UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
For the quarterly period ended September 30, 2007
or
For the transition period from to
Commission File No. 001-15577
QWEST COMMUNICATIONS INTERNATIONAL INC.
(Exact name of registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
(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 x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check One):
Large accelerated filer x
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
On October 26, 2007, 1,804,853,402 shares of common stock were outstanding.
TABLE OF CONTENTS
Glossary of Terms
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.
Access Lines. Telephone lines reaching from the customer’s premises to a connection with the public switched telephone network. When we refer to our access lines we mean all our mass markets, wholesale and business access lines, including those used by us and our affiliates.
Asynchronous Transfer Mode (ATM). A broadband, network transport service utilizing data switches that provides a fast, efficient way to move large quantities of information.
Broadband services (previously referred to as high-speed Internet access). Services used to connect to the Internet and private networks. For Qwest, these services allow our existing telephone lines to operate at higher speeds than dial-up access, thereby giving customers faster connections necessary to access data and video content.
Competitive Local Exchange Carriers (CLECs). Telecommunications providers that compete with us in providing local voice and other services in our local service area.
Data Integration. Voice and data telecommunications customer premises equipment and associated professional services. These services include network management, installation and maintenance of data equipment and building of proprietary fiber-optic broadband networks for our governmental and business customers.
Dedicated Internet Access (DIA). Internet access ranging from 128 kilobits per second to 2.5 gigabits per second.
Frame Relay. A high speed data switching technology primarily used to interconnect multiple local networks.
Incumbent Local Exchange Carrier (ILEC). A traditional telecommunications provider, such as our subsidiary, Qwest Corporation, that, prior to the Telecommunications Act of 1996, had the exclusive right and responsibility for providing local telecommunications services in its local service area.
Integrated Services Digital Network (ISDN). A telecommunications standard that uses digital transmission technology to support voice, video and data communications applications over regular telephone lines.
InterLATA long-distance services. Telecommunications services, including “800” services, that cross LATA boundaries.
Internet Dial Access. Provides ISPs and business customers with a comprehensive, reliable and cost-effective dial-up network infrastructure.
Internet Protocol (IP). Those protocols that facilitate transferring information in packets of data and that enable each packet in a transmission to “tell” the data switches it encounters where it is headed and enables the computers on each end to confirm that message has been accurately transmitted and received.
Internet Service Providers (ISPs). Businesses that provide Internet access to retail customers.
IntraLATA long-distance services. These services include calls that terminate outside a customer’s local calling area but within the customer’s LATA, including wide area telecommunications service or “800” services for customers with geographically highly concentrated demand.
Local Access Transport Area (LATA). A geographical area associated with the provision of telecommunications services by local exchange and long distance carriers. There are 163 LATAs in the United States, of which 27 are in our 14 state local service area.
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Local Calling Area. A geographical area, usually smaller than a LATA, within which a customer can make telephone calls without incurring long-distance charges. Multiple local calling areas generally make up a LATA.
Multi-Protocol Label Switching (MPLS). A standards-approved data networking technology, compatible with existing ATM and frame relay networks that can deliver the quality of service required to support real-time voice and video, as well as service level agreements that guarantee bandwidth. MPLS is deployed by many telecommunications providers and large enterprises for use in their own national networks.
Private Line. Direct circuit or channel specifically dedicated to the use of an end-user organization for the purpose of directly connecting two or more sites.
Public Switched Telephone Network (PSTN). The worldwide voice telephone network that is accessible to every person with a telephone equipped with dial tone.
Unbundled Network Elements (UNEs). Discrete elements of our network that are sold or leased to competitive telecommunications providers and that may be combined to provide their retail telecommunications services.
Virtual Private Network (VPN). A private network that operates securely within a public network (such as the Internet) by means of encrypting transmissions.
Voice over Internet Protocol (VoIP). An application that provides real-time, two-way voice communication similar to our traditional voice services that originates in the Internet protocol over a broadband connection and often terminates on the PSTN.
Web Hosting. The providing of space, power, bandwidth and managed services in data centers.
Wide Area Network (WAN). A communications network that covers a wide geographic area, such as a state or country. A WAN typically extends a local area network outside the building, over telephone common carrier lines to link to other local area networks in remote locations, such as branch offices or at-home workers and telecommuters.
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PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(Dollars in millions except per share amounts,
shares in thousands)
Operating revenue
Operating expenses:
Cost of sales (exclusive of depreciation and amortization)
Selling, general and administrative
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
(Loss) income before income taxes
Income tax benefit
Net income
Earnings per share:
Basic
Diluted
Weighted average shares outstanding:
The accompanying notes are an integral part of these condensed consolidated financial statements.
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CONDENSED CONSOLIDATED BALANCE SHEETS
Current assets:
Cash and cash equivalents
Short-term investments
Accounts receivable—net of allowance of $142 and $146, respectively
Deferred income taxes
Prepaid expenses and other
Total current assets
Property, plant and equipment—net
Capitalized software—net
Prepaid pension
Other
Total assets
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 of $193 and $209, respectively
Post-retirement and other post-employment benefit obligations
Deferred revenue
Total liabilities
Commitments and contingencies (Note 9)
Stockholders’ equity or 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; 1,819,468 and 1,902,642 shares issued, respectively
Additional paid-in capital
Treasury stock—5,175 and 1,993 shares, respectively (including 62 shares held in rabbi trust at both dates)
Accumulated deficit
Accumulated other comprehensive income
Total stockholders’ equity (deficit)
Total liabilities and stockholders’ equity or deficit
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CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
Operating activities:
Adjustments to reconcile net income to net cash provided by operating activities:
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 property and equipment
Proceeds from sale of investment securities
Purchases of investment securities
Acquisition of OnFiber Communications, Inc.
Cash used for investing activities
Financing activities:
Proceeds from long-term borrowings
Repayments of long-term borrowings, including current maturities
Proceeds from issuances of common stock
Repurchases of common stock
Cash used for financing activities
Cash and cash equivalents:
(Decrease) increase in cash and cash equivalents
Beginning balance
Ending balance
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
For the Three and Nine Months Ended September 30, 2007
(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
These condensed consolidated interim financial statements are unaudited and are 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 accounting principles generally accepted in the United States of America (“GAAP”) have been condensed or omitted. We believe that the disclosures made are adequate to make the information not misleading.
In the opinion of management, these statements include all adjustments necessary to fairly present our condensed consolidated results of operations, financial position and cash flows as of September 30, 2007 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, 2006. The condensed consolidated results of operations for the three and nine months ended September 30, 2007 and the condensed consolidated statement of cash flows for the nine months ended September 30, 2007 are not necessarily indicative of the results or cash flows expected for the full year.
Reclassifications
We periodically evaluate the appropriateness of classifications on our consolidated balance sheets. As a result of our most recent evaluation, we determined certain balances previously presented in other intangible assets were more appropriately classified as other non-current assets. This change resulted in a reclassification on our condensed consolidated balance sheets between capitalized software and other non-current assets of $73 million as of December 31, 2006. Certain other prior period balances have been reclassified to conform to the current period presentation.
Use of Estimates
Our condensed consolidated financial statements are prepared in accordance with GAAP. These accounting principles require us to make certain estimates, judgments and assumptions. We believe that the estimates, judgments and assumptions made when accounting for items and matters such as, but not limited to, long-term contracts, customer retention patterns, allowance for bad debts, depreciation, amortization, asset valuations, internal labor capitalization rates, recoverability of assets (including deferred tax assets), impairment assessments, employee benefits, taxes, reserves and other provisions and contingencies are reasonable, based on information available at the time they are made. These estimates, judgments and assumptions can affect the reported amounts of assets and liabilities as of the date of the condensed consolidated financial statements, as well as the reported amounts of revenue and expenses during the periods presented. We also assess potential losses in relation to threatened or pending legal and tax matters. See Note 9—Commitments and Contingencies.
For matters not related to income taxes, if a loss is considered probable and the amount can be reasonably estimated, we recognize an expense for the estimated loss. If we have the potential to recover a portion of the estimated loss from a third party, we make a separate assessment of recoverability and reduce the estimated loss if recovery is also deemed probable.
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
Effective January 1, 2007, our policy for accounting for income taxes changed upon adoption of Financial Accounting Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”). See Note 2—Income Taxes for further discussion.
Actual results could differ from our estimates.
USF, Gross Receipts Taxes and Other Surcharges
Our revenue and expenses include taxes and surcharges that we recognize on a gross basis of $97 million and $283 million for the three and nine months ended September 30, 2007, respectively, and $99 million and $317 million for the three and nine months ended September 30, 2006, respectively.
Depreciation and Amortization
Property, plant and equipment is shown net of accumulated depreciation on our condensed consolidated balance sheets. Accumulated depreciation was $32.750 billion and $31.795 billion as of September 30, 2007 and December 31, 2006, respectively.
Capitalized software is shown net of accumulated amortization on our condensed consolidated balance sheets. Accumulated amortization was $1.340 billion and $1.267 billion as of September 30, 2007 and December 31, 2006, respectively. Effective January 1, 2007, as a result of an internal study, we changed our estimates of the average economic lives for capitalized software from between four and five years to between four and seven years. For the three and nine months ended September 30, 2007, amortization expense would have been higher by $30 million ($0.02 per basic and diluted share) and $90 million ($0.05 per basic and diluted share), respectively, had we not changed our estimates of the average economic lives.
Recently Adopted Accounting Pronouncements
Effective January 1, 2007, we adopted FIN 48. See Note 2—Income Taxes for additional information.
Recently Issued Accounting Pronouncements
In September 2006 and March 2007, the Emerging Issues Task Force reached a consensus on Issue No. 06-4, “Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements” and Issue No. 06-10, “Collateral-Assignment Split-Dollar Life Insurance.” These pronouncements are effective for us beginning January 1, 2008 and require us to record a liability for the life insurance benefit to be paid and an asset for the expected amounts to be recovered from the insurance company or the employee’s estate based on the specific terms of certain types of life insurance policies. At this time, we do not expect the adoption of these pronouncements to have a material impact on our financial position or results of operations.
In February 2007, the FASB issued SFAS No. 159, “Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS No. 159”). Under SFAS No. 159, entities may choose to measure at fair value many financial instruments and certain other items that are not currently required to be measured at fair value. SFAS No. 159 also establishes recognition, presentation, and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. SFAS No. 159 does not affect any existing accounting literature that requires certain assets and liabilities to be carried at fair value. SFAS No. 159 is effective for us beginning January 1, 2008. At this time, we do not expect the adoption of this standard to have any impact on our financial position or results of operations.
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In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” which is effective for us beginning January 1, 2008 and provides a definition of fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements for future transactions. We do not expect the adoption of this standard to have a material impact on our financial position or results of operations.
Note 2: Income Taxes
Valuation Allowance
Prior to 2006, we had a history of losses and, as a result, we recognized a valuation allowance for our net deferred tax assets. A significant portion of our net deferred tax assets relate to tax benefits attributable to U.S. tax net operating loss carryforwards (“NOLs”). During the third quarter of 2007, we reclassified approximately $0.6 billion from our estimated NOLs to another non-current deferred tax asset. Following this reclassification, our estimated NOLs totaled approximately $7.2 billion as of September 30, 2007.
Each quarter we have evaluated the need to retain all or a portion of the valuation allowance on our deferred tax assets. During the three months ended September 30, 2007, we determined that it is more likely than not that we will realize the vast majority of our deferred tax assets, including the NOLs. In making this determination, we analyzed, among other things, our recent history of earnings and cash flows, forecasts of future earnings, the nature and timing of future deductions and benefits represented by the deferred tax assets and our cumulative earnings for the last twelve quarters. The reversal of the valuation allowance resulted in a current period income tax benefit of $2.174 billion and an increase in our current and non-current deferred tax assets on our condensed consolidated balance sheet as of September 30, 2007. Certain deferred tax assets totaling $130 million require future income of special character in order to release the tax benefits. We currently are not forecasting income of appropriate character for these items and, as such, we continue to maintain a valuation allowance for these items. We also expect to release additional valuation allowance through income tax benefit in the fourth quarter of 2007, such that any net tax benefit or expense in that period should be immaterial. We anticipate that in 2008 we will begin reporting income tax expense of approximately 37% to 39% of income before income taxes, excluding any impact of uncertain tax positions as discussed below.
Adoption of FIN 48
Effective January 1, 2007, we adopted FIN 48. The validity of any tax position is a matter of tax law, and generally, there is no controversy about recognizing the benefit of a tax position in a company’s financial statements. The tax law is, however, subject to varied interpretations, and whether a tax position will ultimately be sustained may be uncertain. Prior to January 1, 2007, the impact of an uncertain tax position that did not create a difference between the financial statement basis and the tax basis of an asset or liability and that would have future tax consequences was included in our income tax provision if it was probable the position would be sustained upon audit. The benefit of any uncertain tax position that created a basis difference in an asset or liability was reflected in our tax provision if it was more likely than not that the position would be sustained upon audit. Prior to the adoption of FIN 48, we recognized interest expense based on our estimates of the ultimate outcomes of the uncertain tax positions.
Under FIN 48, the impact of an uncertain tax position that is more likely than not of being sustained upon audit by the relevant taxing authority must be recognized at the largest amount that is more likely than not to be sustained. No portion of an uncertain tax position will be recognized if the position, in the aggregate, has less than a 50% likelihood of being sustained. Also, under FIN 48, interest expense is recognized on the full amount of deferred benefits for uncertain tax positions.
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On January 1, 2007, we recorded the following FIN 48 transition adjustments:
$75 million decrease in our tax liabilities for uncertain tax positions;
$27 million increase in interest accrued for uncertain tax positions;
$119 million increase in our tax liabilities for uncertain tax positions and deferred tax assets to gross-up our balance sheet for the tax benefits of tax credit carryforwards and NOLs that had previously been netted in our uncertain tax position liability; and
$735 million increase in our deferred tax assets that was offset by a corresponding increase to our valuation allowance. See our discussion of the 2002-2003 IRS audit below for further information.
As of January 1, 2007, we had a total liability of $60 million solely for interest on uncertain tax positions. During the three and nine months ended September 30, 2007, we increased our liability for uncertain tax positions by $13 million and $22 million, respectively, as a result of additional interest accruals. In accordance with our accounting policy, both before and after adoption of FIN 48, interest expense and penalties related to income taxes are included in the other—net line of our condensed consolidated statements of operations. As of January 1, 2007, we had unrecognized tax benefits of $654 million. During the third quarter of 2007, our unrecognized tax benefits increased by $151 million to $805 million. Any future adjustments to our uncertain tax position liability will result in an impact on our income tax provision and effective tax rate. As of January 1, 2007, approximately $108 million of the unrecognized tax benefits could affect our income tax provision and effective tax rate. As of September 30, 2007, the amount of unrecognized tax benefits that could affect our effective tax rate increased to approximately $568 million, primarily as a result of the reversal of our valuation allowance discussed above.
Because we are included in the coordinated industry case program of the Internal Revenue Service (“IRS”), the IRS examines all of our federal income tax returns. As of September 30, 2007, all of the federal income tax returns we have filed since 1998 are still subject to adjustment upon audit. We also file combined income tax returns in many states, and these combined returns remain open for adjustments to our federal income tax returns. In addition, certain combined state income tax returns we have filed since 1994 are still open for state specific adjustments.
We have agreed on a tentative settlement with the IRS related to audits for the tax years 1998 through 2001. This settlement is subject to formal approval by the IRS and the Joint Committee on Taxation of the U.S. Congress. If the settlement is effected in accordance with our expectations, we believe that it is reasonably possible that we could recognize up to $146 million of tax and interest benefits (including up to a $105 million increase in net income) and our total unrecognized tax benefits may decrease by approximately $221 million by June 30, 2008.
We are currently going through the appeals process with the IRS on its audit of our returns for 2002 and 2003. This appeal is primarily over deductions we reported totaling approximately $3 billion. Any significant changes to our expectations for this audit could result in significant changes to our deferred tax assets with a corresponding impact on net income.
Note 3: Earnings Per Share
Basic earnings per share excludes dilution and is computed by dividing net income by the weighted average number of shares of common stock outstanding for the period. For purposes of this calculation, common stock outstanding does not include shares of restricted stock on which the restrictions have not yet lapsed. Diluted earnings per share reflects the potential dilution that could occur if certain outstanding stock options are exercised, the premium on convertible debt is converted into common stock and the restrictions on restricted stock awards lapse.
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The following is a reconciliation of the number of shares used in the basic and diluted earnings per share computations:
Basic weighted average shares outstanding
Dilutive effect of options with strike prices equal to or less than the average price of our common stock, calculated using the treasury stock method
Dilutive effect of the equity premium on convertible debt at the average price of our common stock
Dilutive effect of unvested restricted stock and other
Diluted weighted average shares outstanding
The following is a summary of the securities that could potentially dilute basic earnings per share, but have been excluded from the computations of diluted earnings per share:
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 and unvested restricted stock excluded because the market-based vesting conditions have not been met
Other outstanding options to purchase common stock excluded because the impact would have been antidilutive
Note 4: Auction Rate Securities
As of September 30, 2007, we had $119 million invested in auction rate securities, which are classified as non-current, available-for-sale investments and included in other non-current assets on our condensed consolidated balance sheet. As of December 31, 2006, these and similar securities were classified as short-term investments on our condensed consolidated balance sheet. 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 allows existing investors to rollover their holdings and continue to own their respective securities or liquidate their holdings by selling their securities at par.
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The recent uncertainties in the credit markets have prevented us and other investors from liquidating our holdings of auction rate securities in recent auctions for these securities because the amount of securities submitted for sale has exceeded the amount of purchase orders. Accordingly, we still hold these long-term securities and are due interest at a higher rate than similar securities for which auctions have cleared. These investments are insured against loss of principal and interest and have a AAA credit rating. We are uncertain as to when the liquidity issues relating to these investments will improve. We may be able to liquidate these securities in the next twelve months; however, we may choose not to sell them due to the high rate of interest they pay. Accordingly, we reclassified these securities as non-current as of September 30, 2007. We have historically valued these investments at par, since that is the value we received when trading them in the established market. We believe that the fair value of these investments continues to be par and, therefore, we have not adjusted the recorded value of these securities.
Note 5: Borrowings
As of September 30, 2007 and December 31, 2006, our 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
Borrowings classified as current are due and payable within 12 months from the applicable balance sheet date. The balance of the $1.265 billion of our 3.50% Convertible Senior Notes due 2025 was classified as a current obligation as of September 30, 2007 and December 31, 2006 because specified, market-based conversion provisions were met as of those dates. As such, the holders of these notes have the right to convert the notes and receive from us (i) cash for the principal value of notes and (ii) shares of our common stock or equivalent value of cash at our option in accordance with the terms of the notes. These market-based conversion provisions specify that, when our common stock has a closing price above $7.08 per share for 20 or more trading days during certain periods of 30 consecutive trading days, these notes become available for conversion for a specified period. As a result, these notes are classified as a current obligation. If our common stock does not maintain a closing price above $7.08 per share during certain subsequent periods, the notes would no longer be available for immediate conversion and the outstanding notes would be reclassified to long-term borrowings. These notes are registered securities and are freely tradable. As of September 30, 2007, the notes had a market price of $1,663 per $1,000 principal amount of notes, compared to an estimated conversion value of $1,543. The conversion value is calculated based on the specified conversion provisions using the closing prices of our common stock during the 20 trading days ended September 30, 2007.
On May 16, 2007, our wholly owned subsidiary, Qwest Corporation (“QC”), issued $500 million aggregate principal amount of notes that bear interest at 6.5% per year and are due in 2017. The notes are unsecured
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obligations of QC and rank equally in right of payment with all other unsecured and unsubordinated indebtedness of QC. The covenant and default terms are substantially the same as those associated with QC’s other long-term debt. QC plans to file an exchange offer registration statement with the Securities and Exchange Commission (“SEC”) for a new issue of substantially identical notes registered under the Securities Act of 1933, as amended, within 315 calendar days of the date of issuance of the original notes. If QC fails to file this registration statement or fails to satisfy other obligations under the registration rights agreement relating to the notes, QC will be required to pay additional interest on the notes at a rate of 25 basis points per year.
On June 4, 2007, QC redeemed $250 million aggregate principal amount of its 8 7/8% Debentures due June 1, 2031. The extinguishment resulted in a loss on early retirement of debt of $18 million.
Also on June 4, 2007, we redeemed $250 million aggregate principal amount of QCII’s Floating Rate Senior Notes due 2009. The extinguishment resulted in a loss on early retirement of debt of $4 million.
On June 7, 2007, QC redeemed $70 million aggregate principal amount of its 6.0% Notes due 2007.
On June 15, 2007, our wholly owned subsidiary, Qwest Communications Corporation (“QCC”), repaid at maturity $314 million aggregate principal amount of its 7.25% Senior Notes due 2007.
On October 18, 2007, we redeemed $250 million aggregate principal amount of QCII’s Floating Rate Senior Notes due 2009. This extinguishment is not reflected in our condensed consolidated balance sheet as of September 30, 2007. We will recognize a loss on early retirement of debt related to this extinguishment of $4 million in the fourth quarter of 2007.
Note 6: 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 September 30, 2007, the remaining restructuring reserve relates to leases for real estate that we ceased using in prior periods and consists 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 to use this reserve over the remaining lease terms, which range from 0.3 years to 18.3 years, with a weighted average of 12.0 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 and reversals are included in our condensed consolidated statements of operations in selling, general and administrative expense. As of September 30, 2007 and December 31, 2006, our restructuring reserve was $313 million and $347 million, respectively. The amount included in current liabilities was $33 million and $37 million, respectively, and the long-term portion was $280 million and $310 million, respectively, as of those dates.
For the three months ended September 30, 2007 and 2006, we added no restructuring provisions to the reserves, we used $10 million and $8 million, respectively, and we reversed $0 million and $5 million, respectively. For the nine months ended September 30, 2007 and 2006, we added $0 million and $11 million, respectively, of restructuring provisions to these reserves, we used $31 million and $54 million, respectively, and we reversed $3 million and $15 million, respectively.
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Note 7: Employee Benefits
The components of the pension, non-qualified pension and post-retirement benefits expense for the three and nine months ended September 30, 2007 and 2006 are detailed below:
Service cost
Interest cost
Expected return on plan assets
Amortization of transition asset
Amortization of prior service cost
Recognized net actuarial loss
Net expense included in net income
The pension, non-qualified pension and post-retirement benefits expense is allocated between cost of sales and selling, general and administrative expense in our condensed consolidated statements of operations. The measurement date used to determine pension, non-qualified pension and other post-retirement healthcare and life insurance benefit measurements for the plans is December 31.
We recorded combined expense of $8 million and $53 million for the three months ended September 30, 2007 and 2006, respectively, and $28 million and $161 million for the nine months ended September 30, 2007 and 2006, respectively. The expense decreased primarily as a result of benefit plan changes and net reduced costs associated with the recognition of actuarial losses from prior years. Effective January 1, 2007, changes to our benefit plans capped our levels of contributions for certain post-retirement healthcare benefits and reduced the post-retirement benefit under the life insurance plan, which decreased our liability substantially. Actuarial gains or losses reflect the differences between our actuarial assumptions and what actually occurred. The amortization
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of actuarial losses for this period was reduced primarily due to higher discount rates and higher than expected actual returns on pension assets.
For the three and nine months ended September 30, 2007, accumulated other comprehensive income decreased $3 million and $55 million, respectively, for other post-retirement obligations—net of taxes and decreased $2 million and increased $28 million, respectively, for pension—net of taxes.
Note 8: Segment Information
Our operating revenue is generated from our wireline services, wireless services and other services segments. Segment discussions reflect the way we currently report our operating results to our Chief Operating Decision Maker (“CODM”).
Historically, our CODM has reviewed operating results using these segments to evaluate the performance of each segment and to allocate resources. In August 2007, Edward A. Mueller became our chief executive officer and our new CODM, and he currently continues to use these same segments to evaluate performance and allocate resources. However, Mr. Mueller is also currently considering alternative approaches to reviewing our operating results, and we are assessing the data available for such alternatives. As a result, our operating segments may change in the future based upon this assessment and any resulting decision by the CODM to review our operating results based upon an alternative presentation.
The accounting principles used to determine segment results are the same as those used in our condensed consolidated financial statements. Segment income consists of each segment’s revenue and expenses. Segment revenue is based on the types of products and services offered as described below. Wireline and wireless segment expenses include employee-related costs (except for the combined expense of pension, non-qualified pension and post-retirement benefits), facility costs, network expenses and other non-employee related costs such as customer support, collections and telemarketing. We manage administrative services costs such as finance, information technology, real estate, legal, other marketing and advertising and human resources centrally; consequently, these costs are included in the other services segment. We evaluate depreciation, amortization, interest expense, interest income and other income (expense) on a total company basis because we do not allocate our network costs, capital and debt costs, and non-operating income or expenses to specific segments. As a result, these items are not assigned to any segment. Similarly, we do not include impairment charges in the segment results. Therefore, the segment results presented below 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 generate revenue from our wireline services, wireless services and other services as described below.
Wireline services. The wireline services segment uses our network to provide voice services and data, Internet and video services to mass markets, business and wholesale customers. Our wireline services include:
Voice services. Voice services include local voice services, long-distance voice services and access services. Local voice services include basic local exchange, switching and enhanced voice services. Local voice services also include network transport, billing services and providing access to our local network through our wholesale channel. Long-distance voice services include domestic and international long-distance services. Access services include fees we charge to other telecommunications providers to connect their customers and their networks to our network.
Data, Internet and video services. We offer data and Internet services to our mass markets, business and wholesale customers.
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We offer our mass markets customers broadband services and video services, including cable-based video and resold satellite digital television.
We offer our business and wholesale customers a variety of data and Internet products and services such as data integration, private line, MPLS-based services sold as iQ NetworkingTM, web hosting, VoIP, ATM, frame relay, dedicated Internet access, VPN, ISDN and Internet dial-up access. We also include some traditional voice grade services with these services if they are bundled together in an end-to-end solution for the customer.
Wireless services. We sell wireless products and services, including access to a nationwide wireless network, to mass markets and business customers, primarily within our local service area. We also offer an integrated service, which enables customers to use the same telephone number and voice mailbox for their wireless phone as for their home or business phone. Our wireless products and services are primarily marketed to consumers as part of our bundled offerings.
Other services. Other services include the subleasing of space in our office buildings, warehouses and other properties.
The revenue shown below for each segment is derived from transactions with external customers. Substantially all of our assets are in our wireline services and other services segments.
Segment information for the three and nine months ended September 30, 2007 and 2006 is summarized in the following table:
Operating revenue:
Wireline services
Wireless services
Other services
Total operating revenue
Total segment expenses
Segment income (loss):
Total segment income
Capital expenditures:
Total capital expenditures
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The following table reconciles segment income to net income for the three and nine months ended September 30, 2007 and 2006:
Total other expense—net
Revenue derived from external customers for the three and nine months ended September 30, 2007 and 2006 is summarized in the following table:
Wireline voice services
Wireline data, Internet and video services
We do not have any single customer that provides more than 10% of our total operating revenue. Substantially all of our revenue from external customers comes from customers located in the United States.
Note 9: 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.
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 current and former directors, officers and employees in connection with the securities actions and certain other matters.
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
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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. No parties admit any wrongdoing as part of the settlement. Pursuant to the settlement, we have deposited approximately $400 million in cash into a settlement fund. Of this amount, $200 million was deposited in 2006, and the remaining $200 million (plus interest) was deposited in January 2007. In connection with the settlement, we received $10 million from Arthur Andersen LLP. As part of the settlement, the class representatives and the settlement class they represent are also releasing Arthur Andersen. If the 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 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 settlement on behalf of purchasers of our publicly traded securities between May 24, 1999 and July 28, 2002. Messrs. Nacchio and Woodruff have appealed that order to the United States Court of Appeals for the Tenth Circuit.
Settlement of Remaining Securities Actions
A number of persons, including certain large pension funds, were excluded from the settlement class at their request, and filed lawsuits or otherwise pursued claims against us similar to the claims asserted in the consolidated securities action. In the aggregate, those persons contended that they incurred losses resulting from their investments in our securities in excess of $1.9 billion. We have entered into settlement agreements with all of those persons. In connection with those settlements, we have agreed to pay up to an aggregate of approximately $411 million, including applicable interest, on or before June 30, 2008.
KPNQwest Litigation/Investigation
As previously disclosed, we and the other defendants settled a putative class action filed against us and others on behalf of certain purchasers of publicly traded securities of KPNQwest, N.V. (of which we were a major shareholder). The most recent complaint alleged that, among other things, defendants engaged in a fraudulent scheme and deceptive course of business in order to inflate KPNQwest’s revenue and the value of KPNQwest securities. At their request, certain individuals and entities were excluded from the settlement class. As a result, their claims were not released by the court order approving the settlement. Some of these individuals and entities have already filed actions against us, as described below, and we are vigorously defending against these claims. We expect that at least some of the other persons who were excluded from the settlement class will also pursue actions against us if we are unable to resolve their claims amicably. In the aggregate, those who were excluded from the settlement class currently contend that they have incurred losses of at least $76 million resulting from their investments in KPNQwest securities during the settlement class period, which does not include any claims for punitive damages or interest. The amount of these alleged losses may increase or decrease in the future as we learn more about the potential claims of those who opted out of the settlement class. Due to
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the fact that some of them have not filed lawsuits, it is difficult to evaluate the claims that they may assert. Regardless, we will vigorously defend against any such claims.
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 which, as amended, alleges, among other things, that the defendants violated state and federal securities laws and breached their fiduciary duty in connection with investments by plaintiffs in securities of KPNQwest. We are a defendant in this lawsuit along with Qwest B.V. (one of our subsidiaries), Joseph Nacchio and John McMaster, the former President and Chief Executive Officer of KPNQwest. Plaintiffs claim to have lost approximately $10 million in their investments in KPNQwest. The superior court granted defendants’ motion for partial summary judgment with respect to a substantial portion of plaintiffs’ claims and the remainder of plaintiffs’ claims were dismissed without prejudice. Plaintiffs appealed the summary judgment order to the Arizona Court of Appeals, which affirmed in part and reversed in part the superior court’s decision. The case has been remanded to the superior court for further proceedings.
On June 25, 2004, the trustees in the Dutch bankruptcy proceeding for KPNQwest filed a lawsuit in the federal district court for the District of New Jersey alleging violations of the Racketeer Influenced and Corrupt Organizations Act, and breach of fiduciary duty and mismanagement under Dutch law. We are a defendant in this lawsuit along with Joseph Nacchio, Robert S. Woodruff and John McMaster. 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 damages as well as an award of plaintiffs’ attorneys’ fees and costs. On October 17, 2006, the court issued an order granting defendants’ motion to dismiss the lawsuit, concluding that the dispute should not be adjudicated in the United States. Plaintiffs have appealed this decision to the United States Court of Appeals for the Third Circuit.
On June 17, 2005, Appaloosa Investment Limited Partnership I, Palomino Fund Ltd., and Appaloosa Management L.P. filed a lawsuit in the federal district court for the Southern District of New York against us, Joseph Nacchio, John McMaster and Koninklijke KPN N.V., or KPN. The amended complaint alleges that defendants violated federal securities laws in connection with the purchase by plaintiffs of certain KPNQwest debt securities. Plaintiffs seek compensatory damages, as well as an award of plaintiffs’ attorneys’ fees and costs.
On September 13, 2006, Cargill Financial Markets, Plc and Citibank, N.A. filed a lawsuit in the District Court of Amsterdam, The Netherlands, against us, KPN Telecom B.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 $313 million based on the exchange rate on September 30, 2007).
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.
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Purporting to speak for an unspecified number of shareholders, VEB also sought exclusion from the settlement class in the settlements of the KPNQwest putative securities class action described above. The information that VEB provided in support of its request for exclusion did not indicate the losses claimed to have been sustained by VEB or the unspecified shareholders that VEB purports to represent, and thus those claims are not included in the approximately $76 million of losses claimed by those who requested exclusion from the settlement class, as described above. In view of these and other deficiencies in VEB’s request for exclusion, VEB was not excluded from the settlement class. We can provide no assurance, however, that our settlement will be enforced against VEB or the shareholders it purports to represent if VEB or such shareholders were to bring claims against us in The Netherlands.
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 (other than Louisiana and Tennessee) in which Qwest has fiber optic cable in railroad rights-of-way, 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 damages on theories of trespass and unjust enrichment, as well as punitive damages.
On September 1, 2006, Ronald A. Katz Technology Licensing, L.P. (“Katz”) filed a lawsuit in Federal District Court in Delaware against us (including a number of our subsidiaries). The lawsuit alleges infringement by us of 24 patents. The lawsuit also names as defendants a number of other entities that are unrelated to us. Katz is also involved in numerous other cases against unrelated entities. These cases have been consolidated before the United States District Court for the Central District of California for coordinated pretrial proceedings. Although the complaint against us is vague, it generally alleges infringement based on our use of interactive voice response systems to automate processing of customer calls to us. Katz seeks unspecified damages, trebling of damages based on alleged willful infringement, attorney’s fees and injunctive relief. We will vigorously defend against this action.
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.
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QC is a defendant in litigation brought by several owners of payphones, relating to the rates QC charged them for the lines to their payphones between 1997 and 2003. Generally, the payphone owners claim that QC charged more for payphone access lines than QC was permitted to under the applicable FCC rules. Two lawsuits are pending, one filed in the United States District Court for the Western District of Washington, the other in the United States District Court for the District of Utah. The Washington lawsuit resulted in reversal of the district court’s dismissal order by the Ninth Circuit Court of Appeals, and is currently stayed pending resolution of related proceedings before the FCC. In the Utah case, the Tenth Circuit Court of Appeals reversed a dismissal by the district court and directed that the district court refer several issues to the FCC for resolution. A proceeding against QC is also pending before the Oregon Public Utility Commission. Several related proceedings are underway at the FCC involving QC, other telecommunications companies, and payphone owners. In all of these proceedings, the payphone owners seek damages for amounts paid allegedly exceeding that which was permitted under the applicable FCC rules. QC will vigorously defend against these actions.
A putative class action purportedly filed on behalf of certain of our retirees was brought against us and certain other defendants in Federal District Court in Colorado in connection with our decision to reduce life insurance benefits for these retirees to a flat $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 benefits at the levels in place before we decided to reduce them. Plaintiffs seek restoration of life insurance benefits to previous levels and certain equitable relief. We believe that our reduction of life insurance benefits was permissible under applicable law and plan documents and will vigorously defend against this action.
We have tax related matters pending against us, certain of which are before the Appeals Office of the IRS. In addition, 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. Generally, we have not provided for liabilities of former affiliated members or for claims they have asserted or may assert against us. We believe we have adequately provided for these tax-related matters. If the recorded reserves for these tax-related matters are insufficient, we may need to record additional amounts in future periods.
Note 10: Labor Union Contracts
We are a party to collective bargaining agreements with our labor unions, the Communications Workers of America and the International Brotherhood of Electrical Workers. Our three-year labor agreements with the unions expire on August 16, 2008. As of September 30, 2007, employees covered under these collective bargaining agreements totaled 20,929, or 57% of all our employees.
Note 11: Financial Statements of Guarantors
QCII and two of its subsidiaries, Qwest Capital Funding, Inc. (“QCF”) and Qwest Services Corporation (“QSC”), guarantee certain of each other’s registered debt securities against default. As of September 30, 2007, QCII had outstanding a total of $2.325 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”). Each series of QCF’s outstanding notes totaling approximately $2.9 billion in aggregate principal amount (the “QCF Guaranteed Notes”) is guaranteed on a senior unsecured basis by QCII. 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 necessary to meet their debt service or guarantee obligations are provided in large part by distributions or advances from their subsidiaries.
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The following information sets forth our condensed consolidating statements of operations for the three and nine months ended September 30, 2007 and 2006, our condensed consolidating balance sheets as of September 30, 2007 and December 31, 2006, and our condensed consolidating statements of cash flows for the nine months ended September 30, 2007 and 2006. The information for QCII, QSC and QCF is presented for each entity on a stand-alone basis, including that entity’s investments in all of its subsidiaries, if any, 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. The direct subsidiaries of QCII that are not guarantors of the QCII Guaranteed Notes are presented on a combined basis. The subsidiaries of QSC that are not guarantors of the QCII Guaranteed Notes are presented on a combined basis. Both QSC and QCF are 100% owned by 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.
Business Combinations Under Common Control
In February 2007, the FCC issued an order that freed us from some regulatory obligations under the Telecommunications Act of 1996. Among other things, the order gives us more flexibility to integrate our local and long-distance operations, including the operations of our subsidiaries that provide shared services to our two main operating companies.
In light of this order and consistent with our continuing strategy to simplify our corporate structure and gain operational efficiencies, we are currently contemplating reorganizing the legal structure of our subsidiaries. These reorganization activities will impact the entities that are consolidated into our financial statements and, as a result, the future financial statements presented in this note will be different from the financial statements we have historically presented in this note. These reorganization activities will result in a combination of businesses under common control and, as a result, we will be required to adjust previously reported financial statements for all periods presented in this note for any transferred businesses affecting these subsidiaries.
In addition, our reorganization activities may result in the transfer of assets, liabilities or employees between subsidiaries that do not represent a business, as defined, and will be recorded as equity contributions in the affected subsidiaries’ statements of stockholder’s equity. In connection with these activities, we do not expect that we will consummate any business combinations or other transactions that will adversely affect our consolidated financial condition or results of operations or the financial condition or results of operations for any of the guarantors presented in this note.
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CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS
THREE MONTHS ENDED SEPTEMBER 30, 2007
Operating revenue—affiliates
Cost of sales—affiliates
Selling, general and administrative—affiliates
Interest expense—affiliates
Interest income—affiliates
(Income) loss from equity investments in subsidiaries
Income (loss) before income taxes
Income tax benefit (expense)
Net income (loss)
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THREE MONTHS ENDED SEPTEMBER 30, 2006
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NINE MONTHS ENDED SEPTEMBER 30, 2007
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NINE MONTHS ENDED SEPTEMBER 30, 2006
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CONDENSED CONSOLIDATING BALANCE SHEETS
SEPTEMBER 30, 2007
Accounts receivable—net
Accounts receivable—affiliates
Current tax receivable
Notes receivable—affiliates
Investments in subsidiaries
Prepaid pension—affiliates
Current borrowings—affiliates
Accounts payable—affiliates
Accrued expenses and other—affiliates
Current taxes payable
Long-term borrowings—net
Other long-term liabilities primarily related to post-retirement and other post-employment benefits—affiliates
Stockholders’ equity (deficit)
Total liabilities and stockholders’ equity (deficit)
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DECEMBER 31, 2006
Stockholders’ (deficit) equity
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CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOW
Cash (used for) provided by operating activities
Investing Activities:
Net (purchases of) proceeds from investments managed by QSC
Cash infusion to subsidiaries
Net (increase) decrease in short-term affiliate loans
Dividends received from subsidiaries
Cash provided by (used for) investing activities
Net (repayments of) proceeds from short-term affiliate borrowings
Equity infusion from parent
Dividends paid to parent
Cash (used for) provided by financing activities
Increase (decrease) in cash and cash equivalents
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Net proceeds from (purchases of) investments managed by QSC
Net proceeds from short-term affiliate borrowings
Proceeds from issuances of common and treasury stock
Cash provided by (used for) financing activities
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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Certain statements set forth below under this caption constitute forward-looking statements. See “Special Note Regarding Forward-Looking Statements” at the end of this Item 2 for additional factors relating to such 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 voice, data and video services nationwide and globally. We continue to generate the majority of our revenue from services provided within our local service area, which consists of the 14-state region of Arizona, Colorado, Idaho, Iowa, Minnesota, Montana, Nebraska, New Mexico, North Dakota, Oregon, South Dakota, Utah, Washington and Wyoming.
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 wireline, wireless and other services segments. An overview of our segment results is provided in Note 8—Segment Information to our condensed consolidated financial statements in Item 1 of Part I of this report. Segment discussions reflect the way we currently report our operating results to our Chief Operating Decision Maker, or CODM. These discussions include revenue results for each of our customer channels within the wireline services segment: mass markets, business and wholesale. Segment results presented in this item and in Note 8—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.
Historically, our CODM has reviewed operating results using the segments presented below to evaluate the performance of each segment and to allocate resources. In August 2007, Edward A. Mueller became our chief executive officer and our new CODM, and he currently continues to use these same segments to evaluate performance and allocate resources. However, Mr. Mueller is also currently considering alternative approaches to reviewing our operating results, and we are assessing the data available for such alternatives. As a result, our operating segments may change in the future based upon this assessment and any resulting decision by the CODM to review our operating results based upon an alternative presentation.
We have reclassified certain prior period revenue, expense and access line amounts to conform to the current period presentation.
Business Trends
Our financial results continue to be impacted by several significant trends, which are described below:
Data, Internet and video growth. Revenue from data, Internet and video services for the nine months ended September 30, 2007 represents 36% of our total revenue and continues to grow. At the same time, our customers continue to shift away from traditional data, Internet and video products to more advanced technologies. Our results reflect our continued focus on these more-advanced, high-growth products including broadband services, private line, MPLS-based services sold as iQ Networking™, VoIP and video. The revenue increases from these high-growth products have outpaced declines in revenue from traditional data, Internet and video services including ATM, frame relay, DIA, VPN and Internet dial-up access.
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We continue to focus our efforts on improving penetration of broadband services, and broadband subscribers continue to grow as customers migrate from dial-up connections to higher speed connections. We reached 2.5 million broadband subscribers as of September 30, 2007 compared to 2.0 million as of the same date in 2006. We expect growth in broadband subscribers to continue, even though we expect to face continuing competition for these subscribers. In addition, we believe the ability to continually increase connection speeds is competitively important. As such, we continue to invest in increasing our available connection speeds in order to meet customer demand.
Access line losses. Our revenue has been, and we expect it will continue to be, adversely affected by access line losses. Increased competition, including product substitution, continues to be the primary reason for our access line losses. For example, consumers are substituting cable, wireless and VoIP for traditional telecommunications services, which has increased the number and type of competitors within our industry and has decreased our market share. In addition, consolidation in the telecommunications industry continues to negatively impact our revenue. Product bundling, as described below, has been one of our responses to access line losses.
Product bundling. We believe customers value the convenience and price discounts associated with receiving multiple services from a single provider. Accordingly, we promote product bundles through our marketing and advertising efforts. Product bundles represent combinations of products and services, such as local and long-distance (marketed as “digital voice”), broadband, video and wireless for our mass markets customers. As a result of these offerings, our sales of bundled products have increased. While bundle discounts have resulted in lower average revenue for our individual products, we believe product bundles positively impact customer retention and revenue per customer.
Variable expenses. Expenses associated with products and services such as wireless, long-distance and certain data, Internet and video services tend to be more variable in nature than expenses associated with our traditional telecommunications services such as local voice. As our revenue mix shifts away from traditional telecommunications services, our expense structure becomes more variable in nature. We expect this shift, combined with regulatory and market pricing forces, will continue to partially offset other cost saving initiatives.
Facility costs. Facility costs are third-party telecommunications expenses we incur by using other carriers’ networks to provide services to our customers. Facility costs do not always change proportionally with revenue fluctuations. However, we continue to reduce costs in this area through our ongoing initiatives to optimize the cost structure associated with our usage of other carriers’ services.
Operational efficiencies. We continue to evaluate our operating structure and focus. In some cases, this involves adjusting our workforce in response to productivity improvements and changes in the telecommunications industry and governmental regulations. Through targeted restructuring plans in prior years, focused improvements in operational efficiency, process improvements through automation and normal employee attrition, we have reduced our workforce and employee-related costs while achieving operational goals.
While these trends are important to understanding and evaluating our financial results, the other transactions, events and trends discussed in Item 1A of Part II of this report may also materially impact our business operations and financial results.
Results of Operations
Overview
Wireline services. The wireline services segment uses our network to provide voice services and data, Internet and video services to our mass markets, business and wholesale customers. Our wireline services include:
Voice services. Voice services include local voice services, long-distance voice services and access services. Local voice services include basic local exchange, switching and enhanced voice
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services. Local voice services also include network transport, billing services and providing access to our local network through our wholesale channel. Long-distance voice services include domestic and international long-distance services. Access services include fees we charge to other telecommunications providers to connect their customers and their networks to our network.
Data, Internet and video services. Data, Internet and video services represent our fastest growing source of revenue. We offer data and Internet services to our mass markets, business and wholesale customers.
We offer our suite of growth products and services (such as data integration, private line, iQ NetworkingTM, web hosting and VoIP) and traditional products and services (such as ATM, frame relay, DIA, VPN, ISDN and Internet dial-up access) primarily to our business and wholesale customers. We also include some traditional voice grade services with these services if they are bundled together in an end-to-end solution for the customer.
Depending on the products or services purchased, a customer may pay in advance a service activation fee, a monthly service fee, a usage charge or a combination of these.
The following table summarizes our results of operations for the three and nine months ended September 30, 2007 and 2006 and the number of employees as of September 30, 2007 and 2006:
%
Change
Operating expenses
Other expense—net
Employees (as of September 30)
nm—Percentages greater than 200% and comparisons between positive and negative values or to/from zero values are considered not meaningful.
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Operating Revenue
The following table compares our operating revenue by segment, including the detail by customer channels within our wireline services segment, for the three and nine months ended September 30, 2007 and 2006:
Wireline services revenue:
Voice services:
Local voice services:
Mass markets
Business
Wholesale
Total local voice services
Long-distance services:
Total long-distance services
Access services
Total voice services
Data, Internet and video services:
Total data, Internet and video services
Total wireline services revenue
Wireless services revenue
Other services revenue
Wireline Services Revenue
Voice Services
Local voice services. Local voice services revenue decreased primarily due to access line losses as a result of the competitive pressures described in “Business Trends” above. Mass markets and business local voice services revenue were impacted by these competitive pressures as customers disconnected primary and additional
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lines. Additionally, to a lesser extent, mass markets and business local voice services revenue decreased due to lower Universal Service Fund, or USF, revenue (and a corresponding decrease in USF charges) primarily due to the elimination of the USF assessment on certain products in late 2006. Wholesale local services revenue continued to be affected by a declining demand for UNEs.
The following table summarizes our access lines by customer channel as of September 30, 2007 and 2006:
Total access lines
Long-distance services. The decrease in total long-distance services revenue was primarily due to declining volumes in our wholesale channel as industry consolidation continues to affect our revenue. The negative impact on revenue was more significant in the third quarter of 2007 than in previous quarters.
Access services. Access services revenue decreased for the nine months ended September 30, 2007 compared to the same period of 2006 primarily due to a 7% decline in volumes associated with a decline in long-distance usage, as well as mass markets and business access line losses.
Data, Internet and Video Services
The increase in data, Internet and video services revenue in our mass markets channel was primarily due to an increase in broadband subscribers of approximately 28% as of September 30, 2007 compared to September 30, 2006 and, to a lesser extent, an increase in satellite video subscribers. The growth in broadband services revenue resulted from continued increased penetration as customers migrated from dial-up connections as well as customers upgrading to higher speed plans.
Data and Internet services revenue in our business channel increased for the three and nine months ended September 30, 2007 compared to the same periods of 2006 primarily due to growth in our private line and iQ Networking™, partially offset by a decline in traditional data services including frame relay, DIA, VPN and Internet dial-up access. Internet dial-up access services declined as we de-emphasized these services due to advances in technology and the continuing margin decline on these services.
The increase in data and Internet services revenue in our wholesale channel was primarily due to growth in our long-distance VoIP and private line services. Our long-distance VoIP revenue increased as customers migrated to an integrated data technology, which allows them to maintain a single network. Additionally, our private line revenue increased primarily due to volume growth.
Wireless Services Revenue
Wireless services revenue increased for the three and nine months ended September 30, 2007 compared to the same periods of 2006 primarily due to adjustments to wireless revenue and related costs for customer acquisitions. As a result, revenue increased by $5 million in the third quarter of 2007, but due to the corresponding impact on wireless services employee-related costs, these adjustments had no impact on segment income or net income.
Additionally, wireless services revenue increased due to an increase in subscribers offset by lower handset revenue resulting from fewer handsets sold.
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Operating Expenses
The following table provides further detail regarding our operating expenses for the three and nine months ended September 30, 2007 and 2006:
Cost of sales:
Facility costs
Network expenses
Employee-related costs
Other non-employee related costs
Total cost of sales
Selling, general and administrative:
Property and other taxes
Bad debt
Realignment, severance and related costs
Total selling, general and administrative
Cost of Sales (exclusive of depreciation and amortization)
Cost of sales includes costs incurred in the process of providing products and services to our customers. This includes employee-related costs (such as salaries, wages and benefits directly attributable to providing products or services), network expenses, facility costs and other non-employee related costs (such as real estate, USF charges, call termination fees, materials and supplies, contracted engineering services and the cost of data integration and wireless handsets).
Cost of sales as a percentage of revenue decreased to 38% from 40% for the three and nine months ended September 30, 2007 compared to the same periods of 2006.
Facility costs decreased primarily due to lower volumes related to a decrease in wholesale long-distance services, lower costs associated with the de-emphasis of our Internet dial-up services business and, to a lesser extent, ongoing initiatives to optimize the cost structure associated with our usage of other carriers’ services. These decreases were partially offset by higher rates.
Employee-related costs decreased primarily due to lower employee benefit costs as a result of benefit plan changes effective in 2007 and net reduced costs associated with the recognition of actuarial losses from prior years. See additional information under the heading “Pension and Post-Retirement Benefits.” In addition, employee reductions contributed to lower costs. These decreases were partially offset by additional maintenance work.
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Other non-employee related costs decreased for the nine months ended September 30, 2007 compared to the same period of 2006 primarily due to lower USF charges; the lower USF charges were largely related to the elimination of the USF assessment on certain products. In addition, lower call termination fees and decreased equipment costs due to fewer units sold contributed to the decrease.
Selling, General and Administrative Expenses
Selling, general and administrative, or SG&A, expenses include employee-related costs (such as salaries, wages and benefits not directly attributable to providing products or services and sales commissions), realignment, severance and related costs, bad debt, property and other taxes and other non-employee related costs (such as real estate, marketing and advertising, professional service fees, computer systems support services and litigation related charges).
Property and other taxes decreased for the three months ended September 30, 2007 compared to the same period of 2006 primarily due to a reduction recorded in the third quarter of 2007 in our estimated property tax obligations for prior years. Property and other taxes increased for the nine months ended September 30, 2007 compared to the same period of 2006 primarily due to a reduction in our estimated sales tax obligations of $25 million for the nine months ended September 30, 2006. Absent these reductions, we expect property and other taxes to increase in 2007 due to changes in our assessed values of property.
Bad debt expense increased primarily due to a reduction of our reserve balance in the second quarter of 2006. The reduction of the reserve balance reflected improvements in collections and aging of customer accounts over several months prior to June 30, 2006. Absent this reserve adjustment in the second quarter of 2006, bad debt expense would have been relatively flat for the nine months ended September 30, 2007 compared to the same period of 2006.
Realignment, severance and related costs decreased due to a $43 million severance charge in the third quarter of 2006 primarily associated with the closing of two call centers and a planned reduction in network employees as we continued to right-size our workforce in response to changes in the telecommunications industry and productivity improvements.
Employee-related costs decreased primarily due to lower employee benefit costs as a result of benefit plan changes effective in 2007 and net reduced costs associated with the recognition of actuarial losses from prior years. See additional information under the heading “Pension and Post-Retirement Benefits.” These decreases were partially offset by higher commission costs primarily related to an increased sales force and changes in commission structure.
Other non-employee related costs increased primarily due to $353 million of charges related to securities and other litigation in the third quarter of 2007 and a $40 million charge for securities litigation in the first quarter of 2007. For additional information on our securities and other litigation, see Note 9—Commitments and Contingencies to our condensed consolidated financial statements in Item 1 of Part 1 of this report.
Pension and Post-Retirement Benefits
Our results include the combined expense of our pension, non-qualified pension and post-retirement healthcare and life insurance plans. The combined expense of the benefit plans is allocated to cost of sales and SG&A expense. The expense is a function of the amount of benefits earned, interest on projected benefit obligations, amortization of costs and credits from prior benefit changes and the expected return on the assets held in the various plans.
We recorded combined benefits expense of $8 million and $28 million for the three and nine months ended September 30, 2007, respectively, compared to $53 million and $161 million for the three and nine months ended September 30, 2006, respectively. The expense decreased primarily as a result of benefit plan changes and net
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reduced costs associated with the recognition of actuarial losses from prior years. Effective January 1, 2007, changes to our benefit plans capped our levels of contributions for certain post-retirement healthcare benefits and reduced the post-retirement benefit under the life insurance plan, which decreased our liability substantially. Actuarial gains or losses reflect the differences between our actuarial assumptions and what actually occurred. The amortization of actuarial losses for this period was reduced primarily due to higher discount rates and higher than expected actual returns on pension assets.
For additional information on our pension and post-retirement plans, see Note 7—Employee Benefits to our condensed consolidated financial statements in Item 1 of Part I of this report.
Operating Expenses by Segment
Wireline and wireless segment expenses include employee-related costs (except for the combined expense of pension, non-qualified pension and post-retirement benefits), facility costs, network expenses and other non-employee related costs such as customer support, collections and telemarketing. We manage administrative services costs such as finance, information technology, real estate, legal, other marketing and advertising and human resources centrally; consequently, these costs are included in the other services segment. We evaluate depreciation, amortization, interest expense, interest income and other income (expense) on a total company basis. As a result, these items are not assigned to any segment. Similarly, we do not include impairment charges in the segment results. Therefore, the segment results presented below 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. Our CODM regularly reviews the results of operations at a segment level to evaluate the performance of each segment and to allocate resources.
Wireline Services Segment Expenses
The following table provides detail regarding our wireline services segment for the three and nine months ended September 30, 2007 and 2006:
Wireline services expenses:
Total wireline services expenses
Facility costs decreased due to lower volumes related to a decrease in wholesale long-distance services, lower costs associated with the de-emphasis of our Internet dial-up services business and, to a lesser extent, ongoing initiatives to optimize the cost structure associated with our usage of other carriers’ services. These decreases were partially offset by higher rates.
Bad debt expense increased primarily due to a reduction of our reserve balance in the second quarter of 2006. The reduction of the reserve balance reflected improvements in collections and aging of customer
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accounts over several months prior to June 30, 2006. Absent this reserve adjustment in the second quarter of 2006, bad debt expense would have been relatively flat for the nine month period of 2007 compared to the same period of 2006.
Realignment, severance and related costs decreased due to a $40 million severance charge in the third quarter of 2006 primarily associated with the closing of two call centers and a planned reduction in network employees as we continued to right-size our workforce in response to changes in the telecommunications industry and productivity improvements.
Employee-related costs increased for the nine months ended September 30, 2007 due to additional maintenance work and higher commission costs primarily related to an increased sales force and changes in commission structure, partially offset by other employee reductions.
Other non-employee related costs decreased for the nine months ended September 30, 2007 compared to the same period of 2006 primarily due to lower USF charges; the lower USF charges were largely related to the elimination of the USF assessment on certain products. In addition, lower call termination fees contributed to the decrease, partially offset by higher professional fees.
Wireless Services Segment Expenses
The following table provides detail regarding our wireless services segment for the three and nine months ended September 30, 2007 and 2006:
Wireless services expenses:
Wireless equipment costs
Total wireless services expenses
Facility costs increased due to increased subscriber usage of higher-cost data services.
Wireless equipment costs decreased due to fewer handsets sold.
Bad debt expense decreased due to improved collections resulting from changes in wireless credit policies.
Employee-related costs increased primarily due to adjustments to wireless equipment revenue and related costs for customer acquisitions. As a result, employee-related costs increased by $5 million in the third quarter of 2007, but due to the corresponding impact on wireless services revenue, these adjustments had no impact on segment income or net income.
Other non-employee related costs decreased primarily due to decreased professional services in our wireless repair centers that were outsourced in 2006, but were provided by employees in 2007.
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Other Services Segment Expenses
The following table provides detail regarding our other services segment for the three and nine months ended September 30, 2007 and 2006:
Other services expenses:
Real estate costs
Total other services expenses
Employee-related costs decreased primarily due to lower employee benefit costs primarily as a result of benefit plan changes effective in 2007 and net reduced costs associated with the recognition of actuarial losses from prior years. See additional information under the heading “Pension and Post-Retirement Benefits.”
Other non-employee related costs increased primarily due to $353 million of charges related to securities and other litigation in the third quarter of 2007 and a $40 million charge for securities litigation in the first quarter of 2007.
Non-Segment Operating Expenses—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 decrease our estimates of the useful lives of our assets, we expect that our depreciation expense will continue to decrease.
Amortization expense decreased due to the change in our estimate of average economic lives in January 2007 and lower capital spending on software related assets since 2001. Amortization expense would have been $30 million and $90 million higher for the three and nine months ended September 30, 2007, respectively, had we not changed our estimates of the average economic lives to better reflect the expected future use of the software.
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Other Consolidated Results
The following table provides detail regarding other expense (income)—net and income tax benefit:
Loss on early retirement of debt—net
Other Expense (Income)—Net
Interest expense on long-term borrowings and capital leases—net decreased due to lower total borrowings, resulting primarily from the repayment of $485 million of notes in the third quarter of 2006 and net repayments of $384 million of notes in the second quarter of 2007.
The changes in loss on early retirement of debt—net for the nine months ended September 30, 2007 were primarily due to a $22 million loss on early retirement of debt in the second quarter of 2007 and a $9 million loss on early retirement of debt in the third quarter of 2006.
Other—net includes, among other things, interest income and other interest expense (such as interest on income taxes). The decrease in other—net was primarily due to a gain of $39 million in the third quarter of 2006 for interest income related to a settlement of certain open issues covered by a tax sharing agreement and the recognition of a gain in the first quarter of 2006 on a customer’s abandonment of an indefeasible right of use and other non-recurring items.
Income Tax
Prior to 2006, we had a history of losses and, as a result, we recognized a valuation allowance for our net deferred tax assets. A significant portion of our net deferred tax assets relate to tax benefits attributable to U.S. tax net operating loss carryforwards, or NOLs. During the third quarter of 2007, we reclassified approximately $0.6 billion from our estimated NOLs to another non-current deferred tax asset. Following this reclassification, our estimated NOLs totaled approximately $7.2 billion as of September 30, 2007.
Each quarter we have evaluated the need to retain all or a portion of the valuation allowance on our deferred tax assets. During the three months ended September 30, 2007, we determined that it is more likely than not that we will realize the vast majority of our deferred tax assets, including the NOLs. In making this determination, we analyzed, among other things, our recent history of earnings and cash flows, forecasts of future earnings, the nature and timing of future deductions and benefits represented by the deferred tax assets and our cumulative earnings for the last twelve quarters. The reversal of the valuation allowance resulted in a current period income tax benefit of $2.174 billion and an increase in our current and non-current deferred tax assets on our condensed consolidated balance sheet as of September 30, 2007. Certain deferred tax assets totaling $130 million require future income of special character in order to release the tax benefits. We currently are not forecasting income of appropriate character for these items and, as such, we continue to maintain a valuation allowance for these items. We also expect to release additional valuation allowance through income tax benefit in the fourth quarter of
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2007, such that any net tax benefit or expense in that period should be immaterial. We anticipate that in 2008 we will begin reporting income tax expense of approximately 37% to 39% of income before income taxes, excluding any impact of uncertain tax positions as discussed below.
We increased our uncertain tax position liability for certain federal and state income tax issues by $1 million in the first quarter of 2007 and $16 million in the second quarter of 2006. We have agreed on a tentative settlement with the IRS related to audits for the tax years 1998 through 2001. This settlement is subject to formal approval by the IRS and the Joint Committee on Taxation of the U.S. Congress. If the settlement is effected in accordance with our expectations, we believe that it is reasonably possible that we could recognize up to $146 million of tax and interest benefits (including up to a $105 million increase in net income) and our total unrecognized tax benefits may decrease by approximately $221 million by June 30, 2008.
In the third quarter of 2006, we recognized a $53 million income tax benefit as the result of the settlement of certain open issues covered by a tax sharing agreement.
Liquidity and Capital Resources
Near-Term View
Our working capital deficit, or the amount by which our current liabilities exceed our current assets, was $1.486 billion and $1.506 billion as of September 30, 2007 and December 31, 2006, respectively. Our working capital deficit decreased $20 million primarily due to earnings before depreciation, amortization and income taxes and proceeds from the issuance of long-term debt. These items were partially offset by capital expenditures, repurchases of our common stock, the reclassification to current of long-term debt and the reclassification to non-current of investments in auction rate securities.
We expect our 2007 capital expenditures to approximate our 2006 level, with the majority being used in our wireline services segment.
The $1.265 billion of our 3.50% Convertible Senior Notes due 2025 (the “3.50% Convertible Senior Notes”) was classified as a current obligation as of September 30, 2007 and December 31, 2006 because specified, market-based conversion provisions were met as of those dates. As such, the holders of these notes have the right to convert the notes and receive from us (i) cash for the principal value of notes and (ii) shares of our common stock or equivalent value of cash at our option in accordance with the terms of the notes. These market-based conversion provisions specify that, when our common stock has a closing price above $7.08 per share for 20 or more trading days during certain periods of 30 consecutive trading days, these notes become available for conversion for a specified period. As a result, these notes are classified as a current obligation. These notes are registered securities and are freely tradable. As of September 30, 2007, the notes had a market price of $1,663 per $1,000 principal amount of notes, compared to an estimated conversion value of $1,543. Therefore, we do not anticipate holders will elect to convert their notes because the market price of these notes is currently above the estimated conversion value.
We believe that our cash on hand, our currently undrawn credit facility described below and our cash flows from operations should be sufficient to meet our cash needs through the next 12 months. However, if we become subject to significant judgments, settlements and/or tax payments, as further discussed in Note 9—Commitments and Contingencies to our condensed consolidated financial statements in Item 1 of Part I of this report, or if holders of the 3.50% Convertible Senior Notes elect to convert their notes because market-based conversion provisions were met, we could be required to make significant payments that may cause us to draw down significantly on our cash balances. The magnitude of any settlements or judgments resulting from these actions 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.
To the extent that our EBITDA (earnings before interest, taxes, depreciation and amortization as defined in our debt covenants) is reduced by cash judgments, settlements and/or tax payments, our debt to consolidated
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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 line of credit and potential restrictions on incurring additional debt under certain provisions of our debt agreements.
We have $850 million available to us under a revolving credit facility (referred to as the Credit Facility), which is currently undrawn and which expires in October 2010. 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 9—Commitments and Contingencies to our condensed consolidated financial statements in Item 1 of Part I of this report. The Credit Facility is guaranteed by our wholly owned subsidiary, Qwest Services Corporation, and is secured by a senior lien on the stock of its wholly owned subsidiary, Qwest Corporation (“QC”).
The wireline services segment provides 96% of our total operating revenue with the balance attributed to our wireless services and other services segments. The wireline services segment also provides all of the consolidated cash flows from operations. Cash flows used in operations of our wireless services segment are not expected to be significant in the near term. Cash flows used in operations of our other services segment are significant; however, we expect that the cash flows provided by the wireline services segment will be sufficient to fund these operations in the near term.
On October 4, 2006, our Board of Directors approved a stock repurchase program for up to $2 billion of our common stock over two years. It is our intention to fully achieve this plan over this period, while reviewing, on a regular basis, opportunities to enhance shareholder returns. For the three and nine months ended September 30, 2007, we repurchased 27 million and 107 million shares, respectively, of our common stock under this program at a weighted average price per share of $9.17 and $8.82, respectively. As of September 30, 2007, we had repurchased a total of $1.152 billion of common stock under this program; thus $848 million remained available for stock repurchases.
On October 18, 2007, we redeemed $250 million aggregate principal amount of QCII’s Floating Rate Senior Notes due 2009.
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 attempt to improve our capital structure by accessing debt or other markets in a manner designed to create positive economic value.
Long-Term View
We have historically operated with a working capital deficit as a result of our significant debt and it is likely that we will operate with a working capital deficit in the future. We believe that cash provided by operations and our currently undrawn Credit Facility, combined with our current cash position and continued access to capital markets to refinance our current portion of debt, should allow us to meet our cash requirements for the foreseeable future.
We may periodically need to obtain financing in order to meet our debt obligations as they come due. 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 revenue and cash provided by operations decline, if economic conditions weaken, if competitive pressures increase, if we become subject to significant judgments, settlements and/or tax payments as further discussed in Note 9—Commitments and Contingencies to our condensed consolidated financial statements in Item 1 of Part I of this report or if holders of the 3.50% Convertible Senior Notes elect to convert their notes because market-based conversion provisions were met. In the event of an adverse outcome in one or more of these matters, we could be required to make significant payments that may cause us to draw down significantly on our cash balances. The magnitude of any settlements or judgments resulting from these actions 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.
The Credit Facility makes available to us $850 million of additional credit subject to certain restrictions as described below and is currently undrawn. This facility has a cross payment default provision, and this facility
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and certain other debt issues also have cross acceleration provisions. When present, such 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:
we fail to pay any indebtedness when due in an aggregate principal amount greater than $100 million;
any indebtedness is accelerated in an aggregate principal amount greater than $100 million; or
judicial proceedings are commenced to foreclose on any of our assets that secure indebtedness in an aggregate principal amount greater than $100 million.
Upon such 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 such 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. 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 9—Commitments and Contingencies to our condensed consolidated financial statements in Item 1 of Part I of this report.
Historical View
The following table summarizes cash flow activities for the nine months ended September 30, 2007 and 2006:
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 on unconditional purchase obligations in 2006 and lower payments for interest, facility costs, marketing and advertising, and employee-related costs in 2007. These cash flow improvements were partially offset by $200 million of escrow payments related to the settlement of the consolidated securities action in the first quarter of 2007 compared to $100 million of escrow payments related to this settlement in the first quarter of 2006.
Investing Activities
Cash used for investing activities decreased primarily due to a net source of cash of $245 million from investments in auction rate securities and lower capital expenditures resulting from a change in the timing of spending initiatives. However, as discussed under the heading “Near-Term View,” we expect our 2007 capital expenditures to approximate our 2006 level. Additionally, during the third quarter of 2006, we paid $107 million to acquire OnFiber Communications, Inc.
Financing Activities
For the nine months ended September 30, 2007, we took the following measures to improve our capital structure:
On May 16, 2007, QC issued $500 million aggregate principal amount of notes that bear interest at 6.5% per year and are due in 2017. The net proceeds of approximately $493 million from the issuance
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have been or will be used for general corporate purposes, including repayment of indebtedness and funding and refinancing investments in our telecommunications assets;
•
On June 4, 2007, QC redeemed $250 million aggregate principal amount of its 8 7/8% Debentures due June 1, 2031;
On June 4, 2007, we redeemed $250 million aggregate principal amount of QCII’s Floating Rate Senior Notes due 2009;
On June 7, 2007, QC redeemed $70 million aggregate principal amount of its 6.0% Notes due 2007; and
On June 15, 2007, our wholly owned subsidiary, Qwest Communications Corporation, repaid at maturity $314 million aggregate principal amount of its 7.25% Senior Notes due 2007.
For information on our 2006 financing activities, see Note 9—Borrowings to our consolidated financial statements in Item 8 of our Annual Report on Form 10-K for the year ended December 31, 2006 (our “2006 Form 10-K”).
For the nine months ended September 30, 2007, we paid approximately $950 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 $130 million. As of September 30, 2007, we had outstanding letters of credit of approximately $91 million.
Credit Ratings
The table below summarizes our long-term debt ratings as of September 30, 2007:
Corporate rating/Sr. Implied rating
Qwest Corporation
Qwest Capital Funding, Inc.
Qwest Communications International Inc.*
NR = Not rated.
* = QCII notes have various ratings.
On June 7, 2007, S&P raised its rating for QC from BB+ to BBB-, reflecting the only change in the credit ratings above since December 31, 2006.
Debt ratings by the various rating agencies reflect each agency’s opinion of the ability of the issuers to repay debt obligations as they come due. In general, lower ratings result in higher borrowing costs and/or impaired ability to borrow. A security rating is not a recommendation to buy, sell, or hold securities and may be subject to revision or withdrawal at any time by the assigning rating organization.
Given our current credit ratings, as noted above, our ability to raise additional capital under acceptable terms and conditions may be negatively impacted.
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 may employ derivative financial instruments to manage our interest rate risk exposure.
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Approximately $1.25 billion and $1.5 billion of floating-rate debt was exposed to changes in interest rates as of September 30, 2007 and December 31, 2006, respectively. This exposure is linked to LIBOR. A hypothetical increase of 100 basis points in LIBOR would not have had a material effect on pre-tax interest expense for the three and nine months ended September 30, 2007. As of September 30, 2007 and December 31, 2006, we had approximately $200 million and $400 million of long-term fixed rate debt obligations maturing in the subsequent 12 months. We are exposed to changes in interest rates at any time that we choose to refinance this debt. A hypothetical increase of 100 or 200 basis points in the interest rates on any refinancing of the current portion of long-term debt would not have a material effect on our earnings.
Our 3.50% Convertible Senior Notes were classified as a current obligation as of September 30, 2007 and December 31, 2006 because specified, market-based conversion provisions were met as of those dates. As such, the holders of these notes have the right to convert the notes and receive from us (i) cash for the principal value of notes and (ii) shares of our common stock or equivalent value of cash at our option in accordance with the terms of the notes. Although holders of these notes have the right to convert in the near term, we do not anticipate holders will elect to convert their notes because the market price of these notes is currently above the estimated conversion value. In the unlikely event that holders of a substantial amount of these notes did elect to convert, we might choose to borrow additional amounts, which would expose us to changes in interest rates. A hypothetical increase of 100 basis points in the interest rates on any refinancing of the convertible notes would not have a material effect on our earnings.
As of September 30, 2007, we had $1.008 billion invested in highly liquid instruments and $119 million invested in auction rate securities. 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 not have a material effect on our earnings.
Off-Balance Sheet Arrangements
There were no substantial changes to our off-balance sheet arrangements or contractual commitments in the nine months ended September 30, 2007, when compared to the disclosures provided in our 2006 Form 10-K.
Critical Accounting Policies and Estimates
In our 2006 Form 10-K, we identified certain policies and estimates as critical to our business operations and the understanding of our past or present results of operations. These policies and estimates are considered critical because they had a material impact, or they have the potential to have a material impact, on our financial statements and because they require significant judgments, assumptions or estimates. Our preparation of financial statements requires us to make estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of our financial statements, and the reported amounts of revenue and expenses during the reporting period.
In adopting Financial Accounting Standards Board Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”), effective January 1, 2007, we changed our methodology for estimating our potential liability for income tax positions for which we are uncertain regardless of whether taxing authorities will challenge our interpretation of the income tax laws. Previously, we recorded a liability computed at the statutory income tax rate if we determined that (i) we did not believe that we are more likely than not to prevail on an uncertainty related to the timing of recognition for an item, or (ii) we did not believe that it is probable that we will prevail and the uncertainty is not related to the timing of recognition. However, under FIN 48 we do not recognize any benefit in our financial statements for any uncertain income tax position if we believe the position in the aggregate has less than a 50% likelihood of being sustained. If we believe that there is greater than 50% likelihood that the position will be sustained, we recognize a benefit in our financial statements equal to the largest amount that we believe is more likely than not to be sustained upon audit.
The tax law is subject to varied interpretations, and we have taken positions related to certain matters where the law is subject to interpretation and where substantial amounts of income tax benefits have been recorded in
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our financial statements. As we become aware of new interpretations of the relevant tax laws and as we discuss our interpretations with taxing authorities, we may in the future change our assessments of the likelihood of sustainability or of the amounts that may or may not be sustained upon audit. And as our assessments change, the impact to our financial statements could be material. We believe that the estimates, judgments and assumptions made when accounting for these matters are reasonable, based on information available at the time they are made. However, there can be no assurance that actual results will not differ from those estimates.
Special Note Regarding Forward-Looking Statements
This Form 10-Q contains or incorporates by reference forward-looking statements about our financial condition, results of operations and business. These statements include, among others:
statements concerning the benefits that we expect will result from our business activities and certain transactions we have completed, such as increased revenue, decreased expenses and avoided expenses and expenditures; and
statements of our expectations, beliefs, future plans and strategies, anticipated developments and other matters that are not historical facts.
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 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.
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.
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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 September 30, 2007. 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 third quarter of 2007 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
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PART II—OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The information contained in Note 9—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 could adversely affect our operating results and financial performance.
We compete in a rapidly evolving and highly competitive market, and we expect competition to continue to intensify. We are facing greater competition in our core local business from cable companies, wireless providers (including ourselves), facilities-based providers using their own networks as well as those leasing parts of our network, and resellers. As a reseller of wireless services, we face risks that facility-based wireless providers do not have. In addition, regulatory developments over the past few 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 consistently evaluating our responses to these competitive pressures. Our recent responses include product bundling and packaging, our “digital voice” advertising campaign and focusing on customer service. However, we may not be successful in these efforts. We may not have sufficient resources 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, such as wireless services and satellite video services. Even if we are successful, these initiatives may not be sufficient to offset our continuing loss of access lines. If these initiatives are unsuccessful or insufficient and our revenue declines significantly without corresponding cost reductions, this will cause a significant deterioration to our results of operations and financial condition and adversely affect our ability to service debt, pay other obligations, or enhance shareholder returns.
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 performance.
The telecommunications industry is experiencing an ongoing trend towards consolidation, and several of our competitors have consolidated with other telecommunications providers. This trend 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 begun to experience and expect further increased pressures as a result of this trend 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 performance.
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.
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 data, 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 the trading price of our securities and our ability to service our debt.
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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 royalty or licensing agreements on less favorable terms than we could otherwise obtain or may require us to pay damages. If we are required to take one or more of these actions, our 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 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 9—Commitments and Contingencies to our condensed consolidated financial statements in Item 1 of Part I of this report, 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 the KPNQwest matters vigorously and are currently unable to provide any estimate as to the timing of their resolution.
We can give no assurance as to the impacts on our financial results or financial condition that may ultimately result from these matters. We have not recorded reserves in our financial statements for these matters. However, 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 9—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 financial 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.
Our operations are subject to significant federal regulation, including the Communications Act of 1934, as modified by the Telecommunications Act of 1996, or the Telecommunications Act, and the Federal Communications Commission, or FCC, regulations thereunder. We are also subject to the applicable laws and regulations of various states, including regulation by public utility commissions, or PUCs, and other state agencies. Federal laws and FCC regulations generally apply to regulated interstate telecommunications (including international telecommunications that originate or terminate in the United States), while state regulatory authorities generally have jurisdiction over regulated telecommunications services that are intrastate in nature. The local competition aspects of the Telecommunications Act are subject to FCC rulemaking, but the state regulatory authorities play a significant role in implementing those FCC rules. Generally, we must obtain and maintain certificates of authority from regulatory bodies in most states where we offer regulated services and
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must obtain prior regulatory approval of rates, terms and conditions for our intrastate services, where required. Our businesses 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 their own perceptions of our conduct, or based on customer complaints.
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 PUCs have adopted reduced or modified forms of regulation for retail services. This is generally beneficial to us because it reduces regulatory costs and regulatory filing and reporting requirements. These changes also generally allow more flexibility for new product introduction and enhance our ability to respond to competition. At the same time, some of the changes, occurring 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. These changes may necessitate the need for customer-specific contracts to address matters previously covered in our tariffs. Despite these regulatory changes, a substantial portion of our local voice services revenue remains subject to FCC and state PUC pricing regulation, which could expose us to unanticipated price declines. 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 discharge and disposal of hazardous and environmentally sensitive materials, including the emission of electromagnetic radiation. Although we believe that we are in compliance with such regulations, any such discharge, disposal or emission 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 September 30, 2007, our consolidated debt was approximately $14.5 billion. Approximately $2.5 billion of our debt obligations comes due over the next three years. In addition, holders of the $1.265 billion of our 3.50% Convertible Senior Notes may elect to convert the principal of their notes into cash during periods when specified, market-based conversion requirements are met. However, we do not anticipate holders will make such an election because the market price of these notes is currently above the estimated conversion value. While we currently believe we will have the financial resources to meet our obligations when they come due, we cannot anticipate what our future condition will be. We may have unexpected costs and liabilities and we may have limited access to financing. In addition, on October 4, 2006, our Board of Directors approved a stock repurchase program for up to $2 billion of our common stock over two years. Cash used by us in connection with any purchases of our common stock would 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. 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 revenue and cash provided by operations decline, if economic conditions weaken, if competitive pressures increase, if we become subject to significant judgments, settlements and/or tax payments as further discussed in Note 9—Commitments and Contingencies to our condensed consolidated financial statements in Item 1 of Part I of this report and under the heading “Liquidity and Capital Resources” in Item 2 of Part I of this report or if holders of the 3.50% Convertible Senior Notes elect to convert their notes
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because market-based conversion provisions were met. We can give no assurance that this additional financing will be available on terms that are acceptable. 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 $850 million revolving 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 9—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:
placing us at a competitive disadvantage as compared with our less leveraged competitors;
making us more vulnerable to downturns in general economic conditions or in any of our businesses;
limiting our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate; and
impairing our ability to obtain additional financing in the future for working capital, capital expenditures or general corporate purposes.
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, as such, we anticipate that our capital requirements will continue to be significant in the coming years. Although we have reduced our capital expenditures and 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 current 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.
Declines in the value of qualified pension plan assets, or unfavorable changes in laws or regulations that govern pension plan funding, could require us to provide significant amounts of funding for our qualified pension plan.
While we do not expect to be required to make material cash contributions to our qualified defined benefit pension plan in the near term based upon current actuarial analyses and forecasts, a significant decline in the value of qualified pension plan assets in the future or unfavorable changes in laws or regulations that govern pension plan funding could materially change the timing and amount of required pension funding. As a result, we may be required to fund our qualified defined benefit pension plan with cash from operations, perhaps by a material amount.
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
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borrowings at maturity on terms that impose additional financial risks to our various efforts to improve our financial condition and results of operations could exacerbate the other risks described in this report.
If we pursue and are involved in any business combinations, our financial condition could be adversely affected.
On a regular and ongoing basis, we review and evaluate other businesses and opportunities for business combinations that would be strategically 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 results of operations.
Should we make an error in judgment when identifying an acquisition candidate, or should we fail to successfully integrate acquired operations, we will likely fail to realize the benefits we intended to derive from the acquisition and may suffer other adverse consequences. Acquisitions involve a number of other risks, including:
incurrence of substantial transaction costs;
diversion of management’s attention from operating our existing business;
charges to earnings in the event of any write-down or write-off of goodwill recorded in connection with acquisitions;
depletion of our cash resources or incurrence of additional indebtedness to fund acquisitions;
an adverse impact on our tax position;
assumption of liabilities of an acquired business (including unforeseen liabilities); and
imposition of additional regulatory obligations by federal or state regulators.
We can give no assurance that we will be able to successfully complete and integrate strategic acquisitions.
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 accounting principles generally accepted in the United States, or GAAP, 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 2006 Form 10-K and under the heading “Critical Accounting Policies and Estimates” in Item 2 of Part I of this report, 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 from the Internal Revenue Service, or IRS, as well as from state and local tax authorities. These audits could subject us to risks due to adverse positions that may be taken by these tax authorities. Examples of proceedings involving some of these adverse positions are described under the heading “Other Matters” in Note 9—Commitments and Contingencies to our
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condensed consolidated financial statements in Item 1 of Part I of this report. In June 2006, we received notices of proposed adjustments on several significant issues for the 2002-2003 audit cycle, including a proposed adjustment disallowing a loss we recognized relating to the sale of our DEX directory publishing business. There is 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. Generally, we have not provided for liabilities of former affiliated members or for claims they have asserted or may assert against us.
While we believe our tax reserves adequately provide for the associated tax contingencies, our tax audits and examinations may result in tax liabilities that differ materially from those we have recorded in our condensed consolidated financial statements. Also, the ultimate outcomes of all of these matters are uncertain, and 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.
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. In August 2005, we reached agreements with the Communications Workers of America and the International Brotherhood of Electrical Workers on three-year labor agreements. Each of these agreements was ratified by union members and expires on August 16, 2008. Although we believe that our relations with our employees 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 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 could 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:
quarterly fluctuations in our operating results;
changes in investors’ and analysts’ perception of the business risks and conditions of our business;
broader market fluctuations;
general economic or political conditions;
acquisitions and financings including the issuance of substantial number of shares of our common stock as consideration in acquisitions;
the high concentration of shares owned by a few investors;
sale of a substantial number of shares held by the existing shareholders in the public market, including shares issued upon exercise of outstanding options or upon the conversion of our convertible notes; and
general conditions in the telecommunications industry.
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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 third quarter of 2007:
(a)
TotalNumber ofSharesPurchased(1)
(c)
Total Number ofShares Purchasedas Part of PubliclyAnnounced Plansor Programs
(d)
ApproximateDollar Value ofShares That MayYet Be PurchasedUnder the Plansor Programs(2)
Period
July 2007
August 2007
September 2007
Total
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.
Description
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53
54
55
56
57
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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.
By:
/s/ R. WILLIAMJOHNSTON
R. William Johnston
Vice President and Controller
(Chief Accounting Officer and Duly Authorized Officer)
October 30, 2007
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