HECTOR COMMUNICATIONS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The consolidated financial statements include the accounts of Hector Communications Corporation (“HCC” or “Company”) and its subsidiaries. All material intercompany transactions and accounts have been eliminated. Accounting practices prescribed by regulatory authorities have been considered in the preparation of the financial statements and formulation of accounting policies for telephone subsidiaries. These policies conform to generally accepted accounting principles as applied to regulated public utilities in accordance with Statement of Financial Accounting Standards No. 71, “Accounting for the Effects of Certain Types of Regulation” (SFAS 71).
The balance sheet and statement of stockholders’ equity as of June 30, 2006 and the statements of income and cash flows for the periods ended June 30, 2006 and 2005 have been prepared by the Company without audit. In the opinion of management, all adjustments (which include only normal recurring adjustments) necessary to present fairly the financial position, results of operations, and changes in cash flows at June 30, 2006 and 2005 have been made.
Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted. It is suggested these condensed financial statements be read in conjunction with the financial statements and notes thereto included in the Company’s December 31, 2005 Annual Report to Shareholders. The results of operations for the periods ended June 30 are not necessarily indicative of the operating results for the entire year.
The presentation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, and disclosure of contingent assets and liabilities at the balance sheet date, and the reported amounts of revenues and expenses during the reporting period. The estimates and assumptions used in the accompanying consolidated financial statements are based upon management’s evaluation of the relevant facts and circumstances as of the time of the financial statements. Actual results could differ from those estimates. The Company’s financial statements are also affected by depreciation rates prescribed by regulators, which may result in different depreciation rates than for an unregulated enterprise.
Revenues are recognized when earned, regardless of the period in which they are billed. Network access revenues are furnished in conjunction with interexchange carriers and are determined by cost separation studies and nationwide average schedules. Revenues include estimates pending finalization of cost studies. Network access revenues are based upon interstate tariffs filed with the Federal Communications Commission by the National Exchange Carriers Association and state tariffs filed with state regulatory agencies. Management believes recorded revenues are reasonable based on estimates of cost separation studies, which are typically settled within two years.
Income taxes have been calculated in proportion to the earnings and tax credits generated by operations. The Company’s effective income tax rate is higher than the U.S. rate due to the effect of state income taxes.
Certain other amounts in the 2005 financial statements have been reclassified to conform to the 2006 financial statement presentation. These reclassifications had no effect on net income or stockholders’ equity as previously reported.
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COMPREHENSIVE INCOME
The Company’s comprehensive income includes net income and unrealized gains and losses on investments in marketable securities, net of deferred taxes. Comprehensive income for the three-month periods ended June 30, 2006 and 2005 was $7,351,690 and $1,506,782, respectively. Comprehensive income for the six-month periods ended June 30, 2006 and 2005 was $8,982,164 and $2,884,964, respectively.
MERGER AGREEMENT
On June 27, 2006, the Company entered into an agreement and plan of merger which provides for the acquisition of the Company by Hector Acquisition Corp. (“HAC”). HAC is owned by three one-third owners, Blue Earth Valley Communications, Inc., Arvig Enterprises, Inc. and New Ulm Telecom, Inc. Completion of the merger is subject to a number of conditions including approval by the Company’s shareholders, approval by state and federal regulatory authorities and achievement of working capital and long-term debt levels specified in the agreement. In addition, completion of the merger is subject to closing of Alltel Corporation’s acquisition of Midwest Wireless. The merger is expected to close in October 2006. Shareholders of the Company will receive $36.40 per share in cash and outstanding stock options will be cashed out.
The Company has entered into employment agreements or change in control agreements with officers and key employees of the Company. The agreements provide for severance payments in the event of a change in control of the Company and employment termination for reasons other than cause.
STOCK-BASED COMPENSATION
The company adopted Statement of Financial Accounting Standards (SFAS) No. 123R, “Share-Based Payment”, on January 1, 2006. This statement requires Hector to recognize the cost of employee and director services received in exchange for the stock options it has awarded. Under SFAS 123R, Hector is required to recognize compensation expense over an award’s vesting period based on the award’s fair value at the date of grant. Hector has elected to adopt SFAS 123R on a modified prospective basis; accordingly the financial statements for periods prior to January 1, 2006 do not include stock-based compensation costs calculated under the fair value method.
Prior to January 1, 2006 Hector applied APB Opinion No. 25, “Accounting for Stock Issued to Employees” for measurement and recognition of stock-based transactions with its employees and directors. If Hector had recognized compensation cost for its stock-based transactions based on the fair value of the options method prescribed by SFAS No. 123R, net income and net income per share for the three and six month periods ended June 30, 2005 would have been as follows:
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| | Three Months Ended | | Six Months Ended | |
| | June 30, 2005 | | June 30, 2005 | |
Net income as reported | | $ | 1,492,813 | | $ | 2,878,875 | |
Less: Total stock-based employee compensation expense determined under the fair value method for all awards | | (330,695 | ) | (517,465 | ) |
Pro forma net income | | $ | 1,162,118 | | $ | 2,361,410 | |
Basic net income per share: | | | | | |
As reported | | $ | .40 | | $ | .77 | |
Pro forma | | $ | .31 | | $ | .63 | |
Diluted net income per share: | | | | | |
As reported | | $ | .37 | | $ | .71 | |
Pro forma | | $ | .29 | | $ | .58 | |
The Company did not issue any new stock option awards to key employees in the first six months of 2006. Each of the Company’s non-employee directors received an automatic grant of 3,000 shares of nonqualified stock options on May 25, 2006 concurrent with the Company’s annual shareholders meeting. The fair values of the stock options granted in 2006 were estimated on the date of grant using the Black-Scholes option pricing model and the following assumptions:
Exercise price | | $ | 29.97 | |
Expected option holding period | | 7 years | |
Risk free interest rate | | 5.1 | % |
Expected volatility | | 29.9 | % |
Expected dividend yield | | 1.3 | % |
Estimated fair value of the non-employee director options granted in 2006 was $11.20 per share. Total compensation expense recognized for these options was $202,000. Stock based compensation expense recognized in the three-month period and six-month period ended June 30, 2006 for awards issued in prior years was $44,000 and $88,000 respectively.
A summary of stock option activity for the six months ended June 30, 2006 is as follows:
| | | | Average | |
| | Shares | | Price | |
Outstanding, December 31, 2005 | | 386,592 | | $ | 15.27 | |
Granted | | 18,000 | | 29.97 | |
Exercised | | (54,084 | ) | 11.17 | |
Canceled | | (2,666 | ) | 13.38 | |
Outstanding June 30, 2006 | | 347,842 | | $ | 16.69 | |
Options issued to officers and key employees are subject to vesting. Options issued in 2005 vested and became exercisable six months from the date of issue. Options issued prior to 2005 are vested and become exercisable one-third at the date of issue, one-third one year from date of issue and one-third two years from date of issue. There are provisions in the stock plans that accelerate vesting of stock options upon a change in control of the Company. The following table summarizes the status of stock options outstanding at June 30, 2006:
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| | | | Weighted Average | | Weighted | |
| | | | Remaining | | Average | |
Range of Exercise Prices | | Shares | | Option Life | | Exercise Price | |
$7.25 to $9.99 | | 1,000 | | .9 years | | $ | 8.50 | |
$10.00 to $12.00 | | 71,092 | | 2.1 years | | 11.66 | |
$12.01 to $15.00 | | 106,050 | | 2.7 years | | 13.31 | |
$15.01 to $20.00 | | 91,650 | | 3.7 years | | 18.50 | |
$20.01 to $29.97 | | 78,050 | | 6.2 years | | 23.81 | |
| | | | | | | | |
MARKETABLE SECURITIES
Marketable securities consist principally of equity securities of other telecommunications companies. The Company’s marketable securities portfolio is classified as available-for-sale. The cost and fair value of available-for-sale investment securities was as follows:
| | | | Gross | | Gross | | | |
| | | | Unrealized | | Unrealized | | Fair | |
| | Cost | | Gains | | Losses | | Value | |
June 30, 2006 | | $ | 1,102,009 | | $ | 785,639 | | $ | (78,566 | ) | $ | 1,809,082 | |
December 31, 2005 | | 1,102,009 | | 844,188 | | (56,522 | ) | 1,889,675 | |
| | | | | | | | | | | | | |
Net unrealized gains on marketable securities, net of related deferred taxes, are included in accumulated other comprehensive income as follows:
| | Net | | Deferred | | Accumulated | |
| | Unrealized | | Income | | Comprehensive | |
| | Gains | | Taxes | | Income | |
June 30, 2006 | | $ | 707,073 | | $ | (282,829 | ) | $ | 424,244 | |
December 31, 2005 | | 787,666 | | (315,067 | ) | 472,599 | |
| | | | | | | | | | |
These amounts have no cash effect and are not included in the statement of cash flows.
OTHER INVESTMENTS — RURAL TELEPHONE BANK STOCK
As part of its borrowing agreements, the Company made stock investments in CoBank, Rural Telephone Finance Cooperative and the Rural Telephone Bank (“RTB”). In 2005, the Board of Directors of the RTB approved resolutions to liquidate the bank and redeem its stock. Congress removed legal restrictions on the redemption of RTB stock in 2005. In April 2006 the RTB was dissolved and outstanding RTB stock was redeemed at par value. The Company received the par value of its RTB stock, which was $11,610,000 and recorded a gain on sale of $10,341,000.
GOODWILL AND INTANGIBLE ASSETS
The Company accounts for goodwill and other intangible assets under SFAS No. 142, “Goodwill and Other Intangible Assets”. Under the provisions of this accounting standard, goodwill and intangible assets with indefinite useful lives are no longer amortized but are instead tested for impairment on at least an annual basis and when changes in circumstances indicate that the value of goodwill may be below its carrying value.
For 2005, the Company performed its annual impairment test of goodwill during the third quarter. The determined fair value of the reporting units was sufficient to pass the first step impairment test, and no impairment was recorded.
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The carrying value of HCC’s goodwill was $30,921,000 at June 30, 2006 and December 31, 2005; $29,586,000 of goodwill is related to the Company’s telephone operations and $1,335,000 of goodwill is related to other operations.
Changes in the Company’s intangible and other assets are as follows:
| | Intangible | | Other | | | |
| | Assets | | Assets | | Consolidated | |
Balance December 31, 2005 | | $ | 163,868 | | $ | 152,038 | | $ | 315,906 | |
Capitalization of prepaid engineering fees | | | | (5,732 | ) | (5,732 | ) |
Amortization | | (20,308 | ) | | | (20,308 | ) |
Balance June 30, 2006 | | $ | 143,560 | | $ | 146,306 | | $ | 289,866 | |
MIDWEST WIRELESS HOLDINGS, LLC
Midwest Wireless Holdings LLC (“Midwest Wireless”) provides wireless telecommunications services to 456,000 customers in fourteen rural service areas and one metropolitan service area in Minnesota, Wisconsin and Iowa. Population of the service areas is approximately 1,910,000. Midwest Wireless offers a complete package of services, including custom calling features, facsimile and data transmission.
Midwest Wireless is owned by telecommunications companies (principally ILECs) located within Midwest Wireless’ operating footprint in southern Minnesota, northern Iowa and southeastern Wisconsin. HCC owns 8% of Midwest Wireless Holdings LLC. HCC accounts for its investment in Midwest Wireless using the equity method. Income from this investment was $3,043,000 and $2,367,000 in the six-month periods ended June 30, 2006 and 2005, respectively. Cash distributions received from Midwest Wireless were $1,593,000 and $923,000 in the same respective periods.
Income statement information for Midwest Wireless for the periods ended June 30, 2006 and 2005 was as follows:
| | Three Months Ended March 31 | | Six Months Ended June 30 | |
| | 2006 | | 2005 | | 2006 | | 2005 | |
Revenues | | $ | 73,028,493 | | $ | 65,137,404 | | $ | 142,409,105 | | $ | 125,335,079 | |
Operating income | | 22,651,958 | | 20,298,697 | | 45,340,317 | | 36,805,585 | |
Net income | | 18,432,066 | | 16,210,932 | | 37,981,488 | | 29,590,225 | |
| | | | | | | | | | | | | |
On November 17, 2005 Midwest Wireless and Alltel Corporation (“Alltel”) entered into a definitive agreement for Alltel to purchase Midwest Wireless. Compensation paid by Alltel would total $1.075 billion, including payments to Midwest Wireless shareholders, payments to minority interest holders in certain Midwest properties and assumption of Midwest Wireless’ outstanding debt. The Company estimates its pretax share of the proceeds will be $64,900,000. Legal issues raised by U.S. Cellular Corporation related to the definitive agreement have been settled and Midwest Wireless expects to close the transaction in the September/October 2006 timeframe, subject to satisfaction of customary conditions and receipt of regulatory approvals.
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SEGMENT INFORMATION
The Company operates in two business segments. The majority of the Company’s operations consist of providing basic telephone services (often referred to as “plain old telephone service” or “POTS”) to residential and business customers within its service territories. POTS revenues consist mainly of fees for local service which are billed directly to customers and access revenues which are received for intrastate and interstate exchange services provided to long distance carriers. POTS revenues are subject to regulation by a number of state and federal government agencies.
The Company also provides a number of nonregulated telecommunications services to customers. These services include cable television or video service, internet access services, lease of fiber optic transport facilities, billing and collection services to long distance carriers, telephone directory services and equipment rental. The Company also makes retail sales of consumer telecommunications equipment and sells wireless telephone services on a commission basis.
Segment information is as follows:
| | POTS | | Other Services | | Total | |
Six Months Ended June 30, 2006 | | | | | | | |
Revenues | | $ | 10,404,111 | | $ | 5,404,226 | | $ | 15,808,337 | |
Costs and expenses | | 7,844,955 | | 4,739,280 | | 12,584,235 | |
Operating income | | 2,559,156 | | 664,946 | | 3,224,102 | |
Depreciation and amortization | | $ | 3,007,516 | | $ | 732,050 | | $ | 3,739,566 | |
Total assets | | $ | 89,408,933 | | $ | 36,379,681 | | $ | 125,788,614 | |
Capital expenditures | | $ | 1,376,766 | | $ | 379,752 | | $ | 1,756,518 | |
| | | | | | | |
Six Months Ended June 30, 2005 | | | | | | | |
Revenues | | $ | 10,481,436 | | $ | 5,025,653 | | $ | 15,507,089 | |
Costs and expenses | | 8,097,305 | | 3,880,254 | | 11,977,559 | |
Operating income | | $ | 2,384,131 | | $ | 1,145,399 | | $ | 3,529,530 | |
Depreciation and amortization | | $ | 3,026,640 | | $ | 804,186 | | $ | 3,830,826 | |
Total assets | | $ | 94,931,391 | | $ | 31,931,424 | | $ | 126,862,815 | |
Capital expenditures | | $ | 874,170 | | $ | 435,312 | | $ | 1,309,482 | |
| | POTS | | Other Services | | Total | |
Three Months Ended June 30, 2006 | | | | | | | |
Revenues | | $ | 5,298,944 | | $ | 2,755,202 | | $ | 8,054,146 | |
Costs and expenses | | 3,945,815 | | 2,752,991 | | 6,698,806 | |
Operating income | | 1,353,129 | | 2,211 | | 1,355,340 | |
Depreciation and amortization | | $ | 1,504,170 | | $ | 356,959 | | $ | 1,861,129 | |
Capital expenditures | | $ | 352,988 | | $ | 193,236 | | $ | 546,224 | |
| | | | | | | |
Three Months Ended June 30, 2005 | | | | | | | |
Revenues | | $ | 5,335,861 | | $ | 2,522,231 | | $ | 7,858,092 | |
Costs and expenses | | 4,177,004 | | 1,964,869 | | 6,141,873 | |
Operating income | | $ | 1,158,857 | | $ | 557,362 | | $ | 1,716,219 | |
Depreciation and amortization | | $ | 1,513,321 | | $ | 401,870 | | $ | 1,915,191 | |
Capital expenditures | | $ | 565,571 | | $ | 321,915 | | $ | 887,486 | |
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Hector Communications Corporation (“Hector” or “Company”) is a telecommunications holding company which, through its subsidiaries, primarily provides local telephone and cable television service. The Company also invests in other companies providing wireless telephone and other telecommunications related services.
At June 30, 2006 Hector operated nine wholly-owned local exchange company subsidiaries (generally referred to as “local exchange carriers” or “LECs”) serving 29,290 access lines in 28 rural communities in Minnesota, Wisconsin and North Dakota. HCC, through its subsidiaries, also provides cable television service to 8,040 subscribers in Minnesota.
Six Months Ended June 30, 2006 Compared to Six Months Ended June 30, 2005
Revenues increased 2% to $15,808,000 in 2006 from $15,507,000 in 2005. The revenue breakdown was as follows:
| | Six Months Ended June 30 | |
| | 2006 | | 2005 | |
Plain old telephone service (“POTS”): | | | | | |
Local network | | $ | 2,985,549 | | $ | 3,023,572 | |
Network access revenues: | | | | | |
Long distance providers - interstate | | 1,713,745 | | 1,540,215 | |
Long distance providers — intrastate | | 2,255,124 | | 2,171,785 | |
Subscriber line charge revenue | | 1,205,739 | | 1,233,251 | |
High cost and universal service fund support | | 2,243,954 | | 2,512,613 | |
Total network access revenues | | 7,418,562 | | 7,457,864 | |
Total POTS revenues | | 10,404,111 | | 10,481,436 | |
Other services: | | | | | |
Video services | | 1,622,004 | | 1,573,494 | |
Internet services | | 2,131,045 | | 1,763,990 | |
Other nonregulated services: | | | | | |
Fiber leases | | 329,124 | | 343,937 | |
Cellular sales commissions | | 177,100 | | 182,388 | |
Directory revenues | | 263,908 | | 277,809 | |
Retail sales | | 200,039 | | 190,412 | |
Long distance resale | | 234,328 | | 223,499 | |
Customer equipment installation and repair | | 217,670 | | 179,330 | |
All other revenues | | 229,008 | | 290,794 | |
Total nonregulated services revenue | | 1,651,177 | | 1,688,169 | |
Total other service revenues | | 5,404,226 | | 5,025,653 | |
Total revenue | | $ | 15,808,337 | | $ | 15,507,089 | |
Total POTS revenues decreased $77,000 or 1%. Local network revenues decreased $38,000 or 1%. Access lines served were 29,290 at June 30, 2006, a decrease of 27 lines from June 2005. Total network access revenues decreased $39,000 or 1%. The revenue decrease was due to lower high cost and universal service support payments from USAC and NECA, which declined $269,000 or 11% from the 2005 period. The loss of these revenues was offset in this period by higher than anticipated revenues from NECA related to settlement of the Company’s 2005 cost studies.
Total revenues from other services increased $379,000 or 8%. Revenues from video (cable television) services increased $49,000 or 3% due to increases in video revenues in areas where the Company offers
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digital video services. Revenues from internet services increased $367,000 or 21%, due to a 29% increase in the number of DSL customers. At June 30, 2006 the Company had 5,949 digital subscriber line (“DSL”) customers and 5,745 dial-up internet customers, compared to 4,607 DSL customers and 6,566 dial-up customers in June 2005. The DSL customer growth was facilitated by the deployment of broadband equipment manufactured by Next Level Communications, Inc. in the Company’s Sleepy Eye, MN exchange in 2002 and 2003. This equipment makes it possible to deliver voice, video and high speed internet services to the customer over the same circuit. Revenues from other nonregulated services declined $37,000.
Operating costs and expenses increased 5% to $12,585,000 in 2006 from $11,978,000 in 2005. The breakdown of costs and expenses was as follows:
| | Six Months Ended June 30 | |
- | | 2006 | | 2005 | |
Plain old telephone service (“POTS”): | | | | | |
Plant operations, excluding depreciation | | $ | 2,333,170 | | $ | 2,350,833 | |
Customer operations | | 723,257 | | 829,051 | |
General and administrative | | 1,569,446 | | 1,642,062 | |
Depreciation and amortization | | 3,007,516 | | 3,026,640 | |
Operating taxes | | 211,566 | | 248,719 | |
Total POTS costs and expenses | | 7,844,955 | | 8,097,305 | |
Other services: | | | | | |
Plant operations | | 1,666 | | 1,663 | |
Customer operations | | 137,457 | | 106,155 | |
General and administrative | | 996,960 | | 207,129 | |
Depreciation and amortization | | 732,050 | | 804,186 | |
Other costs and expenses: | | | | | |
Video service expenses | | 1,643,015 | | 1,569,120 | |
Internet expenses | | 465,746 | | 489,394 | |
Other | | 762,386 | | 702,607 | |
Total other service costs and expenses | | 4,739,280 | | 3,880,254 | |
Total costs and expenses | | $ | 12,584,235 | | $ | 11,977,559 | |
Total POTS costs and expenses decreased $252,000 or 3%. Plant operations expenses decreased $17,000 or 1%. Customer operations expenses decreased $106,000 or 13% due to decreased marketing expenses. General and administrative expenses decreased $73,000 or 4%. Operating income in 2006 from POTS was $2,559,000, an increase of 7% from $2,384,000 in 2005.
Total costs and expenses for other services increased $859,000 or 22%. Video service expenses increased $74,000 or 5% due to higher fee payments to programming providers. Internet expenses decreased $24,000 or 5%. General and administrative expenses increased $790,000 from 2005 due to the cost of expensing employee and director stock options in accordance with SFAS 123R ($290,000) and legal and consulting costs associated with the Company’s shareholder value initiative ($526,000). Depreciation and amortization expenses decreased $72,000 because a substantial amount of the Company’s cable television plant was fully depreciated at the end of 2005. Operating income in 2006 from other services was $665,000, a decrease of 42% from $1,145,000 in 2005. Total operating income decreased 9% to $3,224,000.
Interest expenses for 2006 increased $172,000. 2006 interest expenses were higher than normal due to a $234,000 charge to settle back income tax issues between the Company and Telephone and Data Systems, Inc. (TDS) related to Pine Island Telephone’s investment in Midwest Wireless. Interest and dividend income increased $235,000 due to higher interest rates earned on invested cash balances.
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Income from the Company’s investment in Midwest Wireless Holdings, LLC was $3,043,000 in 2006 an increase of 29% from $2,367,000 in 2005. At June 30, 2006 Midwest Wireless had 456,000 wireless customers, a 9% increase from 2005.
As part of its borrowing agreements, the Company made stock investments in the Rural Telephone Bank (“RTB”). In 2005, the Board of Directors of the RTB approved resolutions to liquidate the bank and redeem its stock. Congress removed legal restrictions on the redemption of RTB stock in 2005. In April 2006 the RTB was dissolved and outstanding RTB stock was redeemed at par value. The Company received the par value of its RTB stock, which was $11,610,000 and recorded a gain on sale of $10,341,000. The Company also sold the headquarters building of its former Hastad Engineering subsidiary in the 2006 period and recorded a gain of $88,000.
Income before income taxes increased to $15,668,000 in the 2006 period compared to $4,852,000 in 2005. Income tax expense increased to $6,637,000 in 2006 from $1,974,000 in 2005. The Company had net income of $9,031,000 in 2006 compared to $2,879,000 in 2005.
Three Months Ended June 30, 2006 Compared to Three Months Ended June 30, 2005
Revenues increased 2% to $8,054,000 in 2006 from $7,858,000 in 2005. The revenue breakdown was as follows:
| | Three Months Ended June 30 | |
| | 2006 | | 2005 | |
Plain old telephone service (“POTS”): | | | | | |
Local network | | $ | 1,526,281 | | $ | 1,596,408 | |
Network access revenues: | | | | | |
Long distance providers - interstate | | 968,488 | | 822,741 | |
Long distance providers — intrastate | | 1,127,673 | | 1,089,969 | |
Subscriber line charge revenue | | 620,607 | | 632,090 | |
High cost and universal service fund support | | 1,055,895 | | 1,194,653 | |
Total network access revenues | | 3,772,663 | | 3,739,453 | |
Total POTS revenues | | 5,298,944 | | 5,335,861 | |
Other services: | | | | | |
Video services | | 831,994 | | 790,551 | |
Internet services | | 1,081,936 | | 860,326 | |
Other nonregulated services: | | | | | |
Fiber leases | | 163,762 | | 181,316 | |
Cellular sales commissions | | 92,115 | | 99,934 | |
Directory revenues | | 129,803 | | 144,877 | |
Retail sales | | 91,732 | | 105,300 | |
Long distance resale | | 113,187 | | 115,740 | |
Customer equipment installation and repair | | 126,044 | | 92,229 | |
All other revenues | | 124,629 | | 131,354 | |
Total nonregulated services revenue | | 841,272 | | 871,354 | |
Total other service revenues | | 2,755,202 | | 2,522,231 | |
Total revenue | | $ | 8,054,146 | | $ | 7,858,092 | |
Total POTS revenues decreased $37,000 or 1%. Local network revenues decreased $70,000 or 4%. Total network access revenues increased $33,000 or 1%. The revenue decrease was due to higher than anticipated revenues from NECA related to settlement of the Company’s 2005 cost studies.
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Total revenues from other services increased $233,000 or 9%. Revenues from video (cable television) services increased $41,000 or 5%. Revenues from internet services increased $222,000 or 26%, due to a 32% increase in the number of DSL customers. Revenues from other nonregulated services declined $30,000.
Operating costs and expenses increased 9% to $6,699,000 in 2006 from $6,142,000 in 2005. The breakdown of costs and expenses was as follows:
| | Three Months Ended June 30 | |
| | 2006 | | 2005 | |
Plain old telephone service (“POTS”): | | | | | |
Plant operations, excluding depreciation | | $ | 1,169,087 | | $ | 1,239,507 | |
Customer operations | | 368,462 | | 413,317 | |
General and administrative | | 795,356 | | 887,026 | |
Depreciation and amortization | | 1,504,170 | | 1,513,321 | |
Operating taxes | | 108,740 | | 123,833 | |
Total POTS costs and expenses | | 3,945,815 | | 4,177,004 | |
Other services: | | | | | |
Plant operations | | 1,074 | | 1,077 | |
Customer operations | | 95,130 | | 58,406 | |
General and administrative | | 817,350 | | 119,506 | |
Depreciation and amortization | | 356,959 | | 401,870 | |
Other costs and expenses: | | | | | |
Video service expenses | | 855,457 | | 812,394 | |
Internet expenses | | 239,200 | | 208,117 | |
Other | | 387,821 | | 363,499 | |
Total other service costs and expenses | | 2,752,991 | | 1,964,869 | |
Total costs and expenses | | $ | 6,698,806 | | $ | 6,141,873 | |
Total POTS costs and expenses decreased $231,000 or 6%. Plant operations expenses decreased $70,000 or 6%. Customer operations expenses decreased $45,000 or 11% due to decreased marketing expenses. General and administrative expenses decreased $92,000 or 10%. Operating income in 2006 from POTS was $1,353,000, an increase of 17% from $1,159,000 in 2005.
Total costs and expenses for other services increased $788,000 or 40%. Video service expenses increased $43,000 or 5% due to higher fee payments to programming providers. Internet expenses increased $31,000 or 15%. General and administrative expenses increased $698,000 from 2005 due to the cost of expensing employee and director stock options in accordance with SFAS 123R ($246,000 in the 2006 quarter) and legal and consulting costs associated with the Company’s shareholder value initiative ($474,000 in the 2006 quarter). Depreciation and amortization expenses decreased $45,000 because a substantial amount of the Company’s cable television plant was fully depreciated at the end of 2005. Operating income in 2006 from other services was $2,000 compared to $588,000 in 2005. Total operating income decreased 21% to $1,355,000.
Interest expenses for 2006 increased $176,000. 2006 interest expenses were higher than normal due to a $234,000 charge to settle back income tax issues between the Company and Telephone and Data Systems, Inc. (TDS) related to Pine Island Telephone’s investment in Midwest Wireless. Interest and dividend income increased $191,000 due to higher interest rates earned on invested cash balances.
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Income from the Company’s investment in Midwest Wireless Holdings, LLC was $1,477,000 in 2006 an increase of 14% from $1,297,000 in 2005. At June 30, 2006 Midwest Wireless had 455,613 wireless customers, a 9% increase from 2005.
As part of its borrowing agreements, the Company made stock investments in the Rural Telephone Bank (“RTB”). In 2005, the Board of Directors of the RTB approved resolutions to liquidate the bank and redeem its stock. Congress removed legal restrictions on the redemption of RTB stock in 2005. In April 2006 the RTB was dissolved and outstanding RTB stock was redeemed at par value. The Company received the par value of its RTB stock, which was $11,610,000 and recorded a gain on sale of $10,341,000. The Company also sold the headquarters building of its former Hastad Engineering subsidiary in the 2006 period and recorded a gain of $88,000.
Income before income taxes increased to $12,780,000 in 2006 compared to $2,517,000 in 2005. Income tax expense increased to $5,448,000in 2006 from $1,024,000 in 2005. The Company had net income of $7,332,000 in 2006 compared to $1,493,000 in 2005.
Liquidity and Capital Resources
Cash flows from operating activities for the six-month periods were $5,155,000 and $6,362,000 in 2006 and 2005, respectively. At June 30, 2006, the Company’s cash and cash equivalents totaled $25,765,000 compared to $25,245,000 at December 31, 2005. Working capital at June 30, 2006 was $15,926,000 compared to $18,981,000 at December 31, 2005. The current ratio was 2.1 to 1 at June 30, 2006.
Plant additions in the 2006 and 2005 periods were $1,756,000 and $1,309,000, respectively. Plant additions in the 2006 period went primarily to increase the use of fiberoptic technology in the Company’s Loretel Systems subsidiary. The OC-192 ring installed at Loretel will serve as the platform for the Company’s “Triple Play” offering of voice, video and high speed internet to a new group of customers. Plant additions for 2006 are expected to total $4,234,000. These plant additions will upgrade the Company’s telephone equipment to allow advanced telecommunications services, expand telecommunications services into new construction developments and increase usage of broadband equipment and high capacity fiber optics in the telephone network.
As part of its borrowing agreements, the Company has stock investments in CoBank, Rural Telephone Finance Cooperative and the Rural Telephone Bank (“RTB”). In 2005, the Board of Directors of the RTB approved resolutions to liquidate the bank and redeem its stock. Congress removed legal restrictions on the redemption of RTB stock in 2005. In April 2006 the RTB was dissolved and outstanding RTB stock was redeemed at par value. The Company received the par value of its RTB stock, which was $11,610,000.
The Company’s working capital position benefited from debt and equity issuances in 2006 and 2005. Borrowings from the Rural Utilities Service and Rural Telephone Bank totaled $253,000 and $1,769,000 in the respective 2006 and 2005 periods. Loan funds are utilized to finance plant additions. At June 30, 2006, construction funds on hand totaled $756,000. The Company received $594,000 and $258,000 during the respective 2006 and 2005 from employee stock option exercises.
The Company’s long-term debt includes a term loan provided to Hector by CoBank. The loan is secured by a pledge of the stock of Hector’s subsidiary companies. In June 2006 the Company made an unscheduled principal payment of $11,478,000 on this loan, which paid-off all of the floating rate debt. Interest rates on the remaining portions of the loan are fixed through 2007. The average rate on the outstanding loan was approximately 7.4% at June 30, 2006. The outstanding balance on this loan at June 30, 2006 was $7,772,000.
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The Company’s Board of Directors has initiated a policy of paying regular cash dividends. Cash dividends were paid to shareholders of $.10 per share in March 2006 and June 2006, and $.05 per share in March 2005 and June 2005, respectively. The Company’s merger agreement with HAC suspends payments of any future dividends.
In November 2005 Midwest Wireless and Alltel Corporation (“Alltel”) entered into a definitive agreement for Alltel to purchase Midwest Wireless. Compensation paid by Alltel would total $1.075 billion, including payments to Midwest Wireless shareholders, payments to minority interest holders in certain Midwest properties and assumption of Midwest Wireless’ outstanding debt. The Company estimates its pretax share of the proceeds will be $64,900,000. Legal issues raised by U.S. Cellular Corporation related to the definitive agreement have been settled and Midwest Wireless expects to close the transaction in the September/October 2006 timeframe, subject to satisfaction of customary conditions and receipt of regulatory approvals.
By utilizing cash flow from operations, current cash and investment balances, and other available financing sources, the Company feels it has adequate resources to meet its anticipated operating, debt service and capital expenditure requirements. The Company also believes its operations and financial position meet the requirements specified in the merger agreement with HAC.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
The Company does not use derivative financial instruments in its operations or investment portfolio. Its operations are not subject to risks associated with changes in the value of foreign currencies. Portions of the Company’s long-term debt have variable interest rates based on the lenders’ cost of money. The Company has investments in money market funds that earn interest at prevailing market rates. In the opinion of management, the Company does not have a material exposure to loss caused by market risk.
Item 4. Controls and Procedures
Under the supervision and with the participation of our management, including our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), we evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)). Based on that evaluation, our CEO and CFO have concluded that, as of the end of the period covered by this report, our disclosure controls and procedures are operating effectively and are adequately designed to ensure that information required to be disclosed by us in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the applicable rules and forms and is accumulated and communicated to our management, including the CEO and CFO, as appropriate to allow timely decisions regarding required disclosure. During the period covered by this Report there was no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
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From time to time in reports filed with the Securities and Exchange Commission, in press releases, and in other communications to shareholders and the investing public, the Company may make statements regarding the Company’s future financial performance. Such forward looking statements are subject to risks and uncertainties, including but not limited to, the effects of the Telecommunications Act, new technological developments which may reduce barriers for competitors entering the Company’s local exchange or cable television markets, higher than expected expenses and other risks involving the telecommunications industry generally. All such forward-looking statements should be considered in light of such risks and uncertainties.
PART II. OTHER INFORMATION
Item 1 — Not applicable.
Item 1A. Risk Factors
There have been no material changes to the Company’s risk factors from those disclosed in the Company’s 2005 Annual Report on Form 10-K.
Items 2 — 3. Not Applicable
Item 4. Submission of Matters to a Vote of Security Holders
The Annual Meeting of the Shareholders of the Registrant was held on May 25, 2006 in Eden Prairie, MN. The total number of shares outstanding and entitled to vote at the meeting was 4,039,700 of which 3,863,219 were present either in person or by proxy. Shareholders re-elected board members Luella Gross Goldberg, Paul A. Hoff and Gerald D. Pint to three-year terms expiring at the 2009 Annual Meeting of Shareholders.
| | In Favor | | Abstaining | |
Luella Gross Goldberg | | 3,283,323 | | 579,896 | |
Paul A. Hoff | | 3,293,769 | | 569,450 | |
Gerald D. Pint | | 3,293,769 | | 569,450 | |
Board members continuing in office are James O. Ericson, Paul N. Hanson and Wayne E. Sampson (whose terms expire at the 2007 Annual Meeting of Shareholders) and Curtis A. Sampson, Steven H. Sjogren and Ronald J. Bach (whose terms expire at the 2008 Annual Meeting of Shareholders).
Item 5. Other Information
On August 10, 2006, the Company reported its financial results for its second quarter ended June 30, 2006. The Company’s press release is furnished as Exhibit 99 to this quarterly report.
Item 6(a). Exhibits
11 | | Calculation of Earnings Per Share |
31.1 | | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (Rules 13a-14 and 15d-14 of the Exchange Act) |
31.2 | | Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (Rules 13a-14 and 15d-14 of the Exchange Act) |
32 | | Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 USC §1350). |
99 | | Press Release dated August 10, 2006. |
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Item 6(b). Reports on Form 8-K.
On June 30, 2006, the Company filed a current report on Form 8-K with the Securities and Exchange Commission, reporting under Items 1.01, 3.03, 8.01 and 9.01 its merger agreement with Hector Acquisition Corp. An amendment to this Form 8-K under Items 1.01 and 9.01 was filed on July 10, 2006.
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Signatures
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereto duly authorized.
| | Hector Communications Corporation |
| | |
| | By | | /s/Curtis A. Sampson |
Date: August 11, 2006 | | | | Chief Executive Officer |
| | | | |
| | By | | /s/Charles A. Braun |
Date: August 11, 2006 | | | | Chief Financial Officer |
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