, may require us to enter into licensing agreements requiring royalty payments that we would not otherwise have to pay or may require us to pay damages. If we are required to take one or more of these actions, our
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profit margins may decline. In addition, in responding to these claims, we may be required to stop selling or redesign one or more of our products or services, which could significantly and adversely affect the way we conduct business.
Risks Relating to Legal and Regulatory Matters
Any adverse outcome of the securities-related matters pending against us, including the KPNQwest litigation, could have a material adverse impact on our financial condition and operating results, on the trading price of our debt and equity securities and on our ability to access the capital markets.
As described in Note 12—Commitments and Contingencies to our condensed consolidated financial statements in Item 1 of Part I of this report, the securities-related matters, including the KPNQwest matters, present material and significant risks to us. In the aggregate, the plaintiffs in the KPNQwest matters seek billions of dollars in damages. In addition, the outcome of one or more of these matters could have a negative impact on the outcomes of the other matters. We continue to defend against these matters vigorously and are currently unable to provide any estimate as to the timing of their resolution. In addition, the ultimate resolution of the objections by Messrs. Nacchio and Woodruff to the decision approving the Qwest settlement of the consolidated securities action is uncertain and could result in the payment of additional monies by us in connection with indemnification claims by Messrs. Nacchio and Woodruff if the proposed settlement of the claims of the putative class against Messrs. Nacchio and Woodruff is not implemented.
We can give no assurance as to the impacts on our financial results or financial condition that may ultimately result from these matters. The ultimate outcomes of these matters are still uncertain, and substantial settlements or judgments in these matters could have a significant impact on us. The magnitude of such settlements or judgments resulting from these matters could materially and adversely affect our financial condition and ability to meet our debt obligations, potentially impacting our credit ratings, our ability to access capital markets and our compliance with debt covenants. In addition, the magnitude of any such settlements or judgments may cause us to draw down significantly on our cash balances, which might force us to obtain additional financing or explore other methods to generate cash. Such methods could include issuing additional securities or selling assets.
Further, there are other material proceedings pending against us as described in Note 12—Commitments and Contingencies to our condensed consolidated financial statements in Item 1 of Part I of this report that, depending on their outcome, may have a material adverse effect on our financial position. Thus, we can give no assurances as to the impacts on our operating results or financial condition as a result of these matters.
We operate in a highly regulated industry and are therefore exposed to restrictions on our manner of doing business and a variety of claims relating to such regulation.
We are subject to significant state and federal regulation. Interstate communications (including international communications that originate or terminate in the U.S.) are regulated by the Federal Communications Commission, or FCC, pursuant to the Communications Act of 1934, as amended by the Telecommunications Act of 1996, and other laws. Intrastate communications are regulated by state utilities commissions pursuant to state utility laws. Generally, we must obtain and maintain certificates of authority from the FCC and regulatory bodies in most states where we offer regulated services and must obtain prior regulatory approval of rates, terms and conditions for regulated services, where required. We are subject to numerous, and often quite detailed, requirements under federal, state and local laws, rules and regulations. Accordingly, we cannot ensure that we are always in compliance with all these requirements at any single point in time. The agencies responsible for the enforcement of these laws, rules and regulations may initiate inquiries or actions based on customer complaints or on their own initiative.
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Regulation of the telecommunications industry is changing rapidly, and the regulatory environment varies substantially from state to state. A number of state legislatures and state utility commissions have adopted reduced or modified forms of regulation for retail services. These changes also generally allow more flexibility for rate changes and for new product introduction, and they enhance our ability to respond to competition. At the same time, some of the changes at both the state and federal level may have the potential effect of reducing some regulatory protections, including having FCC-approved tariffs that include rates, terms and conditions. Despite these regulatory changes, a substantial portion of our local voice services revenue remains subject to FCC and state utility commission pricing regulation, which could expose us to unanticipated price declines. For instance, in 2009 the state utility commissions in Arizona, New Mexico and Minnesota will be considering whether to renew the price cap plans that govern the rates that we charge in each of these states. The FCC is also considering changing the rates that carriers can charge each other for originating, carrying and terminating traffic and for local access facilities. Also under review by the FCC and state commissions are the intercarrier compensation issues arising from the delivery of traffic destined for entities that offer conference and chat line services for free (known in the industry as "access stimulation," or "traffic pumping"), and of traffic bound for Internet service providers that cross local exchange boundaries (known as "VNXX traffic"). There can be no assurance that future regulatory, judicial or legislative activities will not have a material adverse effect on our operations, or that regulators or third parties will not raise material issues with regard to our compliance or noncompliance with applicable regulations.
All of our operations are also subject to a variety of environmental, safety, health and other governmental regulations. We monitor our compliance with federal, state and local regulations governing the management, discharge and disposal of hazardous and environmentally sensitive materials. Although we believe that we are in compliance with these regulations, our management, discharge or disposal of hazardous and environmentally sensitive materials might expose us to claims or actions that could have a material adverse effect on our business, financial condition and operating results.
Risks Affecting Our Liquidity
Our high debt levels pose risks to our viability and may make us more vulnerable to adverse economic and competitive conditions, as well as other adverse developments.
We continue to carry significant debt. As of March 31, 2009, our consolidated debt was approximately $13.3 billion. Approximately $6.4 billion of our debt obligations comes due over the next three years. This amount includes $1.265 billion of our 3.50% Convertible Senior Notes due 2025 (referred to as our 3.50% Convertible Senior Notes), which we may elect to redeem at any time on or after November 20, 2010 and holders may require us to repurchase for cash on November 15, 2010. In addition, holders of these 3.50% Convertible Senior Notes may also elect to convert the principal of their notes into cash during periods when specified, market-based conversion requirements are met. While we currently believe we will have the financial resources to meet our obligations when they come due, we cannot fully anticipate the future condition of our company, the credit markets or the economy generally. We may have unexpected costs and liabilities, and we may have limited access to financing. In addition, we have $193 million of potential stock repurchases remaining under our previously disclosed stock repurchase program, and it is the current expectation of our Board of Directors that we will continue to pay a quarterly cash dividend. Cash used by us to purchase our common stock or to pay dividends will not be available for other purposes, including the repayment of debt.
We may periodically need to obtain financing in order to meet our debt obligations as they come due. Due to recent turmoil in the credit markets and the continued decline in the economy, we may not be able to refinance maturing debt at terms that are as favorable as those from which we previously benefited, at terms that are acceptable to us or at all. We may also need to obtain additional financing or investigate other methods to generate cash (such as further cost reductions or the sale of assets) if
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revenue and cash provided by operations decline, if economic conditions continue to weaken, if competitive pressures increase, if holders of the 3.50% Convertible Senior Notes elect to convert their notes because market-based conversion provisions are met or require us to repurchase their notes for cash on November 15, 2010, if we are required to contribute a material amount of cash to our pension or other post-retirement benefit plans or if we become subject to significant judgments or settlements in one or more of the matters discussed in Note 12—Commitments and Contingencies to our condensed consolidated financial statements in Item 1 of Part I of this report. We can give no assurance that this additional financing will be available on terms that are acceptable to us or at all. Also, we may be impacted by factors relating to or affecting our liquidity and capital resources due to perception in the market, impacts on our credit ratings or provisions in our financing agreements that may restrict our flexibility under certain conditions.
Our $910 million revolving credit facility (referred to as the Credit Facility), which is currently undrawn, has a cross payment default provision, and the Credit Facility and certain of our other debt issues have cross acceleration provisions. When present, these provisions could have a wider impact on liquidity than might otherwise arise from a default or acceleration of a single debt instrument. Any such event could adversely affect our ability to conduct business or access the capital markets and could adversely impact our credit ratings. In addition, the Credit Facility contains various limitations, including a restriction on using any proceeds from the facility to pay settlements or judgments relating to the securities-related actions discussed in Note 12—Commitments and Contingencies to our condensed consolidated financial statements in Item 1 of Part I of this report.
Our high debt levels could adversely impact our credit ratings. Additionally, the degree to which we are leveraged may have other important limiting consequences, including the following:
We may be unable to significantly reduce the substantial capital requirements or operating expenses necessary to continue to operate our business, which may in turn affect our operating results.
The industry in which we operate is capital intensive, and we anticipate that our capital requirements will continue to be significant in the coming years. Although we have reduced our operating expenses over the past few years, we may be unable to further significantly reduce these costs, even if revenue in some areas of our business is decreasing. While we believe that our planned level of capital expenditures will meet both our maintenance and our core growth requirements going forward, this may not be the case if circumstances underlying our expectations change.
Adverse changes in the value of assets or obligations associated with our employee benefit plans could negatively impact our liquidity and stockholders' equity balance.
We maintain a qualified pension plan, a non-qualified pension plan and post-retirement benefit plans. The funded status of these plans is the difference between the value of all plan assets and benefit obligations under these plans. The process of calculating benefit obligations is complex. Adverse changes in interest rates or market conditions, among other assumptions and factors, could cause a significant increase in our benefit obligations or a significant decrease in the value of plan assets. With respect to our qualified pension plan, adverse changes could require us to contribute a material amount
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of cash to the plan or could accelerate the timing of any required cash payments. We may be required to make cash contributions to this plan as early as 2010. Future material cash contributions, if any, could have a negative impact on our liquidity by reducing our cash flows.
In addition, our condensed consolidated balance sheets indirectly reflect the value of all plan assets and benefit obligations under these plans. The accounting for employee benefit plans is complex, and significant increases in our benefit obligations or significant decreases of the value of plan assets can occur without necessarily impacting our net income in the short term. In addition, our benefit obligations could increase significantly if we need to unfavorably revise the assumptions we used to calculate the obligations. The value of plan assets was several times larger than our stockholders' equity as of December 31, 2007. However, asset values decreased significantly in 2008, which caused our previous stockholders' equity position to become a deficit position as of December 31, 2008. Stockholders' equity or deficit is one of several measures used by certain customers and vendors, among others, to evaluate a company's financial condition. As such, our current stockholders' deficit position or any future increases in our stockholders' deficit could adversely impact our competitiveness in obtaining favorable purchase arrangements and make it more challenging to compete for certain sales contracts, among other things.
Our debt agreements allow us to incur significantly more debt, which could exacerbate the other risks described in this report.
The terms of our debt instruments permit us to incur additional indebtedness. Additional debt may be necessary for many reasons, including to adequately respond to competition, to comply with regulatory requirements related to our service obligations or for financial reasons alone. Incremental borrowings or borrowings at maturity on terms that impose additional financial risks to our various efforts to improve our operating results and financial condition could exacerbate the other risks described in this report.
If we pursue and are involved in any strategic transactions, our financial condition could be adversely affected.
On a regular and ongoing basis, we review and evaluate opportunities for acquisitions, dispositions and other strategic transactions that could be beneficial. As a result, we may be involved in negotiations or discussions that, if they were to result in a transaction, could have a material effect on our financial condition (including short-term or long-term liquidity) or short-term or long-term operating results.
Should we make an error in judgment when identifying strategic transaction partners or fail to successfully execute any strategic transaction, we will likely fail to realize the benefits we intended to derive from the strategic transaction and may suffer other adverse consequences. Strategic transactions may involve a number of other risks, including:
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We can give no assurance that we would be able to successfully complete any strategic transactions.
Other Risks Relating to Qwest
If conditions or assumptions differ from the judgments, assumptions or estimates used in our critical accounting policies, the accuracy of our financial statements and related disclosures could be affected.
The preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles requires management to make judgments, assumptions and estimates that affect the amounts reported in our consolidated financial statements and accompanying notes. Our critical accounting policies, which are described in our Annual Report on Form 10-K for the year ended December 31, 2008, describe those significant accounting policies and methods used in the preparation of our consolidated financial statements that are considered "critical" because they require judgments, assumptions and estimates that materially impact our consolidated financial statements and related disclosures. As a result, if future events or assumptions differ significantly from the judgments, assumptions and estimates in our critical accounting policies, these events or assumptions could have a material impact on our consolidated financial statements and related disclosures.
Taxing authorities may determine we owe additional taxes relating to various matters, which could adversely affect our financial results.
As a significant taxpayer, we are subject to frequent and regular audits by the Internal Revenue Service, or IRS, as well as state and local tax authorities. These audits could subject us to tax liabilities if adverse positions are taken by these tax authorities. In June 2006, we received notices of proposed adjustments on several significant issues for the 2002 through 2003 audit cycle, including a proposed adjustment disallowing a loss relating to the sale of our DEX directory publishing business. We have reached tentative settlements with the IRS on several of these issues, including the DEX sale. These settlements have been approved by the IRS and are now subject to review by the United States Congress Joint Committee on Taxation. There is no assurance that these settlements will ultimately be effected in accordance with our expectations.
In April 2008, we received from the IRS proposed adjustments on several issues for the 2004 and 2005 audit cycle. Based on our evaluation of the IRS's positions reflected in the proposed adjustments, we have not recorded a material adjustment of our unrecognized tax benefits. However, there can be no assurance that we and the IRS will reach settlements on any of these issues or that, if we do reach settlements, the terms will be favorable to us.
Because prior to 1999 we were a member of affiliated groups filing consolidated U.S. federal income tax returns, we could be severally liable for tax examinations and adjustments not directly applicable to current members of the Qwest affiliated group. Tax sharing agreements have been executed between us and previous affiliates, and we believe the liabilities, if any, arising from adjustments to previously filed returns would be borne by the affiliated group member determined to have a deficiency under the terms and conditions of such agreements and applicable tax law. We have not generally provided for liabilities attributable to former affiliated companies or for claims they have asserted or may assert against us.
We believe that we have adequately provided for tax contingencies. However, our tax audits and examinations may result in tax liabilities that differ materially from those that we have recorded in our condensed consolidated financial statements. Because the ultimate outcomes of all of these matters are uncertain, we can give no assurance as to whether an adverse result from one or more of them will have a material effect on our financial results or our net operating loss carryforwards.
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If we fail to extend or renegotiate our collective bargaining agreements with our labor unions as they expire from time to time, or if our unionized employees were to engage in a strike or other work stoppage, our business and operating results could be materially harmed.
We are a party to collective bargaining agreements with our labor unions, which represent a significant number of our employees. Our current four-year agreements with the CWA and the IBEW expire on October 6, 2012. Although we believe that our relations with our employees and unions are satisfactory, no assurance can be given that we will be able to successfully extend or renegotiate our collective bargaining agreements as they expire from time to time. The impact of future negotiations, including changes in wages and benefit levels, could have a material impact on our financial results. Also, if we fail to extend or renegotiate our collective bargaining agreements, if significant disputes with our unions arise, or if our unionized workers engage in a strike or other work stoppage, we could incur higher ongoing labor costs or experience a significant disruption of operations, which could have a material adverse effect on our business.
The trading price of our securities has been and could continue to be volatile.
The capital markets often experience extreme price and volume fluctuations. The overall market and the trading price of our securities may fluctuate greatly. The trading price of our securities may be significantly affected by various factors, including:
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ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
Issuer Purchases of Equity Securities
The following table contains information about repurchases of our common stock during the first quarter of 2009:
Period
January 2009
February 2009
March 2009
Total
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ITEM 6. EXHIBITS
Exhibits identified in parentheses below are on file with the SEC and are incorporated herein by reference. All other exhibits are provided as part of this electronic submission.
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61
62
63
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( ) Previously filed.
In accordance with Item 601(b)(4)(iii)(A) of Regulation S-K, copies of certain instruments defining the rights of holders of certain of our long-term debt are not filed herewith. Pursuant to this regulation, we hereby agree to furnish a copy of any such instrument to the SEC upon request.
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SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
April 29, 2009
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