================================================================================
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark One)
X ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934 [FEE REQUIRED]
For the fiscal year ended December 31, 1997
OR
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED]
Commission File Number: 0-18587
HECTOR COMMUNICATIONS CORPORATION
(Exact name of registrant as specified in its charter)
Minnesota 41-1666660
- ---------------------------------- --------------------
(State or other jurisdiction (Federal Employer
of incorporation or organization) Identification No.)
211 South Main Street
Hector, MN 55342
(Address of principal executive offices and zip code)
Registrant's telephone number, including area code: (320) 848-6611
Securities registered pursuant to Section 12(b) of the Act:
Title of each class
Common Stock, $.01 par value
8.5% Convertible Debentures due 2002
Securities registered pursuant to Section 12(g) of the Act: None
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 a check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. (X)
The aggregate market value of the voting stock held by non-affiliates of the
Registrant was approximately $17,237,000 based upon the closing sale price of
the Company's common stock on the American Stock Exchange on March 19, 1998.
As of March 19, 1998 there were outstanding 2,099,226 shares of the Registrant's
common stock.
Documents Incorporated by Reference: The Company's Proxy Statement for its
Annual Meeting of Shareholders to be held on May 19, 1998 is incorporated by
reference into Part III of this Form 10-K.
================================================================================
PART I.
ITEM 1. BUSINESS
[a] GENERAL DEVELOPMENT OF BUSINESS
Hector Communications Corporation ("HCC" or "Company") is a diversified
telecommunications holding company which, through its wholly-owned and
majority-owned subsidiaries, is principally engaged in providing local telephone
service. At December 31, 1997, the Company's wholly and majority owned telephone
subsidiaries (generally referred to as "local exchange carriers" or "LECs")
served approximately 32,700 access lines and provided telephone service to 34
rural communities in Minnesota, Wisconsin, South Dakota and Iowa. In addition,
at such date, through its cable television subsidiaries and two LEC
subsidiaries, the Company provided cable television services to approximately
8,300 subscribers in Minnesota, South Dakota and Wisconsin. The Company is also
an investor in entities providing wireless telephone and other
telecommunications related services.
Since becoming a publicly-held company in 1990, HCC has owned and
operated five wholly owned local exchange company subsidiaries which served
6,700 access lines at December 31, 1997. On April 25, 1996, HCC, through its 68%
owned subsidiary, Alliance Telecommunications Corporation ("Alliance"), acquired
Ollig Utilities Company ("Ollig"), a privately owned telecommunications holding
company for $80 million. At the time of the acquisition, Ollig subsidiaries
served approximately 25,000 access lines and 3,400 cable television subscribers
in Minnesota, Iowa, North Dakota and South Dakota. In addition to the Company's
68% ownership position, the remaining interests in Alliance are owned by Golden
West Telecommunications Cooperative, Inc. of Wall, South Dakota, and Split Rock
Telecom Cooperative, Inc. of Garretson, South Dakota.
[b] FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS
The Company operates in two business segments, operation of local
exchange telephone companies and cable television. Information regarding
industry segments is provided in Note 11 to the financial statements found under
Item 8 of this report.
[c] NARRATIVE DESCRIPTION OF BUSINESS
(1) Business Strategy
The Company's business strategy is to expand its existing operations
through internal growth and acquisitions, particularly the acquisition of
additional rural telephone exchanges, and to explore other communications
business opportunities, including the acquisition of cable television
properties.
Future growth in existing telephone and cable operations is expected to
come from providing service to new or presently unserved homes and businesses,
from upgrading existing customers to higher grades of service and from providing
new services made possible by improvements in technology.
The Company continually assesses acquisition opportunities. Competition
to acquire attractive telephone or cable television properties is intense.
Further, acquisitions of rural telephone exchanges are subject to the approval
of regulatory agencies in some states and, in some cases, to federal waivers
that may affect the form of regulation or amount of interstate cost recovery of
acquired telephone exchanges. While management will aggressively pursue
acquisitions of telephone exchanges, there can be no assurance that the Company
will be able to negotiate acquisitions on acceptable terms or that regulatory
approvals, where required, will be received.
2
(2) Telephone Operations
The Company provides modern, high-quality local telephone service and
access to long distance telephone service through its five wholly owned and four
majority owned local exchange carrier subsidiaries. Local service is directly
provided by the Company's LECs and long distance or toll service is provided
through connections with interexchange carriers ("IXCs"), primarily AT&T, MCI
and Sprint. All subscribers have private line service. The Company's customer
base is approximately 81% residential and approximately 19% commercial and
industrial.
The following chart presents the number of access lines served by the
Company's wholly owned LEC subsidiaries at December 31, 1997, 1996 and 1995 and
by the LEC subsidiaries of Alliance at December 31, 1997 and 1996:
Telephone Company Access Lines*
December 31
1997 1996 1995
----------- ----------- ---------
Arrowhead Communications Corporation 749 748 738
Eagle Valley Telephone Company 685 678 659
Granada Telephone Company 275 276 263
Pine Island Telephone Company 2,919 2,775 2,663
Indianhead Telephone Company 2,076 2,057 2,008
Alliance Telecommunications Corporation:
Loretel Systems, Inc. 12,023 11,852
Sleepy Eye Telephone Company 5,998 5,814
Sioux Valley Telephone Company 5,457 5,355
Hills Telephone Company 2,545 2,465
---------- --------
32,727 32,020 6,331
========== ========== =========
- ------------------------------------
* An "access line" is a single or multi-party circuit between the customer's
establishment and the central switching office.
The Company's policy, insofar as possible, is to maintain local
management in each of its local exchange carrier subsidiaries. The Company
provides its LEC subsidiaries with centralized purchasing, general management
and other services. These services afford the subsidiaries expertise in the
following areas: finance, accounting and treasury services, marketing, customer
service, traffic, engineering and construction, customer billing, rate
administration, credit and collection, and development of administrative and
procedural practices.
Regulation
The LEC subsidiaries are subject to regulation by Minnesota, South
Dakota, Iowa and Wisconsin regulatory agencies with respect to intrastate toll
rates, intrastate access charges billed to intrastate IXCs, service areas,
service standards, accounting and related matters. In some cases, local rates,
rate of return, depreciation rates, construction plans and borrowings and
certain other financial transactions may be subject to regulatory approval.
Local service rates are not directly determined by regulatory authorities, but
are limited by regulation of these other areas. The Company has sought and will
continue to seek appropriate increases in local and other service rates and
changes in rate structures to achieve reasonable rates and earnings.
A bill passed by the 1995 Minnesota legislature allows telephone
companies serving fewer than 50,000 access lines to elect to provide service
under an alternate form of regulation. Companies choosing alternative regulation
agree not to increase rates for two years (other than in extraordinary
circumstances) and are not subject to rate of return review by the Public
Utilities Commission for the same period. All of the Company's Minnesota based
LEC subsidiaries elected to be covered by alternative rate regulation election
effective January 1, 1996. Local rate increases after January 1, 1998 are not
subject to review by the Minnesota Public Utilities Commission unless the lower
of 500 or five percent of customers file a petition requesting such review.
3
The Federal Communications Commission ("FCC") regulates interstate toll
rates, interstate access charges paid by IXCs to local exchange carriers and
other matters relating to interstate telephone service. The FCC also regulates
the use of radio frequencies in telephone operations. The Company's telephone
subsidiaries use common line and traffic sensitive tariffs set by the National
Exchange Carriers Association ("NECA") and participate in the access revenue
pools administered by NECA for interstate services. Where applicable, the
Company's subsidiaries also participate in intrastate access tariffs approved by
state regulatory authorities for intrastate intra-LATA (Local Access Transport
Area) and inter-LATA services. Such interstate and intrastate arrangements are
intended to compensate LECs, such as the Company's local exchange carrier
subsidiaries, for the costs, including a fair rate of return, of facilities
furnished in originating and terminating interstate and intrastate long distance
services.
A number of the telephone subsidiaries recover a portion of their costs
via interstate and intrastate support mechanisms. Reevaluation and probable
modification of these mechanisms is expected. The interstate universal service
fund, which is administered by NECA, has been capped and indexed as an interim
measure pending regulatory proceedings. Interstate universal service fund
support accounted for $656,000, $617,000 and $484,000 of the Company's network
access revenues in 1997, 1996 and 1995, respectively. The Telecommunications Act
of 1996 includes provisions to widen the base of providers contributing support
for universal service, but also requires development of new mechanisms and
eligibility criteria. There is no assurance cost recovery through direct and
indirect interstate mechanisms will remain at current levels.
Support and rate structures are in the process of being reduced in
Minnesota and have been recently changed in Wisconsin. There is no assurance the
states will continue to provide for cost recovery from current sources at
current levels. The Company's Wisconsin based LEC subsidiary implemented a local
service rate increase December 1, 1995 to compensate for changes in Wisconsin's
support structure. The Company expects to seek higher local service rates to
recover costs for which current interstate or intrastate recovery may become
unavailable.
Construction and Development Program
The Company's policy is to upgrade the plant and equipment of its local
exchange carrier subsidiaries to maintain modern, high quality telephone
service. Plant additions are made to upgrade service, replace existing
facilities and provide for service expansions. This program also allows the
Company to improve service, increase revenues and reduce costs by taking
advantage of technological developments in the telecommunications industry. The
Company has converted 100% of its access lines to digital switching technology
and is installing high-capacity fiber optic cable facilities where appropriate.
Financing for the telephone construction program is expected to come from
internally generated funds, supplemented by long-term financing from federal
financing programs.
Federal Financing Programs and Other Financing Sources
The Company's primary sources of long-term financing for additions to
telephone plant and equipment have been the Rural Utilities Service (RUS) and
the Rural Telephone Bank (RTB). The RUS has made long-term loans to telephone
companies since 1949, at interest rates of 2% and 5%, for the purpose of
improving telephone service in rural areas. Since October 1, 1991 the RUS is
also authorized to make hardship loans at a 5% interest rate and cost-of-money
loans at a rate reflecting the government's cost of money for a like term. The
RTB advances funds under loan applications approved prior to October 1, 1991 at
interest rates based on the RTB's average cost-of-money. For RTB loan
applications approved after October 1, 1991, advances are at the average U.S.
government cost-of-money for the year for like maturities. In some cases RTB
loans are made concurrently with RUS loans.
Substantially all of the telephone plant of the LEC subsidiaries is
pledged or is subject to mortgages to secure obligations to the RUS and RTB. In
addition, the amount of dividends on common stock that may be paid by the LEC
subsidiaries to the Company is limited by certain financial covenants set forth
in the mortgages.
The LEC subsidiaries have applied for and, in 1997, received approval
for additional loans totaling $14,888,000 from RUS and RTB to meet their
respective capital requirements . At December 31, 1997, the Company's local
4
exchange carrier subsidiaries had unadvanced loan commitments under the RUS and
RTB programs aggregating approximately $17,478,000 to finance specific
construction activities in future years. However, there is no assurance the
Company will be able to draw down funds on these loans and no guarantee the loan
terms or interest rates will be acceptable to the Company. If the Company is
unable to borrow funds through the RUS and RTB programs and the LEC subsidiaries
were to borrow instead from conventional lenders, the cost of new loans might
increase significantly.
In 1996, the Company's 68% owned subsidiary, Alliance
Telecommunications Corporation negotiated a term loan agreement with the St.
Paul Bank for Cooperatives ("St. Paul Bank") to provide financing for the
acquisition of Ollig Utilities Company. The face amount of the loan was
$55,250,000. The loan is secured by a pledge of substantially all the assets of
Alliance and its subsidiaries. The Company has fixed interest rates on this loan
for periods ranging from one to ten years at rates averaging 7.4%. The Company
made only interest payments on the loan in 1996. Principal payments began in
January 1997 and will continue until March, 2011.
In 1996, the Company and one of its cable television subsidiaries,
North American Communications Corporation, negotiated a loan agreement with the
St. Paul Bank for Cooperatives to provide additional financing for the
acquisition of Ollig Utilities Company. The outstanding loan balance at December
31, 1997 was $4,000,000. The loan is payable in quarterly installments of
$143,000, with a final balloon payment due December 31, 2001. Interest rate on
the loan, which varies according to St. Paul Bank's cost of money, was 8.0% at
December 31, 1997. The loan is secured by a pledge of the assets of North
American and the stock of one of the Company's telephone subsidiaries.
St. Paul Bank is a cooperative, owned and controlled by its customers.
As a condition to receiving the loans, the Company purchased stock in the bank.
The Company's investment in St. Paul Bank stock at December 31, 1997 was
$2,749,000. Each customer borrowing from the bank on a patronage basis shares in
the bank's net income through payment of patronage refunds. The Company's
patronage refund from St. Paul Bank was $694,000 and $221,000 in 1997 and 1996,
respectively. Approximately 30% of the patronage refund is received in cash,
with the balance in stock of St. Paul Bank. The patronage refund is shown in the
Company's operating statement as a reduction of interest expense. The Company
cannot predict what patronage refunds will be in future years.
In February 1995, the Company completed a public offering of convertible
subordinated debentures. The debentures carry an interest rate of 8.5% and
mature February 15, 2002. The debentures are convertible into common stock of
the Company at a rate of 112.5 common shares per $1,000 par value debenture. As
of February 15, 1997, the Company has the right to call the debentures at a
price (depending on the trading price of the Company's common stock) ranging
from 100% to 104% of par. The debentures include restrictions on payment of
dividends to the Company's shareholders. The debentures are subordinated to
$4,000,000 of senior indebtedness owed by the Company to St. Paul Bank. Total
value of the offering was $12,650,000. Proceeds to the Company, after
underwriting, accounting and legal expenses were approximately $11,300,000. The
underwriters also received warrants to purchase 123,750 shares of the Company's
common stock at a price of $8.70 per share. The warrants are currently
exercisable and expire February 15, 2000. The offering proceeds were used to pay
down debt associated with cable television acquisitions, finance cable
television plant additions, purchase additional cable television systems and as
a portion of HCC's equity contribution to Alliance to acquire Ollig Utilities
Company.
Competition
In February 1996, President Clinton signed into law the
Telecommunications Act of 1996. The new law represents the biggest change in
legislation governing local service since Congress imposed federal regulation
and established the FCC in 1934. Under its provisions, the monopoly on local
service enjoyed by LECs is eliminated and LECs must allow competitors access to
the local network facilities. Among other provisions, the new law mandates
changes in the rules governing universal service supports, permits LECs to enter
the long distance business, and changes many of the provisions of the 1984
consent decree which broke apart AT&T and still restricts the activities of AT&T
and the Regional Bell Operating Companies. The final results of the changes made
by the new law will not be known for some time until new rule making by the FCC
and state regulatory agencies is complete. Several provisions of the new law are
also being contested in the courts, making applications of the new law subject
to the judicial process. The Company is monitoring developments regarding the
new regulatory climate closely, and expects its operations will be materially
5
affected by the new rules, but cannot predict what effect the new law and
regulations adopted pursuant to the new law will have on its business.
Prior to passage of the new telecommunications law, a series of FCC,
court and state regulatory agency decisions had served to introduce competition
into many sectors of the telephone industry, including interstate and intrastate
long distance services, special access services and customer premises equipment.
The Company is presently the only provider of local telephone service in the
areas it serves. The Company does not know to what extent it will be subject to
local competition in the markets it serves in the new regulatory environment
created by the new telecommunications law. Technological developments in
competing technologies such as wireless telephone, digital microwave, coaxial
cable, fiber optics and other wireless and wired technologies may result in
other forms of competition to the Company's landline services. The Company and
many other members of the local exchange carrier industry are seeking to
maintain a strong, universally affordable public telecommunications network
through policies and programs that are sensitive to the needs of small
communities and rural areas served by the Company's telephone subsidiaries.
Certain providers and users of long distance service may seek to bypass
LEC switching services and local distribution facilities, particularly if these
services are not strategically priced. There are many ways these customers may
bypass the Company's switching services. Users may construct and operate or
lease facilities to transmit their traffic to an interexchange carrier. Certain
interexchange carriers provide services which allow users to divert their
traffic from the LEC's usage sensitive services to flat-rate services. Users may
also choose to use wireless telephone service to bypass the LEC's switching
service. The Company's telephone subsidiaries have experienced only a small loss
of traffic due to bypass. The Company and the local exchange carrier industry
are seeking to address bypass problems by advocating flexible pricing, including
reduced pricing of access and long distance services where appropriate.
The new telecommunications law and recent FCC rulings which are
intended to promote competition in voice and video communications may provide
the Company with increased business opportunities. Recent changes permit local
telephone companies to offer video dial tone services, permitting greater
telephone company participation in the video marketplace. The rules against
cross-ownership of telephone and cable television systems have also been
somewhat relaxed. The FCC has also authorized cellular telephone, personal
communications services and other technologies which may compete with
traditional telephone services and provide new business opportunities. The
Company actively monitors legislative and regulatory changes to protect its own
interests and evaluate new opportunities.
The Clinton administration has actively promoted a national
communications policy directed toward creation of a broadband, interactive
national information infrastructure. The administration has advocated
legislation based on five principles: encouraging private investment, providing
and protecting competition, providing open access to the telecommunications
network, avoiding a society of information "haves" and "have nots", and
encouraging flexible and responsive government action. Given the
Administration's initiatives as well as recent Congressional actions, the
Company expects that eventually there may be open access to every aspect of the
communications industry. However, the new telecommunications law also mandates
continuing support for universal service and bans discrimination in toll rates
based on geography. The Company believes high-cost support funds and similar
cost-averaging methods should continue to be employed to ensure that advanced
communications services reach rural areas. The Company plans to compete by
providing advanced, high-quality voice, data and video services.
Wireless Telephone Services
Cellular telephone services provide high quality, high capacity
communications to and from vehicle mounted or hand held radio telephones
("cellular telephones"). Cellular technology is a major improvement over earlier
mobile telephone technologies. Cellular telephone systems are designed to allow
for maximum mobility of the customer. In addition to mobility, cellular
telephone systems provide access through system interconnects to local,
regional, national and worldwide telecommunications networks. Cellular telephone
systems also offer a full range of ancillary services such as conference
calling, call waiting, call forwarding, voice mail, facsimile and data
transmission.
6
The FCC has established 733 cellular service areas in the United
States, consisting of 305 Metropolitan Statistical Areas ("MSAs") and 428 Rural
Service Areas ("RSAs"). The FCC has granted two licenses to provide cellular
service in each territory. One license was granted to a company or affiliated
group of companies providing local telephone service in the area ("Wireline
Carriers"). The other license was granted to a company not providing local
telephone service and not affiliated with a local telephone company in the
service area ("Non-Wireline Carriers"). The Company acquired its interests in
cellular telephone as part of the Wireline Carrier group in the RSA markets in
which it owns a telephone operating company.
At December 31, 1997, the Company was an investor in limited
partnerships and limited liability corporations which provide cellular telephone
service in five RSAs in Minnesota, one RSA in North Dakota, the Rochester,
Minnesota MSA and the Sioux Falls, South Dakota MSA and serve approximately
90,000 customers. The Company accounts for these investments using the equity
method. Income recognized on these wireless investments was $1,580,000,
$502,000, and $126,000 in 1997, 1996 and 1995, respectively. The following table
provides the Company's percentage of ownership in each venture and the Company's
proportionate share of the population served by each venture at December 31,
1997:
Total Company's
Population Percent Share of
Name of Venture Service Area Equivalents(1) Ownership Total POPs
Midwest Wireless Rochester, MN MSA 948,000 9.78% 92,714
Communications LLC and MN RSAs 7, 8,
9, 10 and 11
Sioux Falls Cellular, Ltd. Sioux Falls, SD MSA 120,000 12.25% 14,700
Red River Cellular, Inc. ND RSA 3 92,000 1.60% 1,472
- ------------------------------------------------------------------
(1) Estimated population based on the 1990 United States Census.
The Company is also an investor in Rural Cellular Corporation ("RCC"),
a publicly traded company providing cellular telephone services in Minnesota and
New England. In February, 1996, RCC completed an initial offering of its common
stock to the public. As part of the offering, HCC sold 61,133 shares of RCC and
recorded a gain on sale of $485,000. In June, 1997, HCC sold an additional
161,469 shares of RCC and recorded a gain on sale of $1,464,000. At December 31,
1997, the Company owned 2.4% of RCC's common stock.
In addition to competition between the two cellular licensees in each
territory, competition for wireless customers includes competing communications
technologies such as conventional land-line and mobile telephone, SMR systems
and radio paging. In addition, emerging technologies such as enhanced
specialized mobile radio ("ESMR"), mobile satellite communications systems,
second generation cordless telephones ("CT-2") and personal communications
services ("PCS") offer competition with cellular services.
The Company owns 11.66% of Wireless North, a consortium of three
limited partnerships and one limited liability corporation which have acquired
16 licenses to operate PCS systems in 13 markets in Minnesota, Wisconsin, North
Dakota and South Dakota. The Company has invested $510,000 of cash and
guaranteed debt of $1,373,000 in these entities. The PCS systems are in start-up
mode and have not been profitable to date. Losses recorded by the Company on its
PCS investments were $435,000 and $73,000 in 1997 and 1996, respectively. The
Company has committed to providing $1,486,000 of additional capital to these
entities. It cannot predict if additional funding beyond this amount will be
required.
There are a number of recent technological developments in the wireless
telephone industry. Currently most cellular telephone systems use equipment
which processes information digitally but does radio transmission on an analog
basis. Digital radio technology offers advantages, including less transmission
noise, greater system capacity and lower incremental costs for additional
customers. The conversion from analog to digital radio technology was expected
to take a number of years, but is being accelerated by competition from digital
PCS systems.
7
The wireless telephone industry is characterized by high initial fixed
costs. Accordingly, when system revenues less variable operating costs exceed
fixed costs, the system should generate an operating profit. Wireless profits,
if any, are dependent on service prices and variable marketing costs which are
affected by the amount and extent of competition. Until technological
limitations on total capacity are approached, additional wireless system
capacity can normally be added in increments that closely match demand and cost
proportionately less than the initial fixed costs.
The licensing (including renewal of licenses), construction, operation,
sale, interconnection arrangements and acquisition of wireless systems are
regulated by the FCC and various state public utility commissions. Changes in
the regulation of wireless operators or their activities and of other mobile
service providers (such as the recent FCC issuances of PCS licenses) could have
a material adverse effect on the Company's investment in wireless operations.
Other Telecommunications Investments
The Company also has investments in several other telecommunications
related businesses, including an 11.7% ownership interest in Minnesota Equal
Access Network Services, Inc. ("MEANS"). MEANS was formed in 1988 to bring
state-of-the-art telecommunications to rural areas of Minnesota. MEANS is owned
by shareholders who represent more than two-thirds of the local exchange
carriers in Minnesota. MEANS operates a fiber optic communications network
linking communities throughout the state, including all the major metropolitan
areas. MEANS also provides long-distance telecommun-ications services to
business and residential customers in rural Minnesota. These services include
toll-free telephone numbers providing access from anywhere in the Unites States
and Canada, cellular telephone service, prepaid calling cards, video
conferencing and internet access.
(3) Cable Television Operations
The Company, through its cable television and local exchange carrier
subsidiaries, owns and operates 34 cable television systems serving
approximately 8,300 subscribers in 51 communities in Minnesota, South Dakota and
Wisconsin. All of its cable television systems offer one or more channels of
premium programming, featuring motion pictures which are presented without
commercial interruption.
The Company's cable television revenues are derived almost exclusively
from monthly fees for basic and premium programming. The Company's fees for
basic services range from $9.75 to $22.50 per month. Basic service generally
includes the major television networks, non-network independent stations, sports
programming, news services and automated information channels, children's
programming, access channels for public, governmental, educational and leased
use, senior citizens' programming and religious programming. Premium programming
services are provided to subscribers for an additional fee of $4.95 to $10.95
per month per channel. Approximately one-third of the Company's cable television
customers subscribe to a premium channel. The Company obtains its premium
programming from suppliers for a flat monthly fee per subscriber and/or a fee
based on the monthly charge to subscribers for the service. Subscribers are free
to discontinue the cable service at any time without penalty. The Company
periodically increases its basic and premium programming subscriber fees to
reflect the addition of new cable television services and increased costs due to
inflation.
The Company's cable television systems are operated under 15 year,
non-exclusive franchises granted by local government authorities. These
franchises contain many conditions, including time limitations on commencement
or completion of construction, approval of initial fees charged to subscribers
for basic service, the number of channels offered and the types of programming.
The Company does not anticipate it will experience any difficulty in obtaining
renewal of its franchises at the expiration of their current terms.
8
Maintaining and expanding the Company's cable television subscriber base
depends on numerous factors, including the quality and quantity of signals
available from "off-air" television stations, demand for satellite and premium
television channels and average household income in the area. Cable television
also competes, in varying degrees, with other entertainment and leisure time
activities. Promotional efforts for cable television include telephone and
door-to-door solicitation and local media advertising.
All of the Company's franchises are non-exclusive and the Company
competes with a municipally owned cable system in one community it serves. In
addition to competition from off-air television, other technologies also supply
services provided by cable television. These include low power television
stations, multi-point distribution systems, over-the-air subscription television
and direct broadcast satellite ("DBS"). The Company believes that cable
television presently offers a wider variety of programming at lower cost than
any competing technology. However, the Company is unable to predict the effect
current or developing sources of competition may have on its business.
The Company's cable television systems are regulated by the FCC. FCC
regulations contain many detailed provisions including: "must carry" rules
regarding the broadcast television and translator signals the operator must
include in its channel offerings to subscribers, exclusivity provisions
(requiring the deletion of certain programming carried by out-of-area stations
where it would duplicate programming carried by local stations), technical
standards and performance testing requirements, and franchise fees applicable to
state and local cable television franchises. To date, the Company has not
experienced any difficulty in complying with the FCC rules.
In Minnesota, the award of cable franchises and certain aspects of cable
operations are subject to rules of the Minnesota Cable Communications Board. To
date, the Company has not experienced significant difficulties in complying with
the requirements of Minnesota authorities.
The regulation of cable television at the federal, state and local levels
is subject to the political process and has been in constant flux over the past
decade. This process continues in the context of legislative proposals for new
laws and the adoption or deletion of administrative regulations and policies.
Further material developments in these areas are to be anticipated, but their
direction and impact on the Company's cable television operations cannot be
predicted.
(4) Employees
At March 1, 1998, the Company had 135 employees, of which 120 employees
work in the telephone operations, 10 work in cable television and 5 hold
administrative positions. None of the Company's employees are represented under
collective bargaining agreements. HCC believes its employee relations to be
good.
9
(5) Executive Officers of Registrant
The executive officers of the Company and their ages at March 1, 1998
were as follows:
Name Age Position
Curtis A. Sampson 64 Chairman of the Board and Chief
Executive Officer
Steven H. Sjogren 55 President and Chief Operating
Officer
Paul N. Hanson 51 Vice President and Treasurer
Charles A. Braun 40 Chief Financial Officer
Executive officers serve at the pleasure of the Board of Directors and
are elected annually for one year terms. Each officer above has served the
Company in the indicated capacity since 1990.
Mr. Sjogren devotes his full time to the Company's business. Messrs.
Sampson, Hanson and Braun each devote approximately 40% of their working time to
the Company's business with the balance devoted to management responsibilities
at Communications Systems, Inc. ("CSI"), a diversified telecommunications
holding company also located in Hector, Minnesota, for which they are separately
compensated by CSI.
[d] FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS AND
EXPORT SALES
Not Applicable.
10
ITEM 2. PROPERTIES
Telephone property consists mainly of central office switching equipment,
together with the land and buildings in which such equipment is housed, and
connecting lines which consist of aerial and underground cable, conduit, and
poles and wires, substantially all of which are located within the Company's
operating territories. Substantially all of the customer-leased telephones and
related terminal equipment, including private branch exchanges and a small
amount of connecting lines, are located on customers' premises. These telephones
and related equipment constitute approximately 1% of the Company's telephone
property. The lines, which connect customers' premises with central offices,
constitute approximately 54% of telephone plant. These facilities are located
under or above public rights of way or land owned, for the most part, by others
pursuant to consents of various governmental bodies or to leases, permits,
easements, agreements or licenses, express or implied through use without
objection by the owners.
Central office switching equipment represents approximately 30% of the
Company's telephone property in service. Land, buildings, data processing
equipment, service vehicles and construction equipment constitute the remaining
15%. The Company owns substantially all the land and buildings in which its
central office equipment is located. HCC's principal general offices,
administrative services department and business office are located in Hector,
Minnesota and leased to HCC from CSI.
The principal physical assets of the Company's cable television system
operations consist of signal reception equipment and distribution electronics
and cables. The receiving equipment is comprised of a tower and antennas for
reception of broadcast television signals and one or more satellite dishes for
reception of satellite signals. The Company owns or leases the land on which the
towers for its cable systems and the buildings containing other receiving
equipment are located. Pole attachment space is leased from utilities serving
the community.
See Note 6 of "Notes to Consolidated Financial Statements for additional
information regarding pledged assets.
ITEM 3. LEGAL PROCEEDINGS
No material litigation or other claims are presently pending against the
Company.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
11
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS
[a] MARKET INFORMATION
The Company's common stock is currently being traded on the American
Stock Exchange. Prior to February, 20, 1998, the Company's common stock traded
on the National Market System of the National Association of Securities Dealers
Automated Quotation System ("NASDAQ").
The table below presents the range of high and low trading prices for the
Company's stock for each period as reported by NASDAQ.
______1997______ ______1996______
Quarter High Low High Low
First $8.50 $7.25 $8.75 $6.38
Second 9.75 7.38 8.50 6.00
Third 10.50 7.88 8.38 6.88
Fourth 10.13 8.50 8.00 7.00
[b] HOLDERS
At March 1, 1998 there were approximately 1,100 holders of record of
Hector Communications Corporation common stock.
[c] DIVIDENDS
HCC has not paid cash dividends on its common stock or preferred stock
since it began operating as a public company in 1990, nor does HCC have any
obligations to pay dividends on its preferred stock. At the present time, HCC
intends to retain earnings to finance the expansion of its business, and does
not anticipate any cash dividends will be paid in the foreseeable future. The
financing agreements between HCC's subsidiaries and their lenders restrict their
ability to pay dividends to HCC, thereby limiting HCC's ability to pay dividends
to its shareholders. See Management's Discussion and Analysis of Financial
Condition and Results of Operations, and also Note 6 to the Consolidated
Financial Statements under Item 8 herein for a description of restrictions on
dividends.
12
ITEM 6. SELECTED FINANCIAL DATA
SELECTED CONSOLIDATED FINANCIAL INFORMATION
(in thousands except per share amounts)
Year Ended December 31
-------------------------------------------------------------
1997 1996 1995 1994 1993
- ---------------------------------------------------------------------------------------------------------------------------------
Selected Income Statement Information
Revenues $ 28,866 $ 20,658 $ 5,844 $ 5,740 $ 5,354
Costs and Expenses 19,113 14,066 4,992 4,175 4,037
- ---------------------------------------------------------------------------------------------------------------------------------
Operating Income 9,753 6,592 852 1,565 1,317
Other Income (Expenses), net (3,367) (3,518) (980) 2,055 (394)
- ---------------------------------------------------------------------------------------------------------------------------------
Income (Loss) Before Income Taxes 6,386 3,074 (128) 3,620 923
Income Tax Expense (Benefit) 2,867 1,540 (51) 1,415 354
- ---------------------------------------------------------------------------------------------------------------------------------
Income (Loss) Before Minority Interest 3,519 1,534 (77) 2,205 569
Minority Interest in Earnings of Alliance
Telecommunications Corporation 798 325
- ---------------------------------------------------------------------------------------------------------------------------------
Income (Loss) Before Cumulative Effect of
Change in Accounting Principle 2,721 1,209 (77) 2,205 569
Cumulative Effect of Change
in Accounting Principle 51
- ---------------------------------------------------------------------------------------------------------------------------------
Net Income (Loss) $ 2,721 $ 1,209 $ (77) $ 2,205 $ 620
- ---------------------------------------------------------------------------------------------------------------------------------
- ---------------------------------------------------------------------------------------------------------------------------------
Basic Net Income (Loss) Per Common Share:
Before Cumulative Effect of Change
in Accounting Principle $ 1.44 $ .65 $ (.04) $ 1.18 $ .27
Cumulative Effect of Change in
Accounting Principle .02
- ---------------------------------------------------------------------------------------------------------------------------------
Basic Net Income (Loss) Per Share $ 1.44 $ .65 $ (.04) $ 1.18 $ .29
- ---------------------------------------------------------------------------------------------------------------------------------
- ---------------------------------------------------------------------------------------------------------------------------------
Diluted Net Income (Loss) Per Common Share:
Before Cumulative Effect of Change
in Accounting Principle $ .93 $ .53 $ (.04) $ .97 $ .25
Cumulative Effect of Change in
Accounting Principle .02
- ---------------------------------------------------------------------------------------------------------------------------------
Diluted Net Income (Loss) Per Share $ .93 $ .53 $ (.04) $ .97 $ .27
- ---------------------------------------------------------------------------------------------------------------------------------
- ---------------------------------------------------------------------------------------------------------------------------------
Average Shares Outstanding:
Common shares only 1,893 1,870 1,866 1,863 2,162
Common and potential common shares 3,732 3,694 1,866 2,266 2,269
- ---------------------------------------------------------------------------------------------------------------------------------
- ---------------------------------------------------------------------------------------------------------------------------------
Selected Balance Sheet Information
Working Capital $ 8,504 $ 1,307 $ 9,679 $ 4,740 $ 2,202
Property, Plant and Equipment, net 45,927 47,039 14,609 13,019 12,894
Excess of Cost Over Net Assets Acquired, net 51,170 52,510 907 839 723
Total Assets 139,291 137,348 33,518 22,749 21,173
Long-Term Debt 97,793 96,127 22,096 10,528 10,797
Stockholders' Equity 14,447 9,946 8,134 8,230 6,006
- ---------------------------------------------------------------------------------------------------------------------------------
All net income per share numbers from prior years have been restated to comply with the provisions of SFAS No.
128, "Earnings Per Share". All potential common shares are anti-dilutive for 1995 and are excluded from
calculation of net income per share
Operating results for 1996 include the operations of Ollig Utilities Company from the April 25, 1996 purchase date.
13
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Hector Communications Corporation ("HCC") owns a 100% interest in five local
exchange telephone subsidiaries and one cable television subsidiary. Effective
April 25, 1996, a new 68% owned subsidiary of the Company, Alliance
Telecommunications Corporation ("Alliance"), acquired Ollig Utilities Company
("Ollig") for $80,000,000. At December 31, 1997, the Company's wholly and
majority owned subsidiaries provided telephone service to 32,700 access lines in
34 rural communities in Minnesota, Wisconsin, South Dakota and Iowa. Its cable
television operations provided cable television services to approximately 8,300
subscribers in Minnesota, South Dakota and Wisconsin. The Company is also an
investor in businesses providing cellular telephone and other telecommunications
related services.
Results of Operations
General
The Company's telephone revenues are principally derived from the local
service and access revenues received by its local exchange carrier ("LEC")
subsidiaries. Local service revenues are earned by providing customers with
local service to connecting points within the local exchange boundaries and, in
certain cases, to nearby local exchanges under extended area service ("EAS")
plans which eliminate long distance charges to the neighboring exchanges.
Monthly rates for telephone service differ among the LECs depending upon the
cost of providing service, the type and grade of service, the number of
customers and calling patterns within the toll free calling area and other
factors.
Access revenues are received by LECs for intrastate and interstate
exchange services provided to long distance carriers (generally referred to as
interexchange carriers or "IXCs") which enable IXCs to provide long distance
service to end users in the local exchange network. Access revenues are
determined, in the case of interstate calls, according to rules promulgated by
the Federal Communications Commission ("FCC") and administered by the National
Exchange Carriers Association ("NECA") and, in the case of intrastate calls, by
state regulatory agencies. A relatively small portion of the Company's access
revenues are derived from subscriber line fees determined by the FCC and billed
directly to end users for access to long distance carriers. The balance of the
Company's interstate access revenues are received from NECA, which collects
payments from IXCs and distributes settlement payments to LECs based on a number
of factors, including the cost of providing service and the amount of time the
local network is utilized to provide long distance services. A variety of
factors, including increased subscriber counts, cultural and technological
changes, and rate reductions by IXCs, have resulted in a consistent pattern of
increasing use of the nation's telephone network since 1984. This growth has
produced higher revenues for NECA and increased settlements for its
participating LECs. The Company's settlements from NECA have increased every
year since the pool was established in 1984.
LECs also sell and lease customer premise telephone equipment, provide
inside wiring services and custom calling features, provide internet access and
sell and lease other facilities for private line, teletype, data transmission
and other communications services. LECs also provide billing and collection
services for certain IXCs in lieu of such IXCs directly billing customers within
the LECs service area.
The Company's cable television revenues are derived almost exclusively
from monthly fees for basic and premium services.
The following table presents the percentage of revenues derived from
local service revenues, access revenues, billing and collection services,
nonregulated telephone activities and cable television operations for the last
three years:
14
Year Ended December 31
------------------------------------------------
1997 1996 1995
----------- ---------- ---------
Local network 16.9% 17.8% 18.4%
Network access 58.0 55.8 59.5
Nonregulated telephone activities 13.3 13.0 4.9
Billing and collecting 3.5 4.3 3.9
Cable television 8.3 9.1 13.3
----------- ----------- ---------
100.0 % 100.0% 100.0%
=========== ========== ==========
1997 Compared to 1996
Consolidated revenues increased 40% to $28,866,000. Most of the increase
was due to the 1996 acquisition by Alliance Telecommunications Corporation of
Ollig Utilities Company. The operations of Alliance, which are substantially
larger than those of HCC prior to the acquisition, had a huge impact on
operating results. 1997 results include twelve months of Alliance operations
compared to just eight months included in 1996. The following table shows
revenues from Alliance's operations separate from those of HCC.
Alliance Telecommunications Corp. Hector Communications Corp.
Year Ended Eight Months Ended Year Ended December 31
December 31 December 31
1997 1996 1997 1996
------------------ ------------------ ------------------ -----------------
Local network $ 3,346,733 $ 2,207,217 $ 1,519,514 $ 1,474,912
Network access 12,845,426 7,817,153 3,892,682 3,717,729
Billing and collection 820,540 656,706 209,642 224,908
Nonregulated activities 3,469,234 2,386,360 369,188 303,895
Cable television 1,027,602 628,988 1,365,804 1,239,653
----------------- ------------------ ------------------ -----------------
$ 21,509,535 $ 13,696,424 $ 7,356,830 $ 6,961,097
================= ================== ================== =================
Revenues from HCC's operations increased $396,000 or 6%. Revenues from
telephone operations increased $270,000, or 5%. Local network revenues increased
$45,000 or 3%, due to increases in the number of access lines served. Network
access revenues increased $175,000 or 5% due to increased interstate settlements
from NECA, which offset lower intrastate access revenues. Billing and collection
revenues decreased $15,000 or 7% as IXCs are continuing to reduce their reliance
on LECs to provide these services. Revenues from nonregulated sources increased
$65,000 or 21% due to increased internet revenues. Cable television revenue
increased $126,000 or 10%. The increase was due to increases in subscriber rates
and the full year effect of the acquisition of two small cable systems in
September, 1996.
Alliance's 1997 revenues benefited from a one-time retroactive network
access settlement of $560,000 received from NECA by one of its subsidiaries.
This settlement included $390,000 related to 1995 and 1996 settlements.
Operating costs and administrative expenses increased $5,047,000 or 36%
over 1996. 1997 results include twelve months of Alliance operating expenses
compared to just eight months included in 1996. The following table shows
operating expenses from Alliance's operations separate from those of the
Company.
Alliance Telecommunications Corp. Hector Communications Corp.
Year Ended Eight Months Ended Year Ended December 31
December 31 December 31
1997 1996 1997 1996
------------------ ------------------ ------------------ -----------
Plant operations $ 2,714,192 $ 1,869,098 $ 916,638 $ 838,787
Depreciation/amortization 5,336,031 3,493,668 1,973,699 1,934,117
Customer operations 1,430,676 945,664 243,435 245,277
General and administrative 2,324,079 1,509,010 1,269,042 1,254,197
Other operating 1,830,921 1,069,148 1,074,244 906,902
----------------- ------------------ ------------------ -----------------
$ 13,635,899 $ 8,886,588 $ 5,477,058 $ 5,179,280
================= ================== ================== =================
15
Operating costs and expenses for HCC's operations increased $298,000 or
6%. Expense increases were due to higher maintenance expenses on telephone plant
and higher cable television expenses due to the acquisition of two new cable
systems in 1996. Consolidated operating income increased $3,162,000, or 48%.
Operating income from HCC's operations increased 98,000 or 5%.
Consolidated interest expense, net of investment income increased
$1,463,000. Net interest expense for HCC increased $207,000, reflecting the full
year effect of interest on borrowings from St. Paul Bank used in the acquisition
of Ollig and reduced income due to decreased cash available for investment. Net
interest expense on Alliance increased $1,256,000 due to the full year effect of
interest on the acquisition loan from St. Paul Bank for Cooperatives associated
with the purchase of Ollig Utilities Company. HCC's investment income benefited
from gains on sales of marketable securities of $1,496,000 and $688,000 in 1997
and 1996, respectively. Income from wireless telephone investments increased
$806,000 or 160%, due primarily to the Company's equity interest in the
increased profits of Midwest Wireless LLC. These earnings were more than enough
to offset start-up losses of $435,000 incurred by PCS partnerships in which the
Company holds equity interests.
Consolidated income before income taxes increased 108% to $6,386,000.
HCC's income before income taxes, excluding Alliance, was $1,745,000 in 1997
compared to $885,000 in 1996. Income tax expense increased to $2,867,000 from
$1,540,000 in 1996. The effective income tax rate of 44.9% in 1997 is higher
than the standard tax rate because the amortization expenses associated with
excess of cost over net assets acquired in the acquisition of Ollig ($1,254,000
in 1997) are not tax deductible. The 32% minority shareholders' interest in
earnings of Alliance was $798,000 in 1997 compared to $325,000 in 1996. Net
income increased 125% to $2,721,000.
1996 Compared to 1995
Effective April 25, 1996, the Company's 68% owned subsidiary, Alliance
Telecommunications Corporation purchased Ollig Utilities Company, a privately
owned telecommunications company which served approximately 25,000 telephone
access lines and 3,400 cable television customers in Minnesota, Iowa, North
Dakota and South Dakota for $80,000,000. Prior to the acquisition, HCC served
approximately 6,300 access lines and 4,200 cable television customers. The
operations of Alliance, which are substantially larger than those of HCC prior
to the acquisition, had a huge impact on operating results over the last eight
months of the year. Consolidated revenues increased $14,813,000 in 1996. The
following table shows revenues from Alliance's operations separate from those of
HCC.
Alliance Telecom. Corp. Hector Communications Corp.
Eight Months Ended Twelve Months Ended December 31
December 31, 1996 1996 1995
-------------------- ----------------- -------------
Local network $ 2,207,217 $ 1,474,912 $ 1,076,801
Network access 7,817,153 3,717,729 3,474,738
Billing and collection 656,706 224,908 228,038
Nonregulated activities 2,386,360 303,895 285,355
Cable television 628,988 1,239,653 779,391
------------------ ------------------ ------------------
Total $ 13,696,424 $ 6,961,097 $ 5,844,323
================== ================== ==================
Revenues from HCC's operations increased $1,117,000 or 19%. Local
network revenues increased $398,000 or 37%. The increase was due to local
service rate increases imposed in the Wisconsin telephone exchanges in December,
1995 to offset revenue lost to the extended community calling (ECC) program.
Network access revenues increased $243,000 or 7% due to increased interstate
settlements from NECA. Cable television revenue increased $460,000 or 59%,
reflecting the full year impact of the August, 1995 acquisition of cable systems
from Lake Cable Partnerships.
Operating cost and administrative expenses increased $9,074,000 or 182%
over 1995. Operating costs and administrative expenses for Alliance operations
and HCC operations are presented separately in the following table.
16
Alliance Telecom. Corp. Hector Communications Corp.
Eight Months Ended Twelve Months Ended December 31
December 31, 1996 1996 1995
-------------------- ----------------- -------------
Plant operations $ 1,869,098 $ 838,787 $ 825,263
Depreciation and amortization 3,493,668 1,934,117 1,706,495
Customer operations 945,664 245,277 287,185
General and administrative 1,509,010 1,254,197 1,520,370
Nonregulated and miscellaneous 1,069,148 906,902 652,609
------------------ ------------------ ------------------
Total $ 8,886,588 $ 5,179,280 $ 4,991,922
================== ================== ==================
Operating costs and expenses for HCC's operations increased $187,000 or
4%. Expense increases were due primarily to increased operating expenses and
depreciation and amortization associated with the Lake Cable acquisition.
Consolidated operating income increased $5,739,000. Operating income from
existing operations increased $929,000 or 109%.
Consolidated interest expense, net of investment income increased
$3,800,000. Net interest expense for HCC increased $775,000, reflecting interest
on $6,000,000 of short-term borrowing from St. Paul Bank used in the acquisition
of Ollig, the full year effect on interest expense of the convertible debentures
issued in 1995, and reduced income due to decreased cash available for
investment. Interest expense on Alliance consists mainly of a $55,250,000
acquisition loan from St. Paul Bank for Cooperatives associated with the
purchase of Ollig Utilities Company, and interest on RUS and RTB loans existing
prior to the acquisition. HCC's investment income benefited from gains on sales
of marketable securities of $687,000 made during the first quarter of 1996.
Income from wireless telephone investments increased $377,000 or 299%, due to
the Company's increased ownership percentages of these operations due to the
Ollig acquisition and also due to the increasing profitability of these
operations.
Consolidated income before income taxes was $3,074,000 compared to a loss
of $128,000 in 1995. HCC's income before income taxes, excluding Alliance, was
$885,000 in 1996. Income tax expense was $1,540,000 compared to a benefit of
$51,000 in 1995. The Company's effective tax rate of 50.1% in 1996 is higher
than the standard tax rate because the amortization expenses associated with
excess of cost over net assets acquired in the acquisition of Ollig ($836,000 in
1996) are not tax deductible. The 32% minority shareholders' interest in
earnings of Alliance was $325,000 in 1996. Net income was $1,209,000 compared to
a loss of $77,000 in 1995.
Liquidity and Capital Resources
On April 25, 1996, a newly formed subsidiary of the Company, Alliance
Telecommunications Corporation, purchased Ollig Utilities Company for
$80,000,000 in cash. The Company owns 68% of Alliance with the remaining
interest owned by Golden West Telecommunications Cooperative, Inc. of Wall,
South Dakota and Split Rock Telecom Cooperative, Inc. of Garretson, South
Dakota. Alliance financed the acquisition using the combined equity investments
of its shareholders and $55,250,000 of long-term debt financing provided by St.
Paul Bank for Cooperatives ("St. Paul Bank"). Interest rates on this debt have
been locked for periods of one to ten years at rates averaging 7.4%. The
outstanding balance on this loan at December 31, 1997 was $53,063,000.
The Company's cash investment in Alliance is approximately $16,903,000,
which included $6,000,000 of short term borrowing from St. Paul Bank, purchase
price deposits made in 1995, and $73,000 of acquisition costs. In 1997, the
Company repaid principal of $2,000,000 on the loan and converted the remaining
balance into a five year term loan.
St. Paul Bank is a cooperative, owned and controlled by its customers. As
a condition to receiving the loans, the Company purchased stock in the bank. In
1997, as a condition of maintaining its loan, the Company invested an additional
$649,000 of cash in the stock of St. Paul Bank. Each customer borrowing from the
bank on a patronage basis shares in the bank's net income through payment of
patronage refunds. The Company's patronage refund from St. Paul Bank was
$694,000 and $221,000 in 1997 and 1996, respectively. Approximately 30% of the
patronage refund is received in cash, with the balance in stock of St. Paul
Bank. Total investment in the bank was $2,749,000 at December 31, 1997.
17
The Company's LEC subsidiaries serve its telephone customers with a
100%-digital switching network and almost 100% buried outside plant. Telephone
plant additions in 1997, 1996 and 1995 were $4,262,000, $4,669,000 and $869,000,
respectively. Telephone plant additions for 1998 are expected to total
$5,371,000 and will provide customers with additional advanced switching
services, upgrade the switching system to Year 2000 compliance and expand usage
of high capacity fiber optics in the telephone network.
The Company is an investor in Wireless North, a consortium of three
limited partnerships and one limited liability corporation which have acquired
licenses to operate PCS systems in 13 markets in Minnesota, Wisconsin, North
Dakota and South Dakota. The Company invested $510,000 of cash and guaranteed
debt of $1,373,000 in these entities in 1997 and 1996. The PCS systems are in
start-up mode and have not been profitable to date. The Company has committed to
providing $1,486,000 of additional capital to these entities. It cannot predict
if additional funding beyond this amount will be required.
Telephone asset additions have been financed by internally generated
funds and drawdowns of Rural Utilities Service ("RUS") and Rural Telephone Bank
("RTB") loan funds. Proceeds from long-term borrowings by the telephone
companies were $2,026,000, $411,000, and $414,000 in 1997, 1996 and 1995,
respectively. The average interest rate on outstanding RUS and RTB loans is
5.6%. Substantially all of the telephone assets are pledged or are subject to
mortgages to secure obligations of its LECs to the RUS and RTB. In addition, the
amount of dividends on common stock that may be paid to the Company by the LEC
subsidiaries is limited by covenants in the mortgages. In 1997, the LEC
subsidiaries received approval from the RUS and RTB for new loans to finance
future capital additions. At December 31, 1997 unadvanced loan commitments from
the RUS and RTB totaled $17,478,000.
In February 1995 the Company completed a public offering of convertible
subordinated debentures. The debentures carry an interest rate of 8.5% and
mature February 15, 2002. The debentures are convertible into common stock at a
rate of 112.5 common shares per $1,000 par value bond. As of February 15, 1997,
the Company has the right to call the debentures at a price (depending on the
trading price of the Company's common stock) ranging from 100% to 104% of par.
The debentures include restrictions on payment of dividends to the Company's
shareholders. The debentures are subordinated to $4,000,000 of senior debt owed
to St. Paul Bank. Total value of the offering was $12,650,000. Proceeds to the
Company, after underwriting, accounting and legal expenses were approximately
$11,300,000. The underwriters also received warrants to purchase 123,750 shares
of common stock at a price of $8.70 per share. The warrants are currently
exercisable and expire February 15, 2000. The offering proceeds were used to pay
down debt associated with its cable television operation, finance cable
television plant additions, purchase additional cable television systems and as
a portion of HCC's equity contribution to Alliance to acquire Ollig Utilities
Company.
In December, 1997, the Company sold 171,425 shares of new common stock in
a private placement. Proceeds from the sale, net of issue costs, were
$1,490,000. Proceeds were used to pay down debt and provide additional working
capital.
Cable television operations have been supported through capital additions
and by purchasing additional systems. In 1995, the Company purchased 22 rural
Minnesota cable systems, serving approximately 2,000 customers, from Lake Cable
Partnership for $2.2 million. In September, 1996, two additional cable systems
serving 320 subscribers were acquired for $319,000. In 1997, one small system
was acquired for $120,000. Other capital additions to support the Company's
cable systems totaled $378,000, $270,000, and $263,000 in 1997, 1996 and 1995,
respectively. Total cable television capital additions for 1998 are estimated at
$250,000.
Cable television provided operating income of $115,000 in 1997 after
being unprofitable in earlier years. The operating improvements have been due to
the cable acquisitions made in 1995 and 1996, which have allowed the Company to
spread its costs over a larger number of subscribers. The cable operations
continue to suffer from a lack of scale economies in all its systems, which
necessitates a higher than industry average ratio of employees to customers.
Continuing improvement of cable operating results depends on increasing the
subscriber base, achieving lower operating expense ratios and increasing system
revenues.
18
Investment income has been derived almost exclusively from interest
earned on the Company's cash and cash equivalents. Interest income has
fluctuated in relation to changes in interest rates and availability of cash for
investment. In 1996, the Company received $1,499,000 from the sale of its
remaining shares of Telephone and Data Systems, Inc., obtained in the 1994 sale
of its Rochester, MN cellular MSA interest. The Company also sold 61,133 shares
of Rural Cellular Corporation in that company's initial public offering of its
common stock in February, 1996. Proceeds to the Company after selling expenses
were $554,000. In 1997, an additional 161,469 shares of Rural Cellular
Corporation were sold for $1,728,000. At December 31, 1997, the Company's
marketable securities portfolio consisted primarily of shares of Rural Cellular
Corporation, U.S. West Communications, Inc. and U.S. West Media, Inc. owned by
Ollig Utilities Company prior to its acquisition by the Company.
Cash flows from operating activities were $7,573,000, $6,627,000 and
$2,103,000 in 1997, 1996, and 1995, respectively. At December 31, 1997, the
Company's cash, cash equivalents, temporary cash investments and marketable
securities totaled $18,241,000 compared to $16,110,000 at December 31, 1996.
Working capital at December 31, 1997 was $8,504,000 compared to $1,307,000 at
December 31, 1996. The current ratio was 1.9 to 1. 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.
Acquisitions
Alliance Telecommunications Corporation has entered into a definitive
agreement to purchase all the outstanding common stock of Felton Telephone
Company ("Felton"), a rural telephone company located in northwestern Minnesota
adjacent to areas already served by the Company's telephone subsidiaries. Felton
serves approximately 700 access lines and holds significant portfolio of
marketable securities, including investments in Rural Cellular Corporation, U.S.
West Communications, Inc. and U.S. West Media, Inc. Purchase price is
$3,650,000, which includes a cash downpayment and seller financing of the
balance. The Company is awaiting regulatory approval of the purchase and expects
it to be completed in April, 1998.
Alliance has also entered into a definitive agreement to purchase
Spectrum Cablevision Limited Partnership ("Spectrum"). Spectrum serves 4,600
cable television customers in 20 communities in Minnesota and North Dakota,
including several communities also served by the Company's telephone
subsidiaries. Purchase price is approximately $5,200,000. The Company expects to
use its cash reserves and obtain additional outside financing to make this
purchase. The Company expects to complete this acquisition in the second quarter
of 1998.
Effects of Inflation
The Company's local exchange telephone companies are subject to the
jurisdiction of Minnesota, Iowa, South Dakota and Wisconsin regulatory
authorities with respect to a variety of matters, including rates for intrastate
access services, the conditions and quality of service, issuance of debt,
depreciation rates and accounting methods. Rates for local telephone service are
not established directly by regulatory authorities, but their authority over
other matters limits the Company's ability to implement rate increases. In
addition, the regulatory process inherently restricts the Company's ability to
immediately pass cost increases along to customers unless the cost increases are
anticipated and the rate increases implemented prospectively.
Year 2000 Issues
The software used by the Company's data processing and central office
equipment was originally designed to use references to calendar dates on an
abbreviated basis. Under this system, references to the calendar year are
abbreviated to the last two digits of the year, i.e. 1997 is abbreviated as
"97". Most software using this system does not recognize that the year 2000,
abbreviated as "00", follows 1999. This causes computing errors in date
sensitive processes. The Company has surveyed its telephone and data processing
systems to locate computer systems which may be subject to this error.
19
The Company has determined that the central office switching equipment
used in its local telephone exchanges to connect customer calls and record
telephone usage is not Year 2000 compliant. The Company will be upgrading its
equipment in the third and fourth quarters of 1998 to attain compliance.
Estimated cost is $658,000. No retirements of equipment currently in service
will be required. The Company does not expect Year 2000 problems to cause any
interruption of service to customers.
Changes in Accounting Standards
Effective December 15, 1997, the Company adopted the provisions of
Statement of Financial Accounting Standards No. 128, "Earnings per Share". The
Statement requires the Company to present its net income per share in basic and
diluted forms and to restate net income per share from prior periods to conform
with the new statement. Basic net income per common share is based on the
weighted average number of common shares outstanding during each year. Diluted
net income per common share - takes into effect the dilutive effect of potential
common shares outstanding. The Company's potential common shares outstanding
include preferred stock, stock options, warrants and convertible debentures. The
calculation of the Company's net income per share is included in Exhibit 11 of
this form 10-K.
Effective January 1, 1996, the Company has adopted Statement of Financial
Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to be Disposed Of" (SFAS 121). This statement
requires that assets to be held and used be reviewed for impairment whenever
events or changes in circumstances indicate that the carrying value of an asset
may not be recoverable. An impairment loss should be recognized when the
estimated future cash flows from the asset are less than the carrying value of
the asset. Assets to be disposed of should be reported at the lower of their
carrying amount of fair value less cost to sell. Adoption of this statement did
not have a material effect on the Company's results of operations or financial
position.
Effective January 1, 1996, the Company adopted the pro forma disclosure
provisions of SFAS No. 123, "Accounting for Stock-Based Compensation". This
statement requires the Company to disclose the fair value of stock-based
compensation to employees. The Company has elected to continue to apply APB
Opinion No. 25, "Accounting for Stock Issued to Employees" for measurement and
recognition of stock-based transactions with its employees.
The Financial Accounting Standards Board ("FASB") has issued SFAS No.
130, "Reporting Comprehensive Income". This statement establishes standards for
reporting and presenting comprehensive income and its components in the
financial statements. SFAS No. 130 is effective for fiscal years beginning after
December 15, 1997. Reclassification of financial statements for earlier periods
provided for comparative purposes is required. Adoption of this standard will
have no effect on the Company's results of operations or financial position.
The FASB has also issued SFAS No. 131, "Disclosures about Segments of
an Enterprise and Related Information". This statement establishes standards for
the way public enterprises report information about operating segments in annual
financial statements and requires those enterprises to report selected
information about operating segments in interim financial reports to
shareholders. It also establishes standards for related disclosures about
products and services, geographic areas and major customers. SFAS No. 131 is
effective for fiscal years beginning after December 15, 1997. Financial
statement disclosures from prior periods are required to be restated. Adoption
of this standard will have no effect on the Company's results of operations or
financial position.
20
Factors Affecting Future Performance
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 of 1996, 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.
REPORT OF MANAGEMENT
The management of Hector Communications Corporation and its subsidiary companies
is responsible for the integrity and objectivity of the financial statements and
other financial information contained in the annual report. The financial
statements and related information were prepared in accordance with generally
accepted accounting principles and include amounts that are based on
management's informed judgments and estimates.
In fulfilling its responsibilities for the integrity of financial information,
management maintains accounting systems and related controls. These controls
provide reasonable assurance, at appropriate costs, that assets are safeguarded
against losses and that financial records are reliable for use in preparing
financial statements. Management recognizes its responsibility for conducting
the Company's affairs according to the highest standards of personal and
corporate conduct.
The Audit Committee of the Board of Directors, composed solely of outside
directors, meets with the independent auditors and management periodically to
review accounting, auditing, financial reporting and internal control matters.
The independent auditors have free access to this committee, without management
present to discuss the results of their audit work and their opinion on the
adequacy of internal financial controls and the quality of financial reporting.
/s/ Curtis A. Sampson
------------------------------------
Curtis A. Sampson
Chairman and Chief Executive Officer
/s/ Charles A. Braun
-------------------------------------
Charles A. Braun
March 27, 1998 Chief Financial Officer
21
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
(a) FINANCIAL STATEMENTS
INDEPENDENT AUDITORS REPORT
Shareholders and Board of Directors
Hector Communications Corporation
We have audited the accompanying consolidated balance sheets of Hector
Communications Corporation and subsidiaries as of December 31, 1997 and 1996 and
the related consolidated statements of income, stockholders' equity, and cash
flows for each of the three years in the period ended December 31, 1997. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Hector
Communications Corporation and subsidiaries as of December 31, 1997 and 1996 and
the results of their operations and their cash flows for each of the three years
in the period ended December 31, 1997 in conformity with generally accepted
accounting principles.
/s/ Olsen Thielen & Co., Ltd.
- -----------------------------
Olsen Thielen & Co., Ltd.
February 18, 1998
St. Paul, Minnesota
22
HECTOR COMMUNICATIONS CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
ASSETS
December 31
-----------------------------------
1997 1996
-------------- --------------
CURRENT ASSETS:
Cash and cash equivalents $ 12,455,399 $ 9,571,879
Temporary cash investments 300,000 1,079,900
Construction fund (Note 6) 77,690 74,337
Accounts receivable 4,003,184 3,965,754
Materials, supplies and inventories, at average cost 542,681 512,114
Prepaid expenses 216,351 160,291
-------------- --------------
TOTAL CURRENT ASSETS 17,595,305 15,364,275
PROPERTY, PLANT AND EQUIPMENT,net (Notes 1 and 5) 45,927,153 47,038,952
OTHER ASSETS:
Excess of cost over net assets acquired, less amortization
of $3,391,000 and $1,989,000 (Note 1) 51,169,677 52,510,459
Marketable securities (Note 3) 5,485,698 5,458,400
Wireless telephone investments (Note 4) 10,680,655 10,224,910
Other investments (Notes 1 and 6) 7,231,868 5,246,797
Deferred debenture issue costs (Note 6) 780,089 969,201
Other assets (Note 1) 420,511 535,019
-------------- --------------
TOTAL OTHER ASSETS 75,768,498 74,944,786
-------------- --------------
TOTAL ASSETS $ 139,290,956 $ 137,348,013
============== ==============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Notes payable and current portion of long-term debt (Note 6) $ 4,770,000 $ 10,047,000
Accounts payable (Note 10) 1,591,546 1,860,579
Accrued expenses 2,247,972 2,090,639
Income taxes payable 481,831 59,015
-------------- --------------
TOTAL CURRENT LIABILITES 9,091,349 14,057,233
LONG-TERM DEBT, less current portion (Note 6) 97,793,195 96,127,379
DEFERRED INVESTMENT TAX CREDITS (Note 7) 381,180 526,347
DEFERRED INCOME TAXES (Note 7) 7,594,092 7,457,907
DEFERRED COMPENSATION (Note 9) 940,425 987,944
COMMITMENTS AND CONTINGENCIES (Note 4)
MINORITY INTEREST IN ALLIANCE TELECOMMUNICATIONS, CORP. 9,043,593 8,245,365
STOCKHOLDERS' EQUITY: (Notes 1, 6 and 8)
Preferred stock, par value $1.00 per share; 3,000,000 shares authorized:
Convertible Series A, 378,100 and 389,487 shares issued and outstanding 378,100 389,487
Common stock, par value $.01 per share; 10,000,000 shares authorized;
2,079,364 and 1,883,857 shares issued and outstanding 20,794 18,839
Additional paid-in capital 1,712,954 102,003
Retained earnings 11,726,521 9,005,768
-------------- --------------
13,838,369 9,516,097
Unearned employee stock ownership shares (69,724) (101,312)
Unrealized gains on marketable securities (Note 3) 678,477 531,053
-------------- --------------
TOTAL STOCKHOLDERS' EQUITY 14,447,122 9,945,838
-------------- --------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 139,290,956 $ 137,348,013
============== ==============
See notes to consolidated financial
statements.
23
HECTOR COMMUNICATIONS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
Year Ended December 31
-----------------------------------------------------
1997 1996 1995
------------- ------------- -------------
REVENUES:
Local network $ 4,866,247 $ 3,682,129 $ 1,076,801
Network access 16,738,108 11,534,882 3,474,738
Billing and collection 1,030,182 881,614 228,038
Nonregulated activities 3,838,422 2,690,255 285,355
Cable television revenues 2,393,406 1,868,641 779,391
------------- ------------- -------------
TOTAL REVENUES 28,866,365 20,657,521 5,844,323
COSTS AND EXPENSES:
Plant operations 3,630,830 2,707,885 825,263
Depreciation and amortization 7,309,730 5,427,785 1,706,495
Customer operations 1,674,111 1,190,941 287,185
General and administrative 3,593,121 2,763,207 1,520,370
Other operating expenses 2,905,165 1,976,050 652,609
------------- ------------- -------------
TOTAL COSTS AND EXPENSES 19,112,957 14,065,868 4,991,922
------------- ------------- -------------
OPERATING INCOME 9,753,408 6,591,653 852,401
OTHER INCOME (EXPENSES):
Interest expense (6,797,354) (5,399,617) (1,554,042)
Partnership and LLC income (Note 4) 1,308,346 502,837 125,924
Investment income 625,582 691,215 645,781
Gain on sale of marketable securities (Note 3) 1,495,999 687,947
Unrealized loss on trading marketable securities (Note 3) (197,603)
------------- ------------- -------------
OTHER INCOME (EXPENSES), net (3,367,427) (3,517,618) (979,940)
------------- ------------- -------------
INCOME (LOSS) BEFORE INCOME TAXES 6,385,981 3,074,035 (127,539)
INCOME TAX EXPENSE (BENEFIT) (Note 7) 2,867,000 1,540,000 (51,000)
------------- ------------- -------------
INCOME (LOSS) BEFORE MINORITY INTEREST 3,518,981 1,534,035 (76,539)
MINORITY INTEREST IN EARNINGS OF
ALLIANCE TELECOMMUNICATIONS CORPORATION 798,228 325,365
------------- ------------- -------------
NET INCOME (LOSS) $ 2,720,753 $ 1,208,670 $ (76,539)
============= ============= =============
BASIC NET INCOME (LOSS) ~ PER COMMON SHARE (Note 1) $ 1.44 $ .65 $ (.04)
============= ============= =============
DILUTED NET INCOME (LOSS) ~ PER COMMON SHARE (Note 1) $ .93 $ .53 $ (.04)
============= ============= =============
AVERAGE SHARES OUTSTANDING (Notes 1 and 8):
Common shares only 1,893,000 1,870,000 1,866,000
Common and potential common shares 3,732,000 3,695,000 1,866,000
See notes to consolidated financial
statements.
24
HECTOR COMMUNICATIONS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Year Ended December 31
-------------------------------------------------
1997 1996 1995
-------------- -------------- -------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net Income (loss) $ 2,720,753 $ 1,208,670 $ (76,539)
Adjustments to reconcile net income (loss) to net cash provided by operating
activities:
Depreciation and amortization 7,500,078 5,617,722 1,871,969
Minority stockholders' interest in earnings
of Alliance Telecommunications Corporation 798,228 325,365
Gain on sales of marketable securities (1,495,999) (687,947)
Noncash patronge refunds (661,923) (220,662)
Income from partnership and LLC investments (1,308,346) (502,837) (125,924)
Unrealized losses on investments 231,830
Changes in assets and liabilities net of effects from the purchase of
Ollig Utilities, Inc.:
Decrease in marketable securities 1,499,072 437,521
Decrease (increase) in accounts receivable (37,430) (408,601) 211,145
Decrease (increase) in materials, supplies and inventories (30,567) 75,557 (23,854)
Decrease (increase) in prepaid expenses (56,060) (6,057) 6,365
Increase (decrease) in accounts payable (269,033) (585,734) 55,000
Increase in accrued expenses 157,333 708,528 358,231
Increase (decrease) in income taxes payable 422,816 (615,843) (560,331)
Decrease in deferred investment tax credits (145,167) (129,000) (39,000)
Increase (decrease) in deferred income taxes 25,394 380,000 (243,000)
Decrease in deferred compensation (47,519) (31,679)
-------------- -------------- -------------
Net cash provided by operating activities 7,572,558 6,626,554 2,103,413
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property, plant and equipment (4,695,301) (5,168,997) (3,123,547)
Sales of temporary cash investments 779,900 94,806
Sales of marketable securities 1,728,115 553,645
Proceeds from wireless telephone investments 792,622 437,371
Purchases of wireless telephone investments (98,933) (250,000) (161,638)
Decrease (increase) in construction fund (3,353) 100,393 39,336
Purchases of other investments (1,193,105) (1,274,443) (457,250)
Proceeds from other investments 27,667 29,911 17,057
Increase in excess of cost over net assets acquired (61,107) (88,517) (141,453)
Decrease (increase) in other assets 12,534 107,198 (51,938)
Payment for purchase of Ollig Utilities Company,
net of cash acquired (69,189,692) (2,790,236)
-------------- -------------- -------------
Net cash used in investing activities (2,710,961) (74,648,325) (6,669,669)
CASH FLOWS FROM FINANCING ACTIVITIES:
Repayment of notes payable and long-term debt (5,637,184) (2,607,031) (1,769,634)
Proceeds from issuance of notes payable and long-term debt 2,026,000 63,168,775 13,064,150
Minority interest in Alliance Telecommunications Corporation 7,920,000
Convertible bond issue costs (1,323,787)
Purchase of Hector Communications Corporation
common stock (30,272)
Issuance of common stock 1,575,107 21,768 22,872
ESOP shares allocated (purchased), net 58,000 50,000 (11,683)
-------------- -------------- -------------
Net cash provided by (used in) financing activities (1,978,077) 68,553,512 9,951,646
-------------- -------------- -------------
NET INCREASE IN CASH AND CASH EQUIVALENTS 2,883,520 531,741 5,385,390
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR 9,571,879 9,040,138 3,654,748
-------------- -------------- -------------
CASH AND CASH EQUIVALENTS AT END OF YEAR $ 12,455,399 $ 9,571,879 $ 9,040,138
============== ============== =============
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Interest paid $ 7,316,215 $ 4,974,256 $ 1,023,041
Income taxes paid 2,564,157 1,890,825 791,331
See notes to consolidated financial
statements.
25
HECTOR COMMUNICATIONS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
Unearned
Employee Unrealized
Additional Stock Gains on
Preferred Stock Common Stock Paid-in Retained Ownership Marketable
Shares Amount Shares Amount Capital Earnings Shares Securities Total
--------- --------- --------- --------- --------- ----------- ---------- ---------- ------------
BALANCE AT DECEMBER 31, 1994 392,287 $392,287 1,877,850 $ 18,778 $ 48,001 $ 7,903,703 $(132,800) $ - $ 8,229,969
Net loss (76,539) (76,539)
Issuance of common stock under
Employee Stock Purchase Plan 3,844 39 22,833 22,872
Purchase of common stock (4,200) (42) (164) (30,066) (30,272)
Issuance of common stock in
exchange for preferred stock (2,800) (2,800) 2,800 28 2,772 0
ESOP Shares Purchased,
net of shares allocated 773 (12,456) (11,683)
--------- --------- --------- --------- --------- ----------- ---------- ---------- ------------
BALANCE AT DECEMBER 31, 1995 389,487 389,487 1,880,294 18,803 74,215 7,797,098 (145,256) - 8,134,347
Net income 1,208,670 1,208,670
Issuance of common stock under
Employee Stock Purchase Plan 3,563 36 21,732 21,768
ESOP Shares Allocated 6,056 43,944 50,000
Unrealized gains on marketable
securities 531,053 531,053
--------- --------- --------- --------- --------- ----------- ---------- ---------- ------------
BALANCE AT DECEMBER 31, 1996 389,487 389,487 1,883,857 18,839 102,003 9,005,768 (101,312) 531,053 9,945,838
Net income 2,720,753 2,720,753
Issuance of common stock 171,425 1,714 1,488,255 1,489,969
Issuance of common stock under
Employee Stock Purchase Plan 3,695 37 23,126 23,163
Issuance of common stock under
Employee Stock Option Plan 9,000 90 61,885 61,975
Issuance of common stock in
exchange for preferred stock (11,387) (11,387) 11,387 114 11,273 0
ESOP Shares Allocated 26,412 31,588 58,000
Unrealized gains on marketable
securities 147,424 147,424
--------- --------- --------- --------- --------- ----------- ---------- ---------- ------------
BALANCE AT DECEMBER 31, 1997 378,100 $ 378,100 2,079,364 $ 20,794 $1,712,954 $11,726,521 $ (69,724) $ 678,477 $14,447,122
========= ========= ========= ========= ========= =========== ========== ========== ============
See notes to
consolidated financial statements.
26
HECTOR COMMUNICATIONS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Description of business: Hector Communications Corporation owns a 100% interest
in five local exchange telephone subsidiaries and one cable television
subsidiary. The Company also owns a 68% interest in Alliance Telecommunications
Corporation, which owns and operates four local exchange telephone companies,
two cable companies, an engineering company, and a credit card communications
company. At December 31, 1997, the Company's wholly and majority owned
subsidiaries provided telephone service to 32,700 access lines in 34 rural
communities in Minnesota, Wisconsin, South Dakota and Iowa. Its cable television
operations provided cable television services to approximately 8,300 subscribers
in Minnesota, South Dakota and Wisconsin. The Company is also an investor in
partnerships and corporations providing wireless telephone and other
telecommunications related services.
Principles of consolidation: The consolidated financial statements include the
accounts of Hector Communications Corporation and its wholly and majority owned
subsidiaries ("HCC" or the "Company"). All material intercompany transactions
and accounts have been eliminated.
Regulatory accounting: 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).
As part of the rate-making process, regulators may require recording of an asset
or liability that would not be recognized in an unregulated enterprise. These
costs are recovered through rates authorized in the rate-making process. 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.
Accounting estimates: 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. 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.
Property, plant and equipment: Property, plant and equipment is recorded at
cost. Depreciation is computed using principally the straight-line method.
Depreciation included in costs and expenses was $5,807,103, $4,305,212 and
$1,533,240 for 1997, 1996 and 1995, respectively. Maintenance and repairs are
charged to operations and additions or betterments are capitalized. Items of
property sold, retired or otherwise disposed of are removed from assets and any
gains or losses are included in accumulated depreciation.
Other assets: The excess of cost over net assets of subsidiaries acquired in
purchase transactions is being amortized on the straight-line method principally
over forty years. Amortization included in costs and expenses was $1,401,889,
$961,981 and $73,865 in 1997, 1996 and 1995, respectively.
Deferred bond issue costs are the underwriting, legal and accounting fees
incurred by the Company in completing its February, 1995 public offering of
convertible subordinated debentures. The bond issue costs are being amortized
over the seven year life of the bonds (Note 6). Amortization cost included in
interest expense was $189,112, $189,112 and $165,474 in 1997, 1996 and 1995,
respectively. Accumulated amortization was $543,698 and $354,586 at December 31,
1997 and 1996, respectively.
Other investments consist of Rural Telephone Bank stock, Minnesota Equal Access
Network Services, Inc. stock, St. Paul Bank for Cooperatives stock, and
investments in stock companies and partnerships of other telecommunications
service providers. Long-term investments in companies that are not intended for
resale or are not readily marketable are valued at cost, which does not exceed
net realizable value. Investments in joint ventures, partnerships and limited
27
liability companies are recorded on the equity method of accounting which
reflects original cost and recognition of the Company's share of operating
income or losses from the respective operations.
Other assets are cable television franchises owned by the Company and other
deferred charges. Amortization included in expenses was $100,738, $161,417 and
$91,530 for 1997, 1996 and 1995, respectively.
Financial instruments: The fair value of the Company's financial instruments
approximates carrying value except for long-term investments in other companies
and long-term debt payable to the Rural Utilities Service ("RUS") and Rural
Telephone Bank ("RTB"). Other long-term investments are not intended for resale
and not readily marketable, thus a reasonable estimate of fair value is not
practicable. The fair value of long-term debt owed to RUS and RTB was
$30,215,000 and $29,574,000 at December 31, 1997 and 1996, respectively. Fair
values were estimated based on current rates offered to the Company for debt
with similar terms and maturities.
Revenue recognition: 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 final cost separation studies which are typically settled within
two years.
Income taxes and investment tax credits: The provision for income taxes consists
of an amount for taxes currently payable and a provision for tax consequences
deferred to future periods. For financial statement purposes, deferred
investment tax credits are being amortized as a reduction of the provision for
income taxes over the estimated useful lives of the related property, plant and
equipment.
Net income per share: Effective December 15, 1997, the Company adopted the
provisions of Statement of Financial Accounting Standards No. 128, "Earnings per
Share". The Statement requires the Company to present its net income per share
in basic and diluted forms and to restate net income per share from prior
periods to conform with the new statement. Basic net income per common share is
based on the weighted average number of common shares outstanding during each
year. Diluted net income per common share takes into effect the dilutive effect
of potential common shares outstanding. The Company's potential common shares
outstanding include preferred stock, stock options, warrants and convertible
debentures. The calculation of the Company's net income per share is included in
Exhibit 11 of this form 10-K.
Statement of cash flows: The Company considers temporary cash investments with
an original maturity of three months or less to be cash equivalents.
Effective April 25, 1996, the Company's 68% owned subsidiary, Alliance
Telecommunications Corporation, purchased all of the capital stock of Ollig
Utilities Company. In the acquisition, the following assets were acquired and
liabilities assumed:
Property, plant and equipment $ 31,566,292
Excess of cost over net assets acquired 52,404,243
Wireless telephone investments 8,704,392
Marketable securities 4,334,814
Long-term debt (23,023,316)
Deferred credits (7,028,096)
Other assets and liabilities 13,041,671
-----------------
Total purchase price 80,000,000
Acquisition costs 72,730
-----------------
Total acquisition expenditures 80,072,730
Less cash and cash equivalents acquired (8,092,802)
Less deposits and acquisition costs paid in 1995 (2,790,236)
------------------
Payment for purchase of Ollig Utilities
Company, net of cash acquired $ 69,189,692
==================
28
Change of presentation: Certain amounts in the 1995 and 1996 financial
statements have been reclassified to conform with the 1997 financial statement
presentation. These reclassifications had no effect on net income or
stockholders' equity as previously reported.
NOTE 2 - ACQUISITION OF OLLIG UTILITIES COMPANY, INC.
On April 25, 1996, a newly formed subsidiary of the Company, Alliance
Telecommunications Corporation ("Alliance"), purchased Ollig Utilities Company
("Ollig") for $80,000,000 in cash. The Company owns 68% of Alliance with the
remaining interest owned by Golden West Telecommunications Cooperative, Inc. of
Wall, South Dakota and Split Rock Telecom Cooperative, Inc. of Garretson, South
Dakota. Alliance financed the acquisition using the combined equity investments
of its shareholders and debt financing provided by St. Paul Bank for
Cooperatives ("St. Paul Bank"). The Company's cash investment in Alliance is
approximately $16,903,000.
The acquisition was accounted for as a purchase. The excess of cost over net
assets acquired in the transaction was $51,948,000 (including $6,272,000
allocated to wireless telephone investments) which is being amortized on a
straight line basis over 40 years. The results of operations of Ollig have been
included in the Company's financial results subsequent to April 25, 1996.
Unaudited consolidated results of operations on a pro forma basis as though
Ollig was acquired January 1, 1996 are as follows:
Year Ended
December 31, 1996
-------------------
Revenues $ 27,260,512
Income before minority interest 1,446,644
Net income 1,097,805
Basic net income per share $ .59
Diluted net income per share $ .50
Pro forma financial information is not necessarily indicative of the results of
operations had the acquisition occurred at the beginning of the periods
presented, nor are they necessarily indicative of the results of future
operations.
NOTE 3 - MARKETABLE SECURITIES AND GAINS ON SALES OF INVESTMENTS
Marketable securities consist principally of equity securities obtained by the
Company in sales of its investments in wireless telephone partnerships and
equity securities of other telecommunications companies. The Company's
marketable securities portfolio is classified as available-for-sale at December
31, 1997 and December 31, 1996. The Company classified its marketable securities
as trading in 1995 and sold the related securities in 1996. The cost and fair
values of available-for-sale investment securities was as follows:
Gross Gross
Unrealized Unrealized Fair
Cost Gains Losses Value
----------- ----------- ---------- ------------
December 31, 1997 $ 4,449,976 $ 1,035,722 $ - $ 5,485,698
December 31, 1996 4,680,892 1,390,273 (612,765) 5,458,400
Net unrealized gains on marketable securities, net of related deferred taxes,
are included in stockholders' equity at December 31, 1997 and 1996 as follows:
Net Deferred
Unrealized Income Stockholders'
Gains Taxes Equity
-------------- -------------- --------------
December 31, 1997 $ 1,035,722 $ (357,245) $ 678,477
December 31, 1996 777,508 (246,455) 531,053
These amounts have no cash effect and are not included in the statement of cash
flows. Net income includes unrealized holding losses on trading marketable
securities of $197,603 in 1995.
29
Gross proceeds from sales of available-for-sale securities were $1,728,000 and
$554,000 in 1997 and 1996, respectively. Gross realized gains on sales of these
securities were $1,496,000 and $485,000 in 1997 and 1996, respectively. Realized
gains on sales are based on the difference between net sales proceeds and the
book value of the securities sold, using the specific identification method.
Gross proceeds from sales of trading securities were $1,499,000 and $438,000 in
1996 and 1995, respectively. Gross realized gains on these sales were $203,000
in 1996.
NOTE 4 - WIRELESS TELEPHONE INVESTMENTS
Investments in wireless telephone partnerships and limited liability companies
are recorded on the equity method of accounting which reflects original cost and
recognition of the Company's share of income or losses. At December 31, 1997,
the Company owned 9.78% of Midwest Wireless Communications LLC, which is made up
of the former RSA partnerships which served southern Minnesota and the
Rochester, Minnesota MSA, 12.25% of Sioux Falls Cellular, Ltd., which serves the
Sioux Falls, South Dakota MSA, and 11.66% of Wireless North, a consortium of
three limited partnerships and one LLC with licenses to provide personal
communications services in Minnesota, Wisconsin, North Dakota and South Dakota.
At December 31, 1997, the Company's cumulative share of income from wireless
investments was $1,924,000, of which $883,000 was undistributed. The excess of
cost over the Company's share of equity in the wireless companies, net of
amortization reserves, was $7,174,000 and $7,357,000 at December 31, 1997 and
1996, respectively. Excess cost is being amortized on the straight line method
over forty years. Amortization expense (included as an offset to partnership and
LLC income) was $182,651 and $117,280 in 1997 and 1996, respectively.
The Company invested $510,000 of cash and guaranteed debt of $1,373,000 in
Wireless North in 1997 and 1996. Its PCS systems are in start-up mode and have
not been profitable to date. The Company has committed to providing $1,486,000
of additional capital to these entities. It cannot predict if additional funding
beyond this amount will be required.
Income recognized on cellular telephone investments was $1,580,000, $502,000,
and $126,000 in 1997, 1996 and 1995, respectively. Losses from PCS investments
were $435,000 and $73,000 in 1997 and 1996, respectively. The following table
shows the carrying value of the Company's wireless telephone investments at
December 31, 1997 and 1996. The Company's ownership percentage at December 31,
1997 is in brackets.
December 31
---------------------------------------
1997 1996
------------------- ------------------
Midwest Wireless LLC (9.78%) $ 8,741,586 $ 7,882,493
Sioux Falls, South Dakota MSA (12.25%) 1,931,874 1,958,882
Wireless North (PCS partnerships) (11.66%) 2,317 378,578
Red River Cellular (1.6%) 4,878 4,957
------------------- ------------------
Total $ 10,680,655 $ 10,224,910
=================== ==================
Midwest Wireless LLC was created in June, 1996 from the merger of five RSA
partnerships serving southern Minnesota and the Rochester, Minnesota MSA. Income
recognized from the Company's investment in Midwest Wireless LLC is material to
the Company's operating results. The Company is the largest shareholder of
Midwest Wireless LLC and has the ability to influence the operating and
financial policies of this corporation. Summarized audit information for Midwest
Wireless, LLC for 1997 and 1996 is as follows:
30
Year Ended Six Months Ended
December 31,1997 December 31, 1996
---------------- -----------------
Current assets $ 13,622,176 $ 6,211,038
Noncurrent assets 39,729,609 35,243,820
Current liabilities 8,403,886 4,299,058
Noncurrent liabilities 15,344,657 17,393,410
Members' equity 29,603,242 19,762,390
Revenues 40,284,059 17,982,165
Expenses 26,660,623 13,970,615
Net income 13,623,436 4,011,550
NOTE 5 - PROPERTY, PLANT AND EQUIPMENT
The cost of property, plant and equipment and the estimated useful lives are as
follows:
Estimated December 31
useful life 1997 1996
------------------ -------------------- ------------------
Land $ 556,976 $ 546,673
Buildings 5-40 years 5,171,387 5,207,150
Machinery and equipment 3-15 years 2,089,598 1,864,666
Furniture and fixtures 5-10 years 471,489 388,466
Telephone plant 5-33 years 50,638,166 47,591,324
Cable television plant 10-15 years 6,190,412 5,869,575
Construction in progress 676,535 232,923
-------------------- ------------------
65,794,563 61,700,777
Less accumulated depreciation 19,867,410 14,661,825
-------------------- ------------------
$ 45,927,153 $ 47,038,952
==================== ==================
NOTE 6 - NOTES PAYABLE AND LONG-TERM DEBT
December 31
1997 1996
-------------------- ------------------
Notes payable to St.Paul Bank for Cooperatives, payable
by Alliance Telecommunications Corporation in monthly
installments, average interest rate of 7.4%,
due 1998 to 2011 $ 53,063,200 $ 55,250,000
Note payable to St. Paul Bank for Cooperatives,
payable by cable television subsidiary, interest rate
of 8.0%, due 1998 - 2001 4,000,000 6,000,000
Rural Utilities Service ("RUS") and Rural Telephone Bank ("RTB") mortgage notes,
payable by telephone company subsidiaries in monthly and quarterly
installments, average rate of 5.6%, due 1998 to 2026 32,715,608 32,005,604
Convertible subordinated debentures, payable to
bondholders, interest rate of 8.5%, due 2002 12,650,000 12,650,000
Notes payable to former cable television system owners,
payable annually by cable television subsidiary,
interest rate of 6%, due 1998 134,387 268,775
-------------------- ------------------
102,563,195 106,174,379
Less current portion 4,770,000 10,047,000
-------------------- ------------------
$ 97,793,195 $ 96,127,379
==================== ==================
31
In 1996, the Company's 68% owned subsidiary, Alliance Telecommunications
Corporation negotiated a term loan agreement with the St. Paul Bank for
Cooperatives ("St. Paul Bank") to provide financing for the acquisition of Ollig
Utilities Company. The face amount of the loan was $55,250,000. The loan is
secured by a pledge of substantially all the assets of Alliance and its
subsidiaries. The Company has fixed interest rates on this loan for periods
ranging from one to ten years at rates averaging approximately 7.4%. The Company
made only interest payments on the loan in 1996. Principal payments began in
January 1997 and will continue until March, 2011.
In 1996, the Company and one of its cable television subsidiaries, North
American Communications Corporation, negotiated a loan agreement with the St.
Paul Bank for Cooperatives to provide additional financing for the acquisition
of Ollig Utilities Company. Face amount of the loan was $6,000,000, payable
March 31, 1997. The Company made principal payments of $2,000,000 on this loan
in 1997 and converted the remaining balance into a five year term loan with
quarterly installment payments. Interest rate on the loan, which varies
according to St. Paul Bank's cost of money, was 8.0% at December 31, 1997. The
loan is secured by a pledge of the assets of North American and the stock of one
of the Company's telephone subsidiaries.
St. Paul Bank is a cooperative, owned and controlled by its customers. As a
condition to receiving the loans, the Company purchased stock in the bank. The
Company's investment in St. Paul Bank stock at December 31, 1997 was $2,749,000.
Each customer borrowing from the bank on a patronage basis shares in the bank's
net income through payment of patronage refunds. . The Company's patronage
refund from St. Paul Bank was $694,000 and $221,000 in 1997 and 1996,
respectively. Approximately 30% of the patronage refund is received in cash,
with the balance in stock of St. Paul Bank. The patronage refund is shown in the
Company's operating statement as a reduction of interest expense. The Company
cannot predict what patronage refunds will be in future years.
Substantially all assets of the Company's telephone subsidiaries are pledged as
collateral under the RUS and RTB debt agreements. The telephone company
subsidiaries also have various restrictions on distributions of capital to the
parent company relative to their outstanding indebtedness.
In February 1995 the Company completed a public offering of convertible
subordinated debentures. The debentures carry an interest rate of 8.5% and
mature February 15, 2002. As of February 15, 1997, the Company has the right to
call the debentures at a price (depending on the trading price of the Company's
common stock) ranging from 100% to 104% of par. The debentures include
restrictions on payment of dividends to the Company's shareholders. The
debentures are subordinated to $4,000,000 of senior indebtedness owed by the
Company to St. Paul Bank. Total value of the offering was $12,650,000. Proceeds
to the Company, after underwriting, accounting and legal expenses were
approximately $11,300,000.
The annual requirements for principal payments on notes payable and long-term
debt are as follows:
1998 $4,770,000
1999 4,781,000
2000 5,084,000
2001 6,924,000
2002 17,722,000
The Company is continuing its construction program to upgrade the central office
equipment and outside plant of its telephone subsidiaries. Planned expenditures
for telephone plant additions in 1998 are $5,371,000. The Company intends to use
RUS and RTB loan funds to help finance these projects. Loan funds received are
deposited in construction fund accounts and disbursements are restricted,
subject to RUS approval, to construction costs authorized by the loan
agreements. The Company has unadvanced loan funds available from RUS and RTB of
$17,478,000. Planned cable television plant additions and improvements for 1998
are $250,000.
32
NOTE 7 - INCOME TAXES
Hector Communications Corporation and its wholly owned subsidiaries file a
consolidated tax return separate from the consolidated return for Alliance
Telecommunications Corporation and its subsidiaries. Income tax expenses
(benefits) consist of the following:
Year Ended December 31
--------------------------------------------------------
1997 1996 1995
----------------- ------------------ -----------------
Currently payable taxes:
Federal $ 2,305,000 $ 964,000 $ 141,000
State 682,000 325,000 90,000
----------------- ------------------ -----------------
2,987,000 1,289,000 231,000
Deferred income taxes (benefit) 25,000 380,000 (243,000)
Deferred investment tax credits (145,000) (129,000) (39,000)
------------------ ------------------- ------------------
$ 2,867,000 $ 1,540,000 $ (51,000)
================== =================== ==================
Deferred tax assets and (liabilities) as of December 31 related to the
following:
1997 1996
------------------ ------------------
Accelerated depreciation $ (6,329,092) $ (6,410,907)
Alternative minimum tax credits 60,000 237,000
Marketable securities (1,824,000) (1,724,000)
Deferred compensation 381,000 400,000
Other 118,000 40,000
------------------ -------------------
$ (7,594,092) $ (7,457,907)
================== ===================
The provision for income taxes varied from the federal statutory tax rate as
follows:
Year Ended December 31
-------------------------------------------------------
1997 1996 1995
----------------- ------------------ ----------------
Tax (benefit) at U.S. statutory rate 35.0% 35.0% (35.0)%
Surtax exemption (1.0) (1.0) 1.0
State income taxes, net of federal benefit 7.4 7.5 11.4
Excess of cost over net assets acquired 8.3 12.1 15.6 .
Investment tax credits (2.3) (4.2) (29.5)
Other (2.5) .7 (3.5)
----------------- ------------------ ----------------
Effective tax (benefit) rate 44.9% 50.1% (40.0)%
================= ================== ================
NOTE 8 - STOCKHOLDERS' EQUITY
Preferred stock is entitled to share ratably with common shareholders in any
dividends or distributions paid by the Company, but are not entitled to any
dividend distribution separate from common shareholders. Preferred shareholders
have no voting rights. Each share of preferred stock is convertible into one
share of common stock.
Common shares are reserved for issuance in connection with a stock option plan
(1990 Plan) under which 500,000 shares may be issued to key employees. The plan
was effective August 1, 1990 and expires July 31, 2000. The term of the stock
options may not exceed ten years. The exercise price of options issued will not
be less than fair market value at the time of the grant. Another provision of
the 1990 plan automatically grants 1,000 shares of nonqualified stock options
per year to each nonemployee director. Options issued under this provision have
a ten year term and an exercise price not less than fair market value at date of
grant.
A summary of changes in outstanding employee and director stock options during
the three years ended December 31, 1997 is as follows:
33
Average
Number of exercise price
shares per share
Outstanding at December 31, 1994 158,900 $ 7.15
Granted 46,150 7.02
Canceled (3,700) 7.17
----------------- -------------
Outstanding at December 31, 1995 201,350 7.12
Granted 48,825 6.67
Canceled (38,000) 6.53
----------------- -------------
Outstanding at December 31, 1996 212,175 7.12
Granted 69,775 7.87
Exercised (9,000) 6.89
Canceled (33,200) 7.69
----------------- -------------
Outstanding at December 31, 1997 239,750 $ 7.27
================= =============
Exercise prices of outstanding stock options range from $6.50 to $8.50 per
share. The weighted average remaining life of outstanding stock options at
December 31, 1997 was 2.9 years. Options exercisable at December 31, 1997 are
183,692.
Effective August 1, 1990, the 1990 Employee Stock Purchase Plan ("ESPP") was
adopted, for which 100,000 shares were reserved. Under terms of the plan,
participating employees may acquire shares of common stock through payroll
deductions of not more than 10% of compensation. The price of shares purchased
by the employees is 85% of the lower of fair market value for such shares on one
of two specified dates in each plan year. A participant is limited to the
acquisition in any plan year to the number of shares which their payroll
deductions for the year would purchase based on the market price on the first
day of the year or $25,000, whichever is less. Shares issued to employees under
the plan were 3,695, 3,563 and 3,844 for the plan years ended August 31, 1997,
1996 and 1995, respectively. At December 31, 1997 employees had subscribed to
purchase an additional 11,942 shares in the current plan cycle ending August 31,
1998.
The Company has adopted the disclosure provisions of SFAS No. 123, "Accounting
for Stock-Based Compensation" , but applies APB Opinion No. 25, "Accounting for
Stock Issued to Employees" for measurement and recognition of stock-based
transactions with its employees. If the Company had elected to recognize
compensation cost for its stock based transactions using the method prescribed
by SFAS No. 123, net income and earnings per share would have been as follows:
Year Ended December 31
--------------------------------------------------------------
1997 1996 1995
-------------------- -------------------- ------------------
Net income $ 2,579,427 $ 1,139,265 $ (115,710)
Basic net income per share $ 1.36 $ .61 $ (.04)
Diluted net income per share $ .89 $ .51 $ (.04)
The fair value of the Company's stock options and Employee Stock Purchase Plan
transactions used to compute pro forma net income and net income per share
disclosures is the estimated present value at grant date using the Black-Scholes
option-pricing model with the following assumptions: for 1997 expected
volatility of 21.4%, a risk free interest rate of 6.5%, an expected holding
period of four years for key employee options and seven years for director
options, and no dividend yield. For 1996 and 1995: expected volatility of 21.2%,
a risk free interest rate of 6.8%, an expected holding period of four years for
key employee options and seven years for director options, and no dividend
yield. Pro forma stock-based compensation cost was $141,326, $69,405 and $39,171
in 1997, 1996 and 1995, respectively. Fair value of all options issued was
$180,134, $98,040, and $94,439 in 1997, 1996 and 1995, respectively.
In February 1995 the Company completed a public offering of $12,650,000 (par
value) convertible subordinated debentures. The debentures carry an interest
rate of 8.5% and mature February 15, 2002. The debentures are convertible into
common stock of the Company at a rate of 112.5 common shares per $1,000 par
value bond. If all the outstanding debentures were converted into common stock,
they would represent an additional 1,423,125 common shares. The offering's
underwriters also received warrants to purchase 123,750 shares of the Company's
common stock at a price of $8.70 per share. The warrants are currently
exercisable and expire February 15, 2000.
34
Effective August 1, 1990, the Board of Directors adopted a leveraged employee
stock ownership plan ("ESOP"). Contributions to the ESOP are determined by the
Board on an annual basis and can be made in cash or by issuing shares of the
Company's common stock. During 1997 and 1995, the Company advanced $2,000 and
$62,000, respectively, to the ESOP to purchase the Company's common stock on the
open market. Advances bear interest at 85% of prime and are repaid through
contributions to the plan. ESOP expense reflects the market value of company
stock contributed to the accounts of eligible employees at the time of the
contribution. ESOP expense was $60,000, $50,000 and $50,000 for 1997, 1996 and
1995, respectively. At December 31, 1997, the ESOP held 55,748 shares of the
Company's common stock, of which 49,696 shares had been allocated to the
accounts of participating employees. All eligible employees of Hector
Communications Corporation participate in the plan after completing one year of
service. Employees of Alliance Telecommunications Corporation do not participate
in the plan. Contributions are allocated to each participant based on
compensation and vest 30% after three years of service and incrementally
thereafter, with full vesting after seven years. At December 31, 1997, the fair
value of unallocated ESOP assets was $69,724.
NOTE 9 - EMPLOYEE BENEFIT PLANS
The Company has 401(k) savings plans for its employees. Employees who meet
certain age and service requirements may contribute up to 10% of their salaries
to the plan on a pretax basis. The Company matches a portion of employee
contributions. Contributions to the plan by the Company for 1997, 1996 and 1995
were approximately $121,400, $85,700 and $21,800, respectively.
Employees of Alliance Telecommunications Corporation who meet certain age and
service requirements are eligible to participate in a profit sharing plan.
Contributions are determined annually by Alliance's Board of Directors and are
allocated proportionately to the participants in each allocation group.
Contributions to the plan by the Company in 1997 and 1996 were $166,000 and
$128,900, respectively.
Ollig Utilities Company had a deferred compensation agreement with two of its
former officers which the Company has assumed. Under the agreement, the salaries
of these officers were continued after their retirement based on a formula
stated in the agreement. The Company incurred no expense under this agreement in
1997 or 1996. Payments made under the agreement in 1997 and 1996 were $47,500
and $31,700, respectively.
NOTE 10 - TRANSACTIONS WITH COMMUNICATIONS SYSTEMS, INC.
Transactions between the Company and Communications Systems, Inc. (CSI), the
Company's former parent, are based on a distribution agreement, which provides
for the Company's use of certain of CSI's staff and facilities, with related
costs paid by the Company. Services provided by CSI aggregated approximately
$264,000, $258,000 and $279,000 in 1997, 1996 and 1995, respectively.
Since 1995, employees of the Company have participated in a joint self-funded
medical insurance program with employees of CSI. Costs paid by the Company into
this program were $535,000, $157,000 and $140,000 in 1997, 1996 and 1995,
respectively.
Costs of services from CSI may not be indicative of the costs of such services
had they been obtained from a different party. Intercompany accounts with CSI
are handled on an open account basis. Outstanding amounts payable to CSI were
$357,000 and $307,000 at December 31, 1997 and 1996, respectively.
35
NOTE 11 - SEGMENT INFORMATION
The Company operates in two business segments: local exchange telephone
companies and cable television. Industry segment information is as follows:
Year Ended December 31
--------------------------------------------------------
1997 1996 1995
----------------- ------------------ -----------------
Revenues:
Telephone $ 26,051,145 $ 18,529,701 $ 5,057,777
Cable television 2,393,406 1,868,641 779,391
Corporate 421,814 259,179 7,155
----------------- ------------------ -----------------
$ 28,866,365 $ 20,657,521 $ 5,844,323
================= ================== =================
Operating income (loss):
Telephone $ 9,929,345 $ 6,644,455 $ 1,314,828
Cable television 114,884 (3,357) (335,447)
Corporate (290,821) (49,445) (126,980)
------------------ ------------------- ------------------
$ 9,753,408 $ 6,591,653 $ 852,401
================= ================== =================
Identifiable assets:
Telephone $ 131,982,347 $ 126,596,360 $ 22,298,933
Cable television 5,270,085 5,747,246 4,329,023
Corporate 2,038,524 5,004,407 6,890,488
----------------- ------------------ -----------------
$ 139,290,956 $ 137,348,013 $ 33,518,444
================= ================== =================
Depreciation and amortization:
Telephone $ 6,517,836 $ 4,744,780 $ 1,204,614
Cable television 780,916 679,473 455,130
Corporate 201,326 193,469 212,225
----------------- ------------------ -----------------
$ 7,500,078 $ 5,617,722 $ 1,871,969
================= ================== =================
Capital expenditures:
Telephone $ 4,261,522 $ 4,669,171 $ 869,243
Cable television 378,426 499,826 2,230,637
Corporate 55,353 23,667
----------------- ------------------ -----------------
$ 4,695,301 $ 5,168,997 $ 3,123,547
================= ================== =================
NOTE 12 - PENDING ACQUISITIONS
Alliance Telecommunications Corporation has entered into a definitive
agreement to purchase all the outstanding common stock of Felton Telephone
Company ("Felton"), a rural telephone company located in northwestern Minnesota
adjacent to areas already served by the Company's telephone subsidiaries. Felton
serves approximately 700 access lines and holds significant portfolio of
marketable securities, including investments in Rural Cellular Corporation, U.S.
West Communications, Inc. and U.S. West Media, Inc. Purchase price is
$3,650,000, which includes a cash downpayment and seller financing of the
balance. The Company is awaiting regulatory approval of the purchase and expects
it to be completed in April, 1998.
Alliance has also entered into a definitive agreement to purchase
Spectrum Cablevision Limited Partnership ("Spectrum"). Spectrum serves 4,600
cable television customers in 20 communities in Minnesota and North Dakota,
including several communities also served by the Company's telephone
subsidiaries. Purchase price is approximately $5,200,000. The Company expects to
use its cash reserves and obtain additional outside financing to make this
purchase. The Company expects to complete this acquisition in the second quarter
of 1998.
36
(b) SUPPLEMENTAL FINANCIAL INFORMATION
Unaudited Quarterly Operating Results
(in thousands except per share amounts)
Quarter Ended
------------------------------------------------------
March 31 June 30 Sept 30 Dec 31
- ----------------------------------------------------------------------------------------------------------------
1997
Revenues $ 6,882 $ 6,855 $ 7,975 $ 7,154
Operating income 1,979 2,190 3,243 2,340
Net income 131 1,080 696 814
Basic net income per share $ .07 $ .58 $ .37 $ .43
Diluted net income per share $ .06 $ .34 $ .24 $ .27
1996
Revenues $ 1,666 $ 5,165 $ 7,218 $ 6,609
Operating income 373 1,597 2,497 2,125
Net income 494 110 293 312
Basic net income per share $ .27 $ .06 $ .16 $ .17
Diluted net income per share $ .19 $ .05 $ .13 $ .14
Net income per share for the periods presented above has been restated in accordance with SFAS No. 128.
37
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURE
Not applicable.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information called for by paragraphs (a), (c), (d), (e), and (f) of Item 401
under Regulation S-K, to the extent applicable, will be set forth under the
caption "Election of Directors" in the Company's definitive proxy material for
its May 19, 1998 Annual Meeting of Shareholders to be filed within 120 days from
the end of the Registrant's fiscal year, which information is expressly
incorporated by reference herein. The information called for by paragraph (b) of
Item 401 is set forth under Item 1(c) herein. The information called for by Item
405 under Regulation S-K, to the extent applicable, will be set forth under the
caption "Certain Transactions" in the Company's above referenced definitive
proxy material.
ITEM 11. EXECUTIVE COMPENSATION
The information called for by Item 402 under Regulation S-K to the extent
applicable, will be set forth under the caption "Executive Compensation" in the
Company's definitive proxy materials for its May 19, 1998 Annual Meeting to be
filed within 120 days from the end of the Registrant's fiscal year, which
information is expressly incorporated herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information called for by Item 403 under Regulation S-K will be set forth
under the captions "Security Ownership of Certain Beneficial Owners and
Management" and "Election of Directors" in the Company's definitive proxy
materials for its May 19, 1998 Annual Meeting to be filed within 120 days from
the end of the Registrant's fiscal year, which information is expressly
incorporated herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information called for by Item 404 under Regulation S-K will be set forth
under the caption "Certain Transactions" in the Company's definitive proxy
materials for its May 19, 1998 Annual Meeting to be filed within 120 days from
the end of the Registrant's fiscal year, which information is expressly
incorporated herein by reference.
38
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) (1) Consolidated Financial Statements
The following Consolidated Financial Statements of Hector Communications
Corporation and subsidiaries appear at pages 22 to 36 herein:
Independent Auditors' Report for the years ended
December 31, 1997, 1996 and 1995
Consolidated Balance Sheets as of December 31, 1997 and 1996
Consolidated Statements of Income for the years ended
December 31, 1997, 1996 and 1995
Consolidated Statements of Stockholders' Equity for the years ended
December 31, 1997, 1996 and 1995
Consolidated Statements of Cash Flows for the years ended
December 31, 1997, 1996 and 1995
Notes to Consolidated Financial Statements
(a) (2) Consolidated Financial Statement Schedule Page Herein
----------------------------------------- ------------
The following financial statement schedule is being filed as part of
this Form 10-K Report:
Independent Auditors' Report on financial statement
schedules for the years ended
December 31, 1997, 1996 and 1995 42
Schedule I - Condensed Financial Information
of Registrant 43-45
Separate financial statements of Midwest Wireless Communications LLC, a
50 percent or less owned equity method investment, included as this
entity constitutes a "significant subsidiary" pursuant to the
provisions of Regulation S-X, Article 3-09. 46-58
All other schedules are omitted as the required information is inapplicable or
the information is presented in the financial statements or related notes.
(a) (3) Exhibits
The exhibits which accompany or are incorporated by reference in this report,
including all exhibits required to be filed with this report, are described on
the Exhibit Index, which begins on page 60 of the sequential numbering system
used in this report.
(b) REPORTS ON FORM 8-K FILED DURING THE THREE MONTHS ENDED DECEMBER 31, 1997
Not Applicable.
39
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
HECTOR COMMUNICATIONS CORPORATION
Dated: March 27, 1998 /s/ Curtis A. Sampson
----------------------------------------
Curtis A. Sampson, Chairman of the Board
of Directors and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
Registrant in the capacities and on the dates indicated:
Each person whose signature appears below constitutes and appoints
CURTIS A. SAMPSON and PAUL N. HANSON as his true and lawful attorneys-in-fact
and agents, each acting alone, with full power of substitution and
resubstitution, for him and in his name, place and stead, in any and all
capacities, to sign any or all amendments to this Annual Report on Form 10-K and
to file the same, with all exhibits thereto, and other documents in connection
therewith, with the Securities and Exchange Commission, granting unto said
attorneys-in-fact and agents, each acting alone, full power and authority to do
and perform each and every act and thing requisite and necessary to be done in
and about the premises, as fully to all intents and purposes as he might or
could do in person, hereby ratifying and confirming all said attorneys-in-fact
and agents, each acting alone, or his substitute or substitutes, may lawfully do
or cause to be done by virtue thereof.
Signature Title Date
/s/Curtis A. Sampson Chairman of the Board of Directors, March 27, 1998
- --------------------- Chief Executive Officer and Director
Curtis A. Sampson
/s/Steven H. Sjogren President, Chief Operating Officer, March 27, 1998
- -------------------- and Director
Steven H. Sjogren
/s/Paul N. Hanson Vice President, Treasurer and March 27, 1998
- -------------------- Director
Paul N. Hanson
/s/Charles A. Braun Chief Financial Officer and March 27, 1998
- -------------------- Principal Accounting Officer
Charles A. Braun
/s/Charles R. Dickman Director March 27, 1998
- ---------------------
Charles R. Dickman
/s/James O. Ericson Director March 27, 1998
- ---------------------
James O. Ericson
/s/Paul A. Hoff Director March 27, 1998
- ---------------------
Paul A. Hoff
/s/Wayne E. Sampson Director March 27, 1998
- -------------------
Wayne E. Sampson
Director March 27, 1998
- -----------------------
Edward E. Strickland
40
- --------------------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 or 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
OF
HECTOR COMMUNICATIONS CORPORATION
FOR
YEAR ENDED DECEMBER 31, 1997
-----------------------------------------
FINANCIAL STATEMENT SCHEDULES
- --------------------------------------------------------------------------------
41
INDEPENDENT AUDITORS' REPORT ON FINANCIAL STATEMENT SCHEDULES
Shareholders and Board of Directors
Hector Communications Corporation
The audit of the consolidated financial statements of Hector Communications
Corporation and subsidiaries referred to in our opinion dated February 18, 1998,
included the related financial statement schedules as listed in item 14(a)2. In
our opinion, these financial statement schedules, when considered in relation to
the basic consolidated financial statements, present fairly in all material
respects the information set forth therein.
/s/ Olsen Thielen and Co., Ltd.
- -------------------------------
Olsen Thielen and Co., Ltd.
St. Paul, Minnesota
February 18, 1998
42
HECTOR COMMUNICATIONS CORPORATION
SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
HECTOR COMMUNICATIONS CORPORATION (PARENT COMPANY)
BALANCE SHEETS
December 31
-------------------------------
1997 1996
------------- -------------
Assets:
Cash $ 49,969 $ 57,965
Investment in subsidiaries 27,620,410 24,533,032
Other current assets 69,056 255,922
Property, plant and equipment, net 134,288 126,265
Accounts with subsidiaries 2,873,495 2,445,201
Other investments 270,021 1,636,049
Deferred bond issue costs 780,089 969,201
------------- -------------
Total Assets $ 31,797,328 $ 30,023,635
============= =============
Liabilities and Stockholders' Equity:
Accounts payable $ 146,352 $ 166,155
Other current liabilities 549,759 716,238
Current portion of long-term debt 715,000 6,000,000
Long-term debt 15,935,000 12,650,000
Deferred income taxes 4,095 545,404
Stockholders' equity:
Preferred stock, par value $1.00 per share; 3,000,000 shares authorized:
Convertible Series A, 378,100 and 389,487
shares issued and outstanding 378,100 389,487
Common stock, par value $.01 per share;
10,000,000 shares authorized; 2,079,364 and
1,883,857 shares issued and outstanding 20,794 18,839
Additional paid-in capital 1,712,954 102,003
Retained earnings 11,726,521 9,005,768
Unearned employee stock ownership shares (69,724) (101,312)
Unrealized gains on marketable securities 678,477 531,053
------------- -------------
Total Liabilities and Stockholders' Equity $ 31,797,328 $ 30,023,635
============= =============
43
HECTOR COMMUNICATIONS CORPORATION
SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
HECTOR COMMUNICATIONS CORPORATION (PARENT COMPANY)
STATEMENT OF INCOME
Year Ended December 31
--------------------------------------------------
1997 1996 1995
------------- ------------- -------------
Revenues:
Sales $ 287,345 $ 285,799 $ 49,345
Expenses:
Operating expenses 90,464 80,716 176,325
Amortization of goodwill 52,126 51,519 50,307
Gain on sale of marketable securities (1,464,409) (484,553)
Interest expense (income), net 1,571,655 1,396,393 641,363
Income tax expense (benefit) 24,315 (272,257) (302,437)
------------- ------------- -------------
Total expenses 274,151 771,818 565,558
Income (loss) before equity in earnings of
subsidiaries 13,194 (486,019) (516,213)
Equity in earnings of subsidiaries 2,707,559 1,694,689 439,674
------------- ------------- -------------
Net income (loss) $ 2,720,753 $ 1,208,670 $ (76,539)
============= ============= =============
44
HECTOR COMMUNICATIONS CORPORATION
SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
HECTOR COMMUNICATIONS CORPORATION (PARENT COMPANY)
STATEMENTS OF CASH FLOWS
Year Ended December 31
--------------------------------------------------
1997 1996 1995
------------- ------------- -------------
Cash flows from operating activities:
Net income $ 2,720,753 $ 1,208,670 $ (76,539)
Adjustments to reconcile net income to net cash provided by operating
activities:
Gain on sale of marketable securities (1,464,409) (484,553)
Equity in earnings of subsidiaries (2,707,559) (1,694,689) (439,674)
Depreciation and amortization 304,700 293,601 266,923
Changes in assets and liabilities:
Decrease (increase) in other current assets 186,866 (178,633) 85,932
Decrease (increase) in accounts with subsidiaries (428,294) 1,487,228 436,296
Increase (decrease) in accounts payable (19,803) (17,027) 151,486
Increase (decrease) in other current liabilities (166,479) 877 (140,791)
------------- ------------- -------------
Net cash provided by (used in) operating activities (1,574,225) 615,474 283,633
Cash flows from investing activities:
Purchases of property, plant and equipment (71,485) (16,286) (23,666)
Acquisition costs of stock of affiliate (12,346,388) (2,790,236)
Advance to subsidiaries (3,500,000)
Dividends from subsidiaries 527,444
Purchases of other investments (169,737) (503,583)
Cash proceeds from other investments 1,646,900 715,598
Decrease in other deferred charges 82,092
------------- ------------- -------------
Net cash provided by (used in) investing activities 1,933,122 (11,647,076) (6,735,393)
Cash flows from financing activities:
Issuance of debt 6,000,000 12,650,000
Repayment of long-term debt (2,000,000)
Deferred bond issue costs (1,323,787)
Purchase of common stock (30,272)
Issuance of common stock 1,575,107 21,768 22,872
ESOP shares allocated (purchased), net 58,000 50,000 (11,683)
------------- ------------- -------------
Net cash provided by (used in) financing activities (366,893) 6,071,768 11,307,130
------------- ------------- -------------
Net increase (decrease) in cash and cash equivalents (7,996) (4,959,834) 4,855,370
Beginning cash and cash equivalents 57,965 5,017,799 162,429
------------- ------------- -------------
Ending cash and cash equivalents $ 49,969 $ 57,965 $ 5,017,799
============= ============= =============
Supplemental disclosures of cash flow information:
Interest paid $ 1,420,884 $ 1,248,308 $ 516,906
Income taxes paid 450,000 300,000 773,307
45
MIDWEST WIRELESS COMMUNICATIONS L.L.C.
d/b/a Cellular 2000
REPORT ON AUDIT OF FINANCIAL STATEMENTS
FOR THE YEAR ENDED DECEMBER 31, 1997 AND
FOR THE PERIOD FROM JULY 1, 1996 (DATE OF INCEPTION)
TO DECEMBER 31, 1996
46
Report of Independent Accountants
To the Board of Managers
Midwest Wireless Communications L.L.C.
d/b/a Cellular 2000:
We have audited the accompanying statements of financial position of Midwest
Wireless Communications L.L.C. d/b/a Cellular 2000 as of December 31, 1997 and
1996, and the related statements of operations, changes in members' equity and
cash flows for the year ended December 31, 1997, and the period from July 1,
1996 (date of inception) to December 31, 1996. These financial statements are
the responsibility of the Company's management. Our responsibility is to express
an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Midwest Wireless Communications
L.L.C. d/b/a Cellular 2000 as of December 31, 1997 and 1996, and the results of
its operations and its cash flows for the year ended December 31, 1997, and the
period from July 1, 1996 (date of inception) to December 31, 1996, in conformity
with generally accepted accounting principles.
COOPERS & LYBRAND L.L.P.
Minneapolis, Minnesota
February 27, 1998
47
Midwest Wireless Communications L.L.C.
d/b/a Cellular 2000
Statements of Financial Position
as of December 31, 1997 and 1996
ASSETS 1997 1996
Current assets:
Cash and cash equivalents $ 2,063,280 $ 1,318,098
Marketable securities 5,911,871 -
Accounts receivable, less allowance for doubtful
accounts of $360,122 and $139,996 in 1997 and
1996, respectively 4,548,991 4,139,568
Inventories 770,617 425,266
Other 327,417 328,106
----------------- -----------------
Total current assets 13,622,176 6,211,038
Property, cellular plant and equipment, net 21,032,370 15,788,685
Investment in Switch 2000 1,466,820 1,949,279
FCC license, net 16,832,224 17,281,088
Other 398,195 224,768
----------------- -----------------
Total assets $ 53,351,785 $ 41,454,858
================= =================
LIABILITIES AND MEMBERS' EQUITY
Current liabilities:
Current portion of long-term debt 2,767,000 1,569,000
Accounts payable 2,106,461 521,069
Accrued commissions 649,891 821,311
Accrued liabilities 2,880,534 1,387,678
----------------- -----------------
Total current liabilities 8,403,886 4,299,058
Other liabilities 195,247 -
Long-term debt 15,149,410 17,393,410
----------------- -----------------
Total liabilities 23,748,543 21,692,468
Members' equity 29,603,242 19,762,390
----------------- -----------------
Total liabilities and members' equity $ 53,351,785 $ 41,454,858
================= =================
48
Midwest Wireless Communications L.L.C.
d/b/a Cellular 2000
Statements of Operations
for the year ended December 31, 1997 and the period from July 1, 1996 (date of
inception) to December 31, 1996
1997 1996
(12 months) (six months)
Operating revenues:
Retail service $ 27,785,727 $ 11,043,039
Roamer service 10,374,827 5,824,188
Equipment sales 2,123,505 1,079,355
----------------- -----------------
40,284,059 17,946,582
----------------- -----------------
Operating expenses:
Operations and maintenance 8,464,911 4,259,858
Cost of equipment sold 2,988,131 1,598,400
Depreciation 3,068,687 1,245,068
Amortization 448,864 210,861
Selling, general and administrative 9,517,110 4,949,103
Management fees - 702,709
Home roamer costs 804,709 438,582
----------------- -----------------
25,292,412 13,404,581
----------------- -----------------
Operating income 14,991,647 4,542,001
----------------- -----------------
Other income (expense):
Equity (loss) earnings on Switch 2000 (482,459) 35,583
Interest expense (1,106,380) (566,034)
Interest income 220,628 -
----------------- -----------------
(1,368,211) (530,451)
----------------- -----------------
Net income $ 13,623,436 $ 4,011,550
================= =================
49
Midwest Wireless Communications L.L.C.
d/b/a Cellular 2000
Statements of Changes in Members' Equity
for the year ended December 31, 1997 and the period from July 1, 1996 (date of
inception) to December 31, 1996
Total
Capital Accumulated Members'
Contributions Income Equity
Balance, June 30, 1996 $ 15,750,840 $ - $ 15,750,840
Net income - 4,011,550 4,011,550
----------------- ----------------- -----------------
Balance, December 31, 1996 15,750,840 4,011,550 19,762,390
Redemption of units (2,646) (24,468) (27,114)
Distributions to members - (3,755,470) (3,755,470)
Net income - 13,623,436 13,623,436
----------------- ----------------- -----------------
Balance, December 31, 1997 $ 15,748,194 $ 13,855,048 $ 29,603,242
================= ================= =================
50
Midwest Wireless Communications L.L.C.
d/b/a Cellular 2000
Statements of Cash Flows
for the year ended December 31, 1997 and the period from July 1, 1996 (date of
inception) to December 31, 1996
1997 1996
(12 months) (six months)
Cash flows from operating activities:
Net income $ 13,623,436 $ 4,011,550
Adjustments to reconcile net income to net cash provided by operating
activities:
Provision for bad debts 769,330 364,245
Depreciation 3,068,687 1,245,068
Amortization 448,864 210,861
Equity loss (earnings) on investments in Switch 2000 482,459 (35,583)
Accretion of discount (106,506) -
Changes in assets and liabilities:
Accounts receivable (1,178,753) (4,384,193)
Inventories (345,351) (425,266)
Accounts payable 1,166,996 324,740
Accrued liabilities 1,321,436 1,893,576
Other 195,936 (106,518)
------------------- -----------------
Net cash provided by operating activities 19,446,534 3,098,480
------------------- -----------------
Cash flows from investing activities:
Payments for property, cellular plant and equipment (7,893,976) (2,466,775)
Purchases of marketable securities (10,805,365) -
Proceeds received upon maturity of marketable securities 5,000,000 -
Other (173,427) (97,536)
------------------- -----------------
Net cash used in investing activities (13,872,768) (2,564,311)
------------------- -----------------
Cash flows from financing activities:
Payments on long-term debt (1,046,000) -
Distributions to members (3,755,470) -
Redemption of units (27,114) -
------------------- -----------------
Net cash used in financing activities (4,828,584) -
------------------- -----------------
Net change in cash and cash equivalents 745,182 534,169
Cash and cash equivalents, beginning of period 1,318,098 783,929
------------------- -----------------
Cash and cash equivalents, end of period $ 2,063,280 $ 1,318,098
=================== =================
Supplemental disclosure:
Cash paid during the year for interest $ 1,116,505 $ 328,520
=================== =================
51
Midwest Wireless Communications L.L.C.
d/b/a Cellular 2000
Notes to Financial Statements
1. Organization and Significant Accounting Policies:
Organization:
Midwest Wireless Communications L.L.C. (the Company) is a Delaware limited
liability company organized to provide cellular communications services in
certain service areas within the State of Minnesota. The latest date the
Company may be dissolved is December 31, 2034.
Effective June 29, 1996, pursuant to the Consolidation Agreement dated May
16, 1995, the following entities combined and contributed substantially all
their assets and liabilities to the Company in exchange for all 1,000,000
ownership units of the Company: Cellular Seven Partnership, Hiawathaland
Cellular Limited Partnership, Marshall Cellular Partnership, Minnesota RSA
#9 Limited Partnership and Minnesota RSA #10 Limited Partnership (the
Partnerships). Units were assigned to the Partnerships based upon their pro
rata share of fair market values of the assets contributed as determined by
an appraisal performed as of January 1, 1995. This transaction was
accounted for using the pooling of interests method of accounting, and as
such, the Company recorded the assets and liabilities contributed by the
Partnerships at carrying value.
Effective June 28, 1996, the Company acquired all the operating assets of
Rochester Cellular Telephone Company, L.P. (RCTC) in exchange for cash
totaling $18,846,000. This transaction was accounted for using the purchase
method of accounting, and as such, the assets acquired, principally
cellular plant and equipment and a FCC license, were recorded at fair
value.
Estimates:
The Company prepares its financial statements in conformity with generally
accepted accounting principles, which require management to make estimates
and assumptions that affect the reported amounts of assets, liabilities,
revenues and expenses during the period presented. They also affect the
disclosure of contingencies. Actual results could differ from those
estimates.
Cash and Cash Equivalents:
For the purpose of the statements of cash flows, the Company considers all
investments purchased with original maturities of three months or less to
be cash equivalents.
Marketable Securities:
Marketable securities which the Company has the positive intent and ability
to hold to maturity are stated at cost adjusted for accretion of discounts
computed under a method which approximates the interest method.
The marketable securities have maturity dates ranging from January 1998 to
August 1998. The market value approximated amortized cost at December 31,
1997. Unrealized gains and losses were not significant.
52
Midwest Wireless Communications L.L.C.
d/b/a Cellular 2000
Notes to Financial Statements, Continued
1. Organization and Significant Accounting Policies, continued:
Cellular Telephone Inventories:
Inventories consist primarily of cellular phones and accessories held for
resale with cost determined using the specific identification method.
Consistent with industry practice, losses on sales of cellular phones are
recognized in the period in which sales are made as a cost of acquiring
subscribers.
Property, Cellular Plant and Equipment:
Property, cellular plant and equipment is stated at its original cost.
Depreciation is provided on a straight-line basis over the estimated useful
lives of the cellular plant and equipment, which range from three to
fifteen years. Property, cellular plant and equipment consists of the
following:
1997 1996
Land $ 1,212,608 $ 1,188,840
Plant in service 29,184,958 20,915,824
Plant under construction 1,273,872 1,254,402
------------------ ------------------
31,671,438 23,359,066
Less accumulated depreciation (10,639,068) (7,570,381)
------------------ ------------------
$ 21,032,370 $ 15,788,685
================== ==================
At December 31, 1997 and 1996, accounts payable includes $418,396 and
$53,276, respectively, related to the purchase of property, cellular plant
and equipment. The Company capitalized interest in the amount of $151,361
and $81,396 for the year ended December 31, 1997, and the six-month period
ended December 31, 1996, respectively.
Income Taxes:
No provision for income taxes has been recorded since all income, losses
and tax credits are allocated to the members for inclusion in their
respective income tax returns.
Advertising:
Advertising costs are expensed as incurred. Total advertising expenses were
$1,049,000 and $759,000 for the year ended December 31, 1997, and the
six-month period ended December 31, 1996, respectively.
53
Midwest Wireless Communications L.L.C.
d/b/a Cellular 2000
Notes to Financial Statements, Continued
1. Organization and Significant Accounting Policies, continued:
Federal Communications Commission (FCC) License:
The Company acquired a FCC license to provide cellular service in FCC
market NO. 288B in conjunction with the purchase of the Rochester service
area. This license was recorded at fair market value and is being amortized
on a straight-line basis over 39 years.
Reclassifications:
Certain reclassifications have been made to 1996 amounts to conform to the
1997 presentation. These reclassifications had no effect on net income or
members' equity.
2. Investment in Switch 2000:
Switch 2000 L.L.C. (Switch 2000) is an entity that provides switching and
interconnection services to the Company. As a result of the combination
described in Note 1, the Company gained ownership and voting interests in
Switch 2000 of 54.93% and 45.55%, respectively. Accordingly, this
investment is accounted for using the equity method of accounting.
Effective with the date of combination, the Company retroactively recorded
its share of undistributed earnings of Switch 2000.
Effective June 30, 1997, Switch 2000 and the Company entered into a
Management Agreement which expired on December 31, 1997. Under the terms of
the Management Agreement, Switch 2000 retained the services of the Company
to manage the operations of Switch 2000, including administration of
transport and switching services and other general business operations.
Switch 2000 is required to pay a management fee equal to the total costs
incurred by the Company related to the management of Switch 2000. Total
management fees paid to the Company in 1997 were $119,000. The Company had
management fees due from Switch 2000 of $18,000 as of December 31, 1997.
Switch 2000, in turn, allocates management fees and certain other expenses,
primarily network costs, to its owners, which include the Company. Amounts
billed to the Company totaled approximately $2,879,000 and $2,101,000 for
the year ended December 31, 1997, and the six-month period ended December
31, 1996, respectively. The Company had an amount due to Switch 2000 of
$227,000 and $78,000 at December 31, 1997 and 1996, respectively.
The change in the investment relates to the Company's proportionate
ownership share of Switch 2000's net (loss) earnings. Switch 2000 had
assets of $3,376,866 and $4,519,969 and liabilities of $708,893 and
$971,309 at December 31, 1997 and 1996, respectively.
54
Midwest Wireless Communications L.L.C.
d/b/a Cellular 2000
Notes to Financial Statements, Continued
3. Members' Capital:
Members' capital includes capital contributions made by the members and the
accumulated income resulting from operations. Company income or loss is
allocated to the individual members based upon their ownership percentage,
as defined in the Limited Liability Company Agreement (the Agreement).
Pursuant to the Agreement, members are not obligated for the debts and
obligations of the Company, including accumulated losses in excess of
capital contributions.
Each member is entitled to one vote for each unit owned. Certain
restrictions on voting rights exist when units are sold to an acquiring
person as defined in the Agreement.
4. Debt:
Long-term debt at December 31, 1997 and 1996 consists of a term note with
principal and interest payable quarterly beginning June 30, 1997, with
final maturity on March 31, 2004. The note bears interest at a rate equal
to the bank's 30 day cost of funds plus 1.25%. This rate is reset on the
first business day of each month and was 6.88% and 6.61% at December 31,
1997 and 1996, respectively. The Company has the option to fix the interest
rate for periods of up to seven years at rates set forth in the Term Loan
Agreement.
The Term Loan Agreement contains covenants which restrict distributions to
members and require the Company to maintain certain minimum levels of
equity, as well as debt to operating cash flow and debt service ratios.
Substantially all assets of the Company are pledged as collateral under the
Agreement.
Maturities of long-term debt are as follows:
1998 $ 2,767,000
1999 2,428,000
2000 2,628,000
2001 2,844,000
2002 3,080,000
Thereafter 4,169,410
-------------
$ 17,916,410
=============
The Agreement also provides for a $10,000,000 line of credit expiring May
31, 1998, which is renewable at the option of the bank. This line of credit
bears interest at the varying rates as defined in the Agreement. The
Company had no amounts outstanding under this line of credit as of December
31, 1997 and 1996.
55
Midwest Wireless Communications L.L.C.
d/b/a Cellular 2000
Notes to Financial Statements, Continued
5. Commitments:
Future minimum rental payments required under operating leases, principally
for real estate related to tower sites, that have initial or remaining
noncancellable lease terms in excess of one year as of December 31, 1997,
are as follows:
1998 $ 224,219
1999 200,069
2000 195,070
2001 168,627
2002 121,111
Thereafter 55,585
--------------
$ 964,681
==============
Rental expense was $424,554 and $161,093 for the year ended December 31,
1997, and the six-month period ended December 31, 1996, respectively.
The Company has entered into an agreement with a third party to purchase
certain equipment in the amounts of $5,027,813 and $1,270,000 during 1998
and 1999, respectively.
6. Cell Site Sharing Agreements:
Hiawathaland Limited Partnership, one of the combining entities described
in Note 1, entered into an agreement in 1993 with a partnership located in
Wisconsin, to jointly construct and operate common cellular base station
facilities (Cell Sites) in Nelson, Wisconsin and Red Wing, Minnesota. Under
the agreement, both parties agreed to share the costs to construct the Cell
Sites, selected ongoing costs of operation and roamer revenues attributable
to the Cell Sites. The term of the agreement is for a period of five years
unless terminated by mutual agreement of the parties. Additionally, the
agreement automatically renews for successive five-year terms unless either
party gives prior notice of non-renewal.
The Company has included its proportionate share of the assets,
liabilities, revenues and expenses of the Cell Sites in these financial
statements. As of December 31, 1997 and 1996, these assets were
approximately $766,000 and $588,000 and liabilities were approximately
$2,700 and $6,000, respectively. For the year ended December 31, 1997, and
the six-month period ended December 31, 1996, these operating revenues were
approximately $521,000 and $279,000 and expenses were $165,000 and $77,000,
respectively.
56
Midwest Wireless Communications L.L.C.
d/b/a Cellular 2000
Notes to Financial Statements, Continued
7. Management of the Company:
Under an agreement effective October 25, 1995, the Company contracted with
Pacific Telecom Cellular, Inc. (the Manager), formerly North-West Cellular,
Inc., to construct, operate and manage the cellular system. All services
were provided at cost, including reasonable and necessary overhead expenses
of the Manager.
The management agreement provides for payment of a monthly management fee
equal to 3.75% of adjusted income (as defined in the agreement) plus 3.25%
of adjusted retail revenue. The agreement expired on December 31, 1996, and
was not renewed. During 1997, the Company performed the services formerly
provided by the Manager. In 1996, the Manager also engaged other parties,
including its affiliates, to provide goods or services directly to the
Company. The amount of goods and services provided by the Manager and its
affiliates totaled approximately $4,080,000 for the six-month period ended
December 31, 1996. Accounts payable includes approximately $248,000 due to
the Manager and its affiliates at December 31, 1996. At December 31, 1996,
the Manager had collected $468,000 of roamer receivables subsequently
remitted to the Company.
8. Concentration of Credit Risk:
The Company provides cellular service and sells cellular telephones to a
diversified group of consumers within a concentrated geographical area. The
Company performs credit evaluations of its customers and requires a deposit
when deemed necessary. Receivables are generally due within 30 days. Credit
losses related to customers have been within management's expectations.
9. Employee Benefits:
Effective September 1, 1996, the Company established the Midwest Wireless
Communications L.L.C. 401(k) Profit Sharing Plan and Trust (the 401(k)
Plan) for all employees who meet certain service and age requirements. The
401(k) Plan is comprised of a matching contribution component and a profit
sharing component. Participating employees may contribute a maximum of 15%
of their annual compensation and the Company will match between 33.33% and
75% of the participant contribution. An eligible employee may begin
participating in the plan on the first day of the plan fiscal quarter after
date of employment. Company contributions are 100% vested after one year of
participation. Employer contributions to this component of the plan were
$91,968 and $5,867 for the year ended December 31, 1997, and the six-month
period ended December 31, 1996, respectively. The profit sharing component
of the plan allows for an annual discretionary contribution to the tax
deferred accounts of all eligible employees. Profit sharing contributions
are 100% vested after five years of employment. Profit sharing contribution
expenses were $118,411 and $0 for the year ended December 31, 1997, and the
six-month period ended December 31, 1996, respectively.
57
Midwest Wireless Communications L.L.C.
d/b/a Cellular 2000
Notes to Financial Statements, Continued
9. Employee Benefits, continued:
Effective January 1, 1997, the Company established the Midwest Wireless
Communications L.L.C. Appreciation Rights Plan (the Plan) for certain key
employees. The Plan is designed to create two classes of appreciation
rights, Class A and Class B, which become fully vested three years and five
years after the first day of the year the rights are granted, respectively.
Participants in the Plan are eligible to receive awards based on the change
in members' equity from the date of grant through the end of the vesting
period. The Board of Managers granted both Class A and Class B appreciation
rights in 1997. Under the terms of the Plan, no additional Class B
appreciation rights will be granted, and additional Class A appreciation
rights will be granted at the discretion of the Board of Managers. During
1997, the Company recognized $195,247 in compensation expense related to
the Plan.
58
- --------------------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 or 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
OF
HECTOR COMMUNICATIONS CORPORATION
FOR
YEAR ENDED DECEMBER 31, 1997
---------------------------
EXHIBITS
- --------------------------------------------------------------------------------
59
HECTOR COMMUNICATIONS CORPORATION AND SUBSIDIARIES
Exhibit Index To
Form 10-K for the Year Ended December 31, 1997
Regulation S-K Location in Consecutive Numbering
Exhibit Table System as Filed With the
Reference Title of Document Securities and Exchange Commission
3.1 Articles of Incorporation, Filed as Exhibit 3.1 to the Form
as amended 10 of the Company, File No.0-18587
(the "Form 10") and incorporated
hereby by reference
3.2 Bylaws, as amended Filed as Exhibit 3.2 to the Form
10 of the Company and incorporated
hereby by reference.
4.1 Indenture dated February Filed as Exhibit 4.1 to the
24, 1995 between Hector Company's Registration Statement
Communications Corporation on Form S-2 File No. 33-87888 and
and National City Bank incorporated herein by reference
of Minneapolis, trustee
10.1 1990 Stock Plan Filed as Exhibit 10.1 to the Form
10 of the Company and incorporated
herein by reference.
10.2 Employee Stock Purchase Filed as Exhibit 10.2 to the Form
Plan 10 of the Company and incorporated
herein by reference.
10.3 Employee Stock Ownership Filed as Exhibit 10.3 to the Form
Plan 10 of the Company and incorporated
herein by reference.
10.4 Employee Savings Plan Filed as Exhibit 10.4 to the Form
and Trust 10 of the Company and incorporated
herein by reference.
10.5 Distribution Agreement Filed as Exhibit 10.5 to the Form
10 of the Company and incorporated
herein by reference.
10.7 Flexible Benefit Plan Filed as Exhibit 10.7 to the 1993
Form 10-K and incorporated herein
by reference.
11 Calculation of Net Income Filed herewith at page 61.
Per Share
21 Subsidiaries of the Filed herewith at page 62.
Registrant
23 Independent Auditors' Filed herewith at page 63.
Consent
24 Power of Attorney Included in signatures at page 40.
The exhibits referred to in this Exhibit Index will be supplied to a shareholder
at a charge of $.25 per page upon written request directed to HCC's Assistant
Secretary at the executive offices of the Company.
60
HECTOR COMMUNICATIONS CORPORATION AND SUBSIDIARIES
CALCULATION OF EARNINGS PER SHARE
EXHIBIT 11
Year Ended December 31
---------------------------------------------------
Basic: 1997 1996 1995
- ------- ------------- ------------- -------------
Net income (loss) $ 2,720,753 $ 1,208,670 $ (76,539)
============= ============= =============
Common shares:
Weighted average number of common shares outstanding 1,901,508 1,881,472 1,879,083
Number of unallocated shares held by ESOP (8,930) (11,817) (13,083)
------------- ------------- -------------
1,892,578 1,869,655 1,866,000
============= ============= =============
Basic net income (loss) per common share $ 1.44 $ .65 $ (.04)
============= ============= =============
Diluted:
- -------------
Net income (loss) $ 2,720,753 $ 1,208,670 $ (76,539)
Interest on convertible debentures, net of tax (1) 758,616 758,616
------------- ------------- -------------
Adjusted net income $ 3,479,369 $ 1,967,286 $ (76,539)
============= ============= =============
Common and potential common shares:
Weighted average number of common shares outstanding 1,901,508 1,881,472 1,879,083
Assumed conversion of convertible debentures into common stock 1,423,125 1,423,125
Dilutive effect of convertible preferred shares outstanding 378,100 389,487
Dilutive effect of stock options outstanding after application of
treasury stock method 36,130 11,649
Dilutive effect of Employee Stock Purchase Plan shares subscribed 2,455 577
Weighted average number of unallocated shares held by ESOP (8,930) (11,817) (13,083)
------------- ------------- -------------
3,732,388 3,694,493 1,866,000
============= ============= =============
Diluted net income (loss) per share $ .93 $ .53 $ (.04)
============= ============= =============
(1) All potential common shares are anti-dilutive for 1995 and are excluded from the calculation of earnings per share.
61
SUBSIDIARIES OF HECTOR COMMUNICATIONS CORPORATION
EXHIBIT 21
Subsidiaries Jurisdiction of Incorporation
Arrowhead Communications Corporation Minnesota
Eagle Valley Telephone Company Minnesota
Granada Telephone Company Minnesota
Indianhead Telephone Company Wisconsin
North American Communications Corporation Minnesota
Pine Island Telephone Company Minnesota
Indianhead Communications Corporation Wisconsin
Alliance Telecommunications Corporation Minnesota
Ollig Utilities Company Minnesota
Loretel Systems, Inc. Minnesota
Sleepy Eye Telephone Company Minnesota
Sioux Valley Telephone Company South Dakota
Hills Telephone Company Minnesota
OU Connection, Inc. Minnesota
Aurora Cable TV, Inc. South Dakota
Loretel Financial Systems, Inc. Minnesota
Hastad Engineering Co. Minnesota
Valley Cablevision of SD, Inc. South Dakota
Arrowhead Communications Corporation, Eagle Valley Telephone Company, Granada
Telephone Company, Indianhead Telephone Company, North American Communications
Corporation and Indianhead Communications Corporation are 100% owned by Hector
Communications Corporation. Pine Island Telephone Company is 69% owned by Hector
Communications Corporation and 31% owned by Indianhead Telephone Company.
Alliance Telecommunications Corporation is 68% owned by Hector Communications
Corporation, 20% owned by Golden West Telecommunications Cooperative, Inc. of
Wall, South Dakota and 12% owned by Split Rock Telecom Cooperative of Garretson,
South Dakota.
Loretel Systems, Inc., Sleepy Eye Telephone Company, Sioux Valley Telephone
Company, Hills Telephone Company, OU Connection, Inc., Aurora Cable TV, Inc.,
Loretel Financial Systems, Inc., Hastad Engineering Co. and Valley Cablevision
of SD, Inc. are 100% owned by Alliance Telecommunications Corporation.
The financial statements of these subsidiaries are included in the Consolidated
Financial Statements of Hector Communications Corporation.
62
EXHIBIT 23
INDEPENDENT AUDITORS' CONSENT
We consent to the incorporation by reference in Registration Statements No.
33-39865, 33-39866, 33-65176, 33-87888, 333-45971 and 333-45975 of Hector
Communications Corporation of our report dated February 18, 1998, appearing in
this Annual Report on Form 10-K of Hector Communications Corporation and its
subsidiaries for the year ended December 31, 1997.
/s/ Olsen Thielen and Co., Ltd.
- -------------------------------
Olsen Thielen and Co., Ltd.
March 27, 1998
St. Paul, Minnesota
63