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Section 1: 10-K (FORM 10-K)

Form 10-K
Table of Contents

 

 

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

For the fiscal year ended December 31, 2011

or

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from             to             .

Commission File Number: 001-35180

 

 

Lumos Networks Corp.

(Exact name of registrant as specified in its charter)

 

 

 

Delaware   80-0697274

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

One Lumos Plaza, Waynesboro, Virginia 22980

(Address of principal executive offices) (Zip Code)

(540) 946-2000

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

Title of each class

 

Name of each exchange on which registered

Common stock, $0.01 par value   The NASDAQ Stock Market LLC

Securities registered pursuant to Section 12(g) of the Act:

None

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    ¨  Yes    x  No

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    ¨  Yes    x  No

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.    x  Yes    ¨  No

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    x  Yes    ¨  No

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) 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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer   ¨    Accelerated filer   ¨
Non-accelerated filer   x  (Do not check if a smaller reporting company)    Smaller reporting company   ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    ¨  Yes    x  No

As of June 30, 2011, the Registrant’s common stock was not publicly traded and accordingly its aggregate market value was $0.

There were 21,276,616 shares of the registrant’s common stock outstanding as of the close of business on March 16, 2012.

 

 

DOCUMENTS INCORORATED BY REFERENCE

Document

  

Incorporated Into

Proxy statement for the 2012 Annual Meeting of Stockholders    Part III

 

 

 


Table of Contents

LUMOS NETWORKS CORP.

2011 ANNUAL REPORT ON FORM 10-K

TABLE OF CONTENTS

 

Part I

     

Item 1.

  

Business.

     2   

Item 1A.

  

Risk Factors.

     11   

Item 1B.

  

Unresolved Staff Comments.

     23   

Item 2.

  

Properties.

     24   

Item 3.

  

Legal Proceedings.

     24   

Item 4.

  

Mine Safety Disclosures.

     24   

Part II

     

Item 5.

  

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

     25   

Item 6.

  

Selected Financial Data

     28   

Item 7.

  

Management’s Discussion and Analysis of Financial Condition and Results of Operations.

     30   

Item 7A.

  

Quantitative and Qualitative Disclosures About Market Risk.

     47   

Item 8.

  

Financial Statements and Supplementary Data.

     49   

Item 9.

  

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.

     80   

Item 9A.

  

Controls and Procedures.

     80   

Item 9B.

  

Other Information.

     80   

Part III

     

Item 10.

  

Directors, Executive Officers and Corporate Governance.

     80   

Item 11.

  

Executive Compensation.

     80   

Item 12.

  

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.

     81   

Item 13.

  

Certain Relationships and Related Transactions, and Director Independence.

     81   

Item 14.

  

Principal Accountant Fees and Services.

     81   

Part IV

     

Item 15.

  

Exhibits, Financial Statement Schedules.

     81   

Signatures

     

 

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PART I

FORWARD-LOOKING STATEMENTS

Any statements contained in this report that are not statements of historical fact, including statements about our beliefs and expectations, are forward-looking statements and should be evaluated as such. The words “anticipates,” “believes,” “expects,” “intends,” “plans,” “estimates,” “targets,” “projects,” “should,” “may,” “will” and similar words and expressions are intended to identify forward-looking statements. These forward-looking statements are contained throughout this report, for example in “Business,” “Risk Factors,” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Such forward-looking statements reflect, among other things, our current expectations, plans and strategies, and anticipated financial results, all of which are subject to known and unknown risks, uncertainties and factors that may cause our actual results to differ materially from those expressed or implied by these forward-looking statements. Many of these risks are beyond our ability to control or predict. All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the cautionary statements contained throughout this report. Because of these risks, uncertainties and assumptions, you should not place undue reliance on these forward-looking statements. These risks and other factors include those listed under “Risk Factors” and elsewhere in this report. Furthermore, forward-looking statements speak only as of the date they are made. We do not undertake any obligation to update or review any forward-looking information, whether as a result of new information, future events or otherwise.

 

Item 1. Business.

Separation from NTELOS Holdings Corp.

On October 31, 2011, Lumos Networks Corp. (“Lumos Networks,” the “Company,” “we,” “us” or “our”) became an independent, publicly traded company as a result of our spin-off from NTELOS Holdings Corp. (“NTELOS”). On October 14, 2011, NTELOS announced a distribution date of October 31, 2011 for the spin-off of all of the issued and outstanding shares of common stock of Lumos Networks Corp., which operated NTELOS’s wireline operations (the “Business Separation”). Prior to and in connection with the Business Separation, following the market close on October 31, 2011, NTELOS effectuated a 1-for-2 reverse stock split (the “Reverse Stock Split”) of its shares of common stock. The spin-off of Lumos Networks was in the form of a tax-free stock distribution to NTELOS stockholders of record as of the close of business on October 24, 2011, the record date (the “Distribution”). On October 31, 2011, NTELOS distributed one share of Lumos Networks common stock for every share of NTELOS common stock outstanding, on a post-Reverse Stock Split basis. As of November 1, 2011, our common stock publicly trades on The NASDAQ Stock Market LLC (“NASDAQ”) under the ticker symbol “LMOS.”

Lumos Networks Overview

We are a fiber-based network service provider in the Mid-Atlantic region. We have a six state regional presence in western Virginia, West Virginia, and portions of Pennsylvania, Maryland, Ohio and Kentucky, with an approximate 5,800 route-mile fiber-optic network as of December 31, 2011. We serve a wide range of customers, including telecommunication carriers, enterprise and other business customers and residential customers over a dense fiber network offering data, voice, and IP-based services utilizing an on-network service strategy.

We have two reportable business segments, which conduct the following principal activities:

 

   

Competitive—high capacity transport services, data and voice services marketed primarily to enterprise customers through our competitive local exchange carrier (“CLEC”) and Internet Service Provider (“ISP”) operation and wholesale carriers’ carrier operations; and

 

   

Rural Local Exchange Carrier (“RLEC”)—wireline communications services offered to residential and enterprise customers in the western Virginia cities of Waynesboro and Covington, and portions of Alleghany, Augusta and Botetourt counties.

Our primary objective is continued growth and profitability by being the preferred provider of high bandwidth data products in our six state region. Our strategy is to (i) leverage our network assets with sales of data and IP based services to new and existing regional enterprise and government customers; (ii) expand the Competitive segment to add additional on-net locations and connect additional wireless carrier cell sites and networks; (iii) continue to provide high quality customer service with low churn and a compelling value proposition; and (iv) generate cash flow from the RLEC customer base with additional sales of fiber based broadband and IP video services to our RLEC customer base and targeted non-RLEC developments.

 

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We also follow a strategy of being first to offer in our regional markets technology and services first introduced in metropolitan areas by large national service providers, including high speed transport, wavelengths and Metro Ethernet. Our tradition of service and innovation and our diversified portfolio of products are attractive to carriers with needs for transport and fiber to the cell site and to regional enterprise customers seeking high quality data and IP services and interconnection to data centers in the region.

For detailed financial information about our business segments, see Note 4 to the audited consolidated financial statements contained in Part II, Item 8. of this Annual Report on Form 10-K and for a detailed review of our financial performance and results of operations by business segment, see Part II, Item 7. Managements’ Discussion and Analysis of Financial Condition and Results of Operations of this Annual Report on Form 10-K.

We conduct all of our business through our wholly-owned subsidiary Lumos Networks Operating Company and its subsidiaries. Our principal executive offices are located at One Lumos Plaza, Waynesboro, Virginia 22980. The telephone number at that address is (540) 946-2000.

Business Segments

Competitive

The Competitive segment was launched in 1998 offering voice service but now focuses on data and IP based services. As of December 31, 2011, the Competitive business currently serves more than 100 areas in Virginia, West Virginia and portions of Pennsylvania, Maryland, Ohio and Kentucky over an approximately 5,800 route-mile fiber network. We market and sell data transport, IP-based services and voice services almost exclusively to business and carrier customers. As of December 31, 2011, we had approximately 122,000 CLEC lines and approximately 35,700 broadband network connections in service, of which approximately 95% are business lines. We also finished the year with over 98% broadband capability in our RLEC markets. Revenues from the Competitive segment accounted for approximately 75%, 61% and 54% of our total revenue for the years ended December 31, 2011, 2010 and 2009, respectively. Pro forma to include the FiberNet acquisition for the year ended December 31, 2010, the Competitive segment accounted for approximately 73% of our total revenue.

The Competitive operations are based on an “edge-out” strategy that seeks to take advantage of our fiber network and established RLEC back-office systems in order to deliver a high incremental return on investment to our core business. Technicians, vehicles, operations and support systems, network planning and engineering, billing and core network assets are shared between our segments.

In addition to utilizing a successful “edge-out” strategy, our Competitive business has also benefited from a commitment to an “on-net” access strategy for a true facilities-based approach. We have been disciplined in our decision to expand the Competitive network and generally require proven customer demand before we make such investment decisions. In addition to the higher-margin revenues that are characteristic of on-net expansion, we have also been able to deliver other competitive services such as high-bandwidth internet access and Metro Ethernet transport services as a direct result of on-net connectivity growth. Our dedication to the facilities-based strategy, combined with our commitment to customer service, has proven successful in attracting large customers in key vertical markets. Specifically, the education, healthcare, financial, and government sectors have been particularly receptive to our Competitive business model.

Through our wholesale carriers’ carrier network, we offer other carriers access to our approximately 5,800 route-mile fiber network which provides connectivity to regional cities, carrier switches and cell sites across the Mid-Atlantic region. We sell backhaul services to major wireline and wireless carriers including connectivity to cell sites located near our fiber network in our Competitive and RLEC markets. We finished 2011 with almost 150 cell sites connected to our network and have plans to more than double that total in 2012. Through interconnections with other regional fiber networks, we are able to extend our network east to Richmond, Virginia and south to areas in north central North Carolina.

We have also invested in fiber-to-the-home, which passed approximately 14,800 homes as of December 31, 2011. The fiber network provides the foundation for IP-based video services, currently up to 20 Mbps high speed Internet services and will allow us to offer future high-bandwidth applications as they evolve. While our RLEC subsidiary owns the fiber, the products are sold through the Competitive segment. The Competitive segment purchases basic fiber services from the RLEC but provides its own sales, customer service and customer equipment. The intercompany revenue is eliminated in our consolidated statements of operations.

 

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RLEC

Our incumbent local exchange carrier business is conducted through two subsidiaries that qualify as RLECs under the Telecommunications Act. These two RLECs provide wireline communications services to residential and enterprise customers in the western Virginia cities of Waynesboro and Covington, and portions of Alleghany, Augusta and Botetourt counties. As of December 31, 2011, we operated approximately 33,200 RLEC telephone access lines, 3,700 of which are fiber-fed and have IPTV-based video services and broadband Internet access with speeds up to 20Mbps (approximately 25% penetration of homes passed). In 2010, we received a federal broadband stimulus award to bring broadband services and infrastructure to Alleghany County, Virginia. The total project in Alleghany is expected to cost $16 million, 50% ($8 million) of which is being funded by the grant from the federal government. The project is required to be completed in 2015.

We anticipate significant access revenue declines in the RLEC segment as a result of recent actions taken by applicable regulatory authorities, principally the Federal Communications Commission (“FCC”) and the Virginia State Corporation Commission (“SCC”). Access revenue also will be negatively impacted by network grooming by carriers, which commenced in 2011 and is expected to continue in 2012 and beyond. On November 18, 2011, the FCC released a significant order on access reform and Universal Service Fund (“USF”) reform. In the order, the FCC determined that interstate and intrastate access charges, as well as local reciprocal compensation, should be eliminated entirely over time (see Access Charges and Universal Service in “Regulation”).

Products and Services

We offer a wide variety of voice services to our RLEC and Competitive customers, including:

 

Voice Service

  

•    Business and residential telephone local and long distance service for the Competitive and RLEC customer base including calling features

Primary Rate ISDN Services

  

•    High capacity connections between customers’ private branch exchange, or PBX, equipment and public switched telephone network

In addition to traditional voice services, we provide broadband and data services including:

 

High-Speed DSL Access

  

•    DSL technology that enables a customer to receive high-speed Internet access through a copper telephone line at speeds up to 6 Mbps

Broadband XL

  

•    High speed Internet access over fiber available in portions of our RLEC markets at speeds from 10 to 20 Mbps

Video

  

•    IPTV-based video services with 300 channels, including 67 high definition, and video-on-demand and DVR capability

 

•    Available in new subdivisions and overbuild areas within the RLEC and in one area in each of Lynchburg, Harrisonburg and Staunton, Virginia

 

•    Powered by Microsoft Mediaroom IPTV platform

Metro Ethernet

  

•    Ethernet connectivity among multiple locations in the same city or region over our fiber optic network

  

•    Used by wireless carriers as backhaul replacement for private line services for migration to 4G network services

  

•    Speed ranging from 1.5 Mbps to 1 Gbps

 

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IP Services

  

•    IP-enabled product offerings that combine voice and data services over a dedicated broadband facility utilizing VoIP protocols

 

•    Allows customers to dynamically allocate bandwidth to maximize voice and data transmissions

 

•    Enables advanced features such as simultaneous ring, remote office, business continuity and fixed mobile convergence

 

•    Product offerings include Integrated Access, IP Centrex, and IP Trunking

High-capacity Private Line Service and Wavelength Services

  

•    High-capacity, non-switched facilities provided to end users and carriers for voice and data applications. Wavelength technology is a means to efficiently utilize fiber in broadband applications and provide high-capacity bandwidth

Sales, Marketing and Customer Care

The Competitive and RLEC segments share sales, marketing, and customer care resources. We seek to capitalize on technology leadership, positive service reputation and local presence of sales and service personnel in our marketing efforts. We have retail presence located in Waynesboro, Daleville and Covington, Virginia to allow walk-in payments and sell new services to RLEC customers. Customer care is provided through call centers which are located in Waynesboro and Daleville, Virginia and Charleston, West Virginia. The call center operation is supported by an integrated systems infrastructure and automated linkages to our billing, operations, and engineering systems. We provide customer care and operations representatives with incentives to up-sell additional products and features and to retain current customers that may wish to disconnect services.

We serve three groups of customers: RLEC residential and small businesses, mid-size and larger regional businesses within the Competitive and RLEC areas, and regional and national wireline and wireless carriers. For RLEC residential and small businesses, we focus our marketing efforts on selling bundled services and higher revenue-generating services to maximize penetration, average monthly revenues-per-unit-in-service (“ARPU”) and retention. We use Salesforce.com to manage our opportunities within all of our sales channels. We have an inside sales and customer service team that works to retain customers and offer additional revenue-generating services, including residential and small business voice, broadband and IPTV services. We also have a team of service professionals who focuses on proactively contacting customers near renewal dates and working to retain customers who call in to discontinue service. For mid-size and regional firms, we offer voice, basic and high capacity broadband data services and advanced IP-based services, including Metro Ethernet. We retain account executives to cultivate relationships with these customers to meet their integrated communications needs and provide state of the art communication and network solutions. We strive to drive scale for on-net connectivity to control service quality and maximize the return on our network investments. The wholesale business offers transport, interconnection and fiber-to-the-cell site services to regional and national carriers throughout our six state region.

Plant and Equipment

Our network includes two Alcatel-Lucent 5ESS digital switches, which provide end-office functions for both the RLEC and Competitive businesses in Virginia. Our Waynesboro, Virginia switch also acts as an access tandem for our RLEC and Competitive segments and portions of other carriers’ traffic. Another Alcatel-Lucent 5ESS digital switch located in Charleston, West Virginia, supports the Competitive business in West Virginia. We have seven remote switching modules deployed throughout our RLEC territory and three more supporting our Competitive areas. VITAL, a company for which we serve as the managing partner, acts as a regional node on TNS’s (an inter-operability solution provider) nationwide SS7 network using a pair of Tekelec signal transfer points located on our premises.

We use Alcatel-Lucent, Tellabs, Adtran and Cisco digital loop carriers and Digital Subscriber Line Access Multiplexer throughout our RLEC and Competitive networks to provide voice and broadband access services. Our centralized network operations center monitors data networks on a continuous basis using IBM-based network management systems. We provide native Ethernet data services via our 10Gig core Cisco Systems, Inc. data network and IP-enabled voice services using soft switches from Cisco Systems, Inc. and Metaswitch. Enhanced IP services are delivered via feature servers provided from Broadsoft. We have also deployed a Head-End utilizing a combination of Tandberg, Cisco and Motorola hardware and we utilize Microsoft’s Mediaroom software to deliver IPTV-based video services.

 

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Competition

Several factors have resulted in increased competition in the landline telephone market, including:

 

   

expansion of wireless networks and pricing plans which offer very high usage at a fixed cost, resulting in wireless substitution;

 

   

IP-based voice and data services offered by incumbent cable companies;

 

   

technological advances in the transmission of voice, data and video;

 

   

development of fiber optics, wireless data and IP technology; and

 

   

legislation and regulations, including the Telecommunications Act of 1996, designed to promote competition.

As the RLEC for Waynesboro, Clifton Forge and Covington and portions of Alleghany, Augusta and Botetourt Counties, Virginia, we have competition from cable companies and are subject to competition from wireless carriers. A portion of residential customers moving into our service area do not purchase landline phone service. Although no CLECs have entered our incumbent markets to compete with us, it is possible that one or more may enter our markets. Voice over Internet Protocol (“VoIP”) based carriers like Vonage could take voice customers from our RLECs using existing broadband connections (such as DSL or cable modem connections). To minimize potential competition in the RLEC markets, we offer fiber-to-the-home and a variety of bundled services for broadband, voice and video.

Our Competitive operations compete primarily with ILECs, incumbent cable operators, and to a lesser extent CLECs. We also face competition from potential future market entrants. In the last year, we have seen increasing competition from the cable operators and ILECs for metro-Ethernet services to mid-size businesses. To be competitive, we position our company as a leading edge provider with a full portfolio of broadband and IP-based services and the theme that our “technology comes with people.”

The Internet industry is characterized by the absence of significant barriers to entry and the rapid growth in Internet usage among customers. As a result, we expect that our competition will increase from market entrants offering high-speed data services, including DSL, cable and wireless access. Our competition includes:

 

   

local, regional and national Internet service providers such as AT&T, Level 3, Verizon, Zayo, Frontier, Windstream and CenturyLink;

 

   

cable modem services offered by incumbent cable providers such as Comcast, Shentel, Cox, Time Warner and Suddenlink;

 

   

wireless providers offering services based on EV-DO, Worldwide Interoperability for Microwave Access (“Wi-Max”) or other technologies; and

 

   

small local providers in southwest Virginia enabled by the Virginia Tobacco Commission investment in fiber optic infrastructure.

Many of our competitors have financial resources, corporate backing, customer bases, marketing programs and brand names that are greater than ours. Additionally, competitors may charge less than we do for Internet services, causing us to reduce, or preventing us from, raising our fees.

Employees

As of December 31, 2011, we employed 518 full-time and 6 part-time employees. Of these employees, 67 are covered by a collective bargaining agreement that expires June 30, 2014. We believe that we have good relations with our employees.

Access to Public Filings

We routinely post important information on our website at www.lumosnetworks.com. Information contained on our website is not incorporated by reference into this annual report on Form 10-K. We provide public access to our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to these reports filed with the U.S. Securities and Exchange Commission (“SEC”) under the Securities Exchange Act

 

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of 1934. These documents may be accessed free of charge on our website at the following address: http://ir.lumosnetworks.com. These reports are available as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC.

 

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Regulation

The following summary does not describe all present and proposed federal and state legislation and regulations affecting the telecommunications industry. Some legislation and regulations are currently the subject of judicial proceedings, legislative hearings and administrative proposals which could change the manner in which this industry operates. Neither the outcome of any of these developments, nor their potential impact on us, can be predicted at this time. Regulation can change rapidly in the telecommunications industry, and such changes may have an adverse effect on us in the future. See “Risk Factors” elsewhere in this report.

Regulation Overview

Our communications services are subject to varying degrees of federal, state and local regulation. Under the federal Telecommunications Act, the FCC has jurisdiction over interstate and international common carrier services. In 1996, Congress enacted the Telecommunications Act of 1996 which amended the Communications Act and mandated significant changes in telecommunications rules and policies to promote competition, ensure nationwide availability of telecommunications services and to streamline regulation of the telecommunications industry to remove regulatory burdens as competition develops. As a result, the FCC has jurisdiction over certain aspects of local interconnection between carriers.

In addition to FCC regulation, our communications services are regulated to different degrees by state public service commissions and by local authorities. Such local authorities have jurisdiction over public rights-of-way and video and telecommunications franchises.

Intercarrier compensation includes regulated interstate and intrastate access charges that we and other ILECs and CLECs receive from long distance carriers for the origination and termination of long distance calls and reciprocal compensation that interconnected local carriers pay to each other for terminating interconnected local and wireless calls. On average, intrastate switched access charges, which are currently regulated by state public utility commissions, are generally higher than interstate switched access charges, which are regulated by the FCC, and in turn interstate switched access charges are generally higher on a per-minute basis than are reciprocal compensation rates.

Our operations are subject to various federal and state laws intended to protect the privacy of customers who subscribe to our services. The FCC has regulations that place restrictions on the permissible uses that we can make of customer-specific information, known as Customer Proprietary Network Information (“CPNI”), received from subscribers and that govern procedures for release of such information. On November 1, 2008, the Federal Trade Commission’s “Red Flag” rules went into effect and the Federal Trade Commission began to enforce those rules on December 31, 2010. Among other requirements, the Red Flag Rules require that companies develop and implement written Identity Theft Prevention programs. The Federal Trade Commission is considering additional regulations governing on-line behavioral marketing and consumer privacy. Congress, federal agencies and states also are considering imposing additional requirements on entities that possess consumer information to protect the privacy of consumers.

Many of the services we offer are unregulated or subject only to minimal regulation. Internet services are not considered to be common carrier services, although the regulatory treatment of certain Internet services, including VoIP services, is evolving and still uncertain. To date, the FCC has, among other things, directed providers of certain VoIP services to offer E-911 emergency calling capabilities to their subscribers, applied the requirements of the Communications Assistance for Law Enforcement Act, or CALEA, to these VoIP providers, determined that the VoIP providers are subject to federal universal service assessments and must pay access charges at interstate rates. The FCC has preempted states from exercising entry and related economic regulation of nomadic VoIP providers but the FCC has not preempted state regulation of fixed VoIP service commonly offered by cable operators.

Federal Regulation of Interconnection and Interexchange Services

The Communications Act requires all common carriers to interconnect on a non-discriminatory basis with other carriers, imposes additional requirements on incumbent local exchange carriers (such as our RLEC’s), and imposes even more comprehensive requirements on the largest ILECs. The large ILECs are required to provide to our CLECs and other competitors physical collocation to allow competitors to place qualifying equipment in ILEC central offices; to unbundle some of their services into unbundled network elements (“UNE”) at “forward looking” rates, permit resale of some of their services, provide access to poles, ducts, conduits and rights-of-way, and to establish reciprocal compensation for the transport and termination of local traffic. In order to obtain access to an ILEC network, a CLEC must negotiate an interconnection agreement or “opt-in” to an existing interconnection

 

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agreement. These agreements cover, among other items, reciprocal compensation rates and required UNEs. If the parties cannot agree on the terms of an interconnection agreement, the matter is submitted to the applicable state public utility commission or to the FCC, as appropriate, for binding arbitration. The obligations of the large ILECs to provide these network facilities and services are in flux and could be further altered or removed by new legislation, regulations or court order.

ILEC operating entities that serve fewer than 50,000 lines are defined as “rural telephone companies” under the Communications Act and are exempt from the additional requirements applicable to the large ILECs unless and until such exemption is removed by the state regulatory body. Each of our RLEC operations is considered separately and each is currently exempt from the requirements imposed on the largest ILECs. Lumos Telephone Inc. is an “average schedule” company for purposes of interstate access charges. Lumos Telephone Inc. participates in the common line pool tariff administered by the NECA and therefore charges subscriber line charges computed by NECA, but files its own traffic sensitive (i.e., “per-minute”) tariff to establish interstate access rates applicable to switching and transport of telecommunications traffic. R&B Telephone Company is a “rate-of-return” company for purposes of interstate access charges and participates in NECA’s common line pool and NECA’s traffic sensitive pool.

Access Charges and Universal Service

The FCC has reformed and continues to reform the structure of the federal access charge system. On November 18, 2011, the FCC released a significant order on access reform and USF reform. In the order, the FCC determined that interstate and intrastate access charges, as well as local reciprocal compensation, should be eliminated entirely over time. The FCC therefore adopted a uniform national bill-and-keep framework as the ultimate end state for all telecommunications traffic exchanged with any local exchange carrier. Price Cap carriers will be at bill-and-keep in eight years and Rate-of-Return carriers will be at bill-and-keep in 11 years.

In the initial phase of the transition to bill-and-keep, intrastate end office switching rates for terminating traffic, carrier common line charges on terminating traffic, and certain intrastate, transport rates associated with terminating traffic are to be brought to interstate rates “within two steps by July 2013.” VOIP providers must begin paying access charges at the federal rate level. The FCC has issued a further Notice of Proposed Rulemaking to seek comment on, among other things, the treatment/transition for originating access and for the transport elements not included in the initial order.

The FCC will permit carriers to raise end user rates to recover a portion of the loss in access charge revenues. This mechanism is the Access Recovery Charge (“ARC”). The maximum ARC for residential customers will be $3 per month after six years. Multi-line business customers will have their Subscriber Line Charge and ARC combined capped at $12.20 per line. In addition, RLECs will be able to recover a portion of lost access revenues from a new Connect America Fund (“CAF”). This recovery will be calculated initially based on fiscal year 2011 switched access revenues and reciprocal compensation revenues and that baseline will decline at five percent annually.

In the order, the FCC established an annual cap on the “high cost” portion of USF of $4.5 billion per year in each of the next six years. This $4.5 billion will be the sole funding source for the existing support mechanisms (high-cost loop, switching support, safety net, etc.); and for the CAF. The FCC has designated approximately $2 billion of the $4.5 billion annually from this fund for RLECs through 2017.

The order also affects our Competitive operations. CLECs are required to “mirror” the access charges of the large ILECs in whose service area the CLEC competes. As the large ILECs move toward bill-and-keep for access charges, our CLECs will be mirroring those reductions. In addition, our legacy FiberNet operations in West Virginia have been designated as an Eligible Telecommunications Carrier and receives USF funding. USF funding for CLECs will decrease by 20% annually and thus be eliminated in five years.

Intercarrier compensation reform will result in significant decreases in the access charge revenues received by our rural telephone companies.

Net Neutrality. Proposals in Congress and at the FCC that would regulate the manner in which providers of high-speed Internet service may manage their networks or utilize data from their customers could affect our ability to manage our network and market IP-based value-added services to our customers. These proposals are sometimes referred to as “Internet regulation” or “net neutrality” proposals. It is uncertain whether any such regulations will be adopted or enforcement actions taken, and if so, what impact they may have on our business. The FCC in 2005 adopted a policy statement expressing its view that consumers are entitled to access lawful Internet content and to run applications and use services of their choice, subject to the needs of law enforcement and reasonable network management techniques. On December 23, 2010, the FCC adopted “net neutrality” rules requiring fixed and mobile

 

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broadband Internet service providers (ISPs) to be transparent about their service terms, service performance, and network management practices; prohibiting fixed broadband ISPs from blocking lawful content, applications, services, or nonharmful devices, except as required for reasonable network management; prohibiting mobile broadband ISPs from blocking lawful websites or applications that compete with their voice and video services; and prohibiting fixed broadband ISPs from engaging in unreasonable discrimination with respect to the transmission of Internet traffic. These net neutrality rules are the subject of an appeal in the federal courts.

State Regulation of RLEC, CLEC and Interexchange Services

Most states require wireline telecommunications providers to obtain authority from state regulatory commissions prior to offering common carrier services. State regulatory commissions generally regulate RLEC rates for intrastate services, including rates for intrastate access services paid by providers of intrastate long distance services. RLECs must file tariffs setting forth the terms, conditions and prices for their intrastate services. Our RLECs are subject to regulation in Virginia by the SCC. Our tariffs are approved by and on file with the SCC for RLEC services in our certificated service territory in and around Waynesboro and Covington, Virginia and in portions of Alleghany, Augusta, and Botetourt Counties, Virginia. In addition, the SCC establishes service quality requirements applicable to RLECs, including ours, and resolves disputes involving intrastate communications services.

In its 2010 session, the Virginia General Assembly enacted legislation requiring all Virginia local exchange carriers to eliminate carrier common line charges from their interstate access charges. For our two ILECs, the SCC approved the schedule for reducing and eliminating these charges beginning on January 1, 2012 and completely eliminating carrier common line charges by January 1, 2015.

In Virginia and West Virginia, CLECs’ intrastate switched access charges are capped at the higher of the CLEC’s interstate switched access charge or the intrastate switched access charge of the ILEC (or the average of all ILECs) providing service in the territory served by the CLEC. The Telecommunications Act preempts state statutes and regulations that restrict entry into the telecommunications market. As a result, we can provide the full range of competitive intrastate local and long distance services in all states in which we currently operate and in any states into which we may expand. We are certificated as a CLEC in Virginia, West Virginia, Pennsylvania, Maryland, Ohio and Kentucky. Although we file tariffs covering our CLEC services, our rates for such CLEC services generally fluctuate based on market conditions.

Local Government Authorizations

Certain governmental authorities require permits to open streets for construction and/or telecommunications franchises to install or expand facilities. Video franchises are also required for our video services. We obtain such permits and franchises as required.

The 2006 Virginia Cable Act provides for “negotiated” CATV franchises and “ordinance” CATV franchises. All new entrants must first attempt to negotiate a cable franchise with a locality. Should the negotiations not result in the granting of a franchise during a 45-day negotiation period, the applicant can elect to accept a default ordinance cable franchise that authorizes the applicant to begin offering CATV services 75 days after the initial negotiated franchise request, subject to the applicant abiding by certain requirements set forth in the statute. In September of 2006, we obtained a negotiated franchise in Waynesboro and an ordinance franchise in Botetourt County. Augusta County does not have a franchise requirement and, accordingly, we did not need to obtain a franchise prior to offering video services in Augusta County. In October of 2007, we obtained a negotiated franchise in Lynchburg for a new mixed-use residential development called Cornerstone. On January 12, 2009, we requested a negotiated franchise in Harrisonburg for a residential development called Liberty Square, but Harrisonburg has failed to act on that request. In 2010, we obtained video franchises from the City of Staunton for the Gypsy Hill Development and from Alleghany County, Covington, Clifton Forge, and Iron Gate.

Retransmission Consent. Local television stations may require that a video provider obtain “retransmission consent” for carriage of the station’s signal, which can enable a popular local television station to obtain concessions from video providers for the right to carry the station’s signal.

 

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Item 1A. Risk Factors.

RISK FACTORS

The following risk factors and other information included in this Form 10-K should be carefully considered. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial also may adversely impact our business operations. Our business, financial condition or results of operations could be materially adversely affected by any or all of these risks.

Risks Relating to Our Business

The telecommunications industry is generally characterized by rapid development, introduction of new technologies, substantial regulatory changes and intense competition, any of which could cause us to suffer price reductions, customer losses, reduced operating margins and/or loss of market share.

The telecommunications industry has been, and we believe will continue to be, characterized by several trends, including the following:

 

   

rapid development and introduction of new technologies and services, such as VoIP, high speed data services, or other technologies;

 

   

substantial regulatory change due to the continuing efforts of the FCC to reform intercarrier compensation, to modify USF availability, and to limit availability of UNEs used by CLECs under the Telecommunications Act of 1996;

 

   

increased competition within established markets from current and new market entrants that may provide competing or alternative services;

 

   

an increase in mergers and strategic alliances that allow one telecommunications provider to offer increased services or access wider geographic markets; and

 

   

the blurring of traditional dividing lines between, and the bundling of, different services, such as local telephone, long distance, wireless, video, data and Internet services.

We expect competition to intensify as a result of new competitors and the development of new technologies, products and services. Some or all of these trends may cause us to have to spend significantly more in capital expenditures than we currently anticipate in order to keep existing and to attract new customers. Many of our voice and data competitors, such as cable providers, wireless service providers, Internet access providers and long distance carriers have brand recognition, a national presence and financial, personnel, marketing and other resources that are significantly greater than ours. In addition, due to consolidation and strategic alliances within the telecommunications industry, we cannot predict the number of competitors that will emerge, especially as a result of existing or new federal and state regulatory or legislative actions. Such increased competition from existing and new entities could lead to price reductions, loss of customers, reduced operating margins and/or loss of market share.

As competition develops and technology evolves, federal and state regulation of the telecommunications industry continues to change rapidly. We anticipate that this state of regulatory flux will persist in the future, as the FCC and state regulators respond to competitive, technological, and legislative developments by modifying their existing regulations or adopting new ones.

Taken together or individually, new or changed regulatory requirements affecting any or all of the local and long distance industries may harm our business and restrict the manner in which we operate our business. The enactment of adverse regulation or regulatory requirements may slow our growth and have a material adverse effect upon our business, results of operations and financial condition. For a discussion of recent developments in this area, see the “Regulation” section above.

Adverse economic conditions may harm our business.

Economic conditions may not improve or may decline further for the foreseeable future. Unfavorable economic conditions, including the recession and recent disruptions to the credit and financial markets, could cause customers to slow spending. If demand for our services decreases, our revenues would be adversely affected and churn may increase. In addition, during challenging economic times our customers may face issues gaining timely access to sufficient credit, which may impair the ability of our customers to pay for services they have purchased. Any of the above could have a material effect on our business, financial position, results of operations and cash flows.

 

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We are also susceptible to risks associated with the potential financial instability of the vendors and third parties on which we rely to provide services or to which we outsource certain functions. The same economic conditions that may affect our customers could also adversely affect vendors and third parties and lead to significant increases in prices, reduction in quality or the bankruptcy of our vendors or third parties upon which we rely. Any interruption in the services provided by our vendors or by third parties could adversely affect our business, financial position, results of operating and cash flows.

Any significant impairment of our goodwill or intangible assets would lead to a decrease in our assets and a reduction in net operating performance.

As of December 31, 2011, we had goodwill and other intangible assets of approximately $146 million (approximately 29% of total assets), which amount is reflective of a reduction of approximately $65 million in 2011 in connection with asset impairment charges totaling $86 million. If the impact or the timing of ongoing regulatory reform actions are significantly different than what we anticipate or if there are other regulatory or operating changes to our business, we may be forced to record an additional impairment charge, which would lead to a decrease in the company’s assets and reduction in net income. We test goodwill and other indefinite lived intangible assets for impairment annually or whenever events or changes in circumstances indicate an impairment may have occurred. If the testing performed indicates that impairment has occurred, we are required to record an impairment charge for the difference between the carrying value of the goodwill or indefinite lived intangible asset and the implied fair value of the asset in the period in which the determination is made. The testing of goodwill and indefinite lived intangible assets for impairment requires us to make significant estimates about our future performance and cash flows, as well as other assumptions. These estimates can be affected by numerous factors, including changes in economic, industry or market conditions, changes in underlying business operations, future reporting unit operating performance, existing or new product market acceptance, changes in competition or changes in technologies. Any changes in key assumptions, or actual performance compared with those assumptions, about our business and our future prospects or other assumptions could affect the fair value of one or more of the indefinite-lived intangible assets or of the reporting units, resulting in an additional impairment charge.

Our rural local telephone company subsidiaries face substantial competition from competitors that are less heavily regulated than we are, which could increase our expenses or force us to lower prices, causing our revenues and operating results to decline.

As the rural local telephone companies for the western Virginia cities of Waynesboro and Covington, and portions of Alleghany, Augusta and Botetourt Counties, Virginia, we currently compete with a number of different providers, many of which are unregulated or less heavily regulated than we are. Our rural telephone company subsidiaries qualify as rural local telephone companies under the Telecommunications Act and are, therefore, exempt from many of the most burdensome obligations of the Telecommunications Act, such as the obligation to sell unbundled elements of our network to our competitors at “forward-looking” prices that the Telecommunications Act places on larger carriers. Nevertheless, our rural telephone company subsidiaries face significant competition, particularly from competitors that do not need to rely on access to our network to reach their customers. For example, wireless providers and cable companies continue to increase their market share and pose a significant competitive risk to our business. Comcast has introduced wireline digital voice services to its cable customers in Charlottesville and other Virginia markets, including in Waynesboro and Augusta County in May 2008, and it may offer these services in our Botetourt County service area in the future. Shenandoah Telecommunications Company purchased the cable property overlapping our RLEC territory in Clifton Forge and Covington, Virginia and began offering digital voice and data services to its customers in these markets during 2010. Wireless carriers provide services used by a growing number of customers as a substitute for wireline voice services.

Wireless carriers, cable companies and other VoIP providers are able to compete with our rural telephone company subsidiaries even though the “rural exemption” under the Telecommunications Act is in place. If our rural exemption were removed, CLECs could more easily enter our rural telephone company subsidiaries’ markets. Moreover, the regulatory environment governing wireline local operations has been, and we believe will likely continue to be, very liberal in its approach to promoting competition and network access.

Consistent with the experience of other rural telephone companies, our rural telephone company subsidiaries have experienced a reduction in access lines caused by, among other things, wireless competition, cable competition and business customer migration from Centrex services to IP-based and other PBX services using fewer lines. As

 

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penetration rates of these technologies increase in our markets, our revenues could decline. Our rural telephone company subsidiaries experienced a net loss of approximately 2,200 access lines in the year ended December 31, 2011, or 6.3% of our access lines served at the end of 2010. A continued net loss of access lines would impact our revenues and operating results.

Our rural telephone company subsidiaries are subject to several regulatory regimes and consequently face substantial regulatory burdens and uncertainties.

The SCC imposes service quality obligations on our rural telephone company subsidiaries and requires us to adhere to prescribed service quality standards, but many of our competitors are not subject to these standards. These standards measure the performance of various aspects of our business. If we fail to meet these standards, the SCC may impose fines or penalties or take other actions that may impact our revenues or increase our costs. The FCC may also impose fines and forfeitures for failure to comply with FCC rules and requirements.

Many of our competitors are unregulated or less heavily regulated than we are. For example, VoIP technology is used to carry voice communications services over a broadband Internet connection. The FCC has ruled that VoIP services are jurisdictionally interstate and that some VoIP arrangements (those not using the Public Switched Telephone Network) are not subject to regulation as telephone services. In 2006, the FCC expanded the base of USF contributions by extending universal service contribution obligations to providers of VoIP service interconnected to the Public Switched Telephone Network. The United States Supreme Court upheld the FCC’s ruling that cable broadband Internet services are not subject to common carrier telecommunications regulation.

Regulatory developments at the FCC and the Virginia SCC will reduce revenues that our rural telephone company and Competitive subsidiaries receive from network access charges.

For the years ended December 31, 2011 and 2010, approximately $24 million and $28 million, respectively, of our rural telephone company subsidiaries’ revenues came from network access charges paid to us by long distance carriers for originating and terminating calls in the areas we serve. These revenues are highly profitable for us. The amount of access charge revenues that we receive is based on rates set by the FCC for interstate long distance calls and the SCC for intrastate long distance calls. Such access rates are subject to change. Our federal access rates are periodically reset by the FCC, and our interstate access rates were subject to a biennial reset on July 1, 2011, which resulted in a reduction of these rates. This rate reset resulted in a $1.2 million reduction in revenue during the second half of 2011. The SCC is currently reducing our access rates to eliminate the Carrier Common Line Charge and could conduct further access reform proceedings or rate cases and earnings reviews, all of which could result in rate reductions. In addition, the Virginia General Assembly could pass legislation mandating intrastate access charge reductions.

On October 27, 2011, the FCC adopted a significant order on access reform and USF reform. In the order, which was released on November 18, 2011, the FCC determined that interstate and intrastate access charges, as well as local reciprocal compensation, should be eliminated entirely over time. The FCC therefore adopted a uniform national bill-and-keep framework as the ultimate end state for all telecommunications traffic exchanged with any local exchange carrier. Price Cap carriers will be at bill-and-keep in eight years and Rate-of-Return carriers will be at bill-and-keep in 11 years.

In the initial phase of the transition to bill-and-keep, intrastate end office switching rates for terminating traffic, carrier common line charges on terminating traffic, and certain intrastate transport rates associated with terminating traffic are to be brought to interstate rates within two steps by July 2013. VOIP providers must begin paying access charges at the federal rate level. The FCC has issued a further Notice of Proposed Rulemaking to seek comment on, among other things, the treatment/transition for originating access and for the transport elements not included in the initial order.

The FCC will permit carriers to raise end user rates to recover a portion of the loss in access charge revenues. This mechanism is the Access Recovery Charge. The maximum ARC for residential customers will be $3 per month after six years. Multi-line business customers will have their Subscriber Line Charge and ARC combined capped at $12.20 per line. In addition, RLECs will be able to recover a portion of lost access revenues from a new Connect America Fund. This recovery will be calculated initially based on fiscal year 2011 switched access revenues and reciprocal compensation revenues and that baseline will decline at five percent annually.

In the order, the FCC established an annual cap on the “high cost” portion of USF of $4.5 billion per year in each of the next six years. This $4.5 billion will be the sole funding source for the existing support mechanisms (high-cost loop, switching support, safety net, etc.); and for the CAF. The FCC has designated approximately $2 billion of the $4.5 billion annually from this fund for RLECs through 2017.

 

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The order also affects our Competitive operations. CLECs are required to “mirror” the access charges of the large ILECs in whose service area the CLEC competes. As the large ILECs move toward bill-and-keep for access charges, our CLECs will be mirroring those reductions. In addition, our legacy FiberNet operations in West Virginia have been designated as an Eligible Telecommunications Carrier and receives USF funding. USF funding for CLECs will decrease by 20% annually and thus be eliminated in five years.

Regulatory developments at the FCC will reduce revenues that our rural telephone company subsidiaries receive from the federal Universal Service Fund or other fund allocations.

For the years ended December 31, 2011 and 2010, we received approximately $5.0 million and $5.1 million, respectively, in payments from the federal Universal Service Fund in connection with our rural telephone company subsidiaries’ operations. Additionally, for the years ended December 31, 2011 and 2010, we received approximately $2.6 million (net) and $2.9 million (net), respectively, from other National Exchange Carrier Association, or NECA, pool distributions to compensate us for a portion of our interstate costs. In its November 18, 2011 order, the FCC established an annual cap on the “high cost” portion of USF of $4.5 billion per year in each of the next six years. This $4.5 billion will be the sole funding source for the existing support mechanisms (high-cost loop, switching support, safety net, etc.) and for the CAF. The FCC has designated approximately $2 billion of the $4.5 billion annually from this fund for RLECs through 2017. It is unknown whether that $2 billion will be sufficient to fund these USF programs for all RLECs, including ours.

We have substantial indebtedness, which could restrict our ability to pay dividends and have a negative impact on our financing options and liquidity position.

In connection with the Business Separation, we borrowed $340 million under a senior secured credit facility with certain financial institutions and used the proceeds to fund a working capital cash reserve and to pay $315 million to NTELOS Inc., a subsidiary of NTELOS. Our new indebtedness ($325 million at December 31, 2011) carries interest expense of approximately $13 million annually.

Our indebtedness could adversely affect our financial health and business and future operations by, among other things:

 

   

making it more difficult for us to satisfy our obligations with respect to our indebtedness;

 

   

increasing our vulnerability to adverse economic and industry conditions by making it more difficult for us to react quickly to changing conditions;

 

   

limiting our ability to obtain any additional financing we may need to operate, develop and expand our business;

 

   

requiring us to dedicate a substantial portion of any cash flows from operations to service our debt, which reduces the funds available for operations and future business opportunities;

 

   

potentially making us more highly leveraged than our competitors, which could potentially decrease our ability to compete in our industry;

 

   

exposing us to risks inherent in interest rate fluctuations because some of our borrowings are at variable rates of interest, which could result in higher interest expense in the event of increases in interest rates; and

 

   

limiting our flexibility in planning for, or reacting to, changes in our business, and the industry in which we operate.

The ability to make payments on our debt will depend upon our subsidiaries’ future operating performance, which is subject to general economic and competitive conditions and to financial, business and other factors, many of which we cannot control. If the cash flows from our subsidiaries’ operating activities are insufficient to service our debt obligations, we may take actions, such as delaying or reducing capital expenditures, reducing or eliminating our quarterly cash dividend, attempting to restructure or refinance our debt, selling assets or operations or seeking additional equity capital. Any or all of these actions may not be sufficient to allow us to service our debt obligations. Further, we may be unable to take any of these actions on satisfactory terms, in a timely manner or at all.

 

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Our senior secured credit facility imposes operating and financial restrictions, which may prevent us from capitalizing on business opportunities and taking some corporate actions.

Our senior secured credit facility imposes operating and financial restrictions on our subsidiaries. These restrictions generally:

 

   

restrict our subsidiaries’ ability to incur additional indebtedness;

 

   

restrict our subsidiaries from entering into transactions with affiliates;

 

   

restrict our subsidiaries’ ability to consolidate, merge or sell all or substantially all of their assets;

 

   

impose financial covenants relating to the business of our subsidiaries, including leverage and interest coverage ratios;

 

   

require our subsidiaries to use a portion of “excess cash flow” (as defined in the debt agreement) to repay indebtedness if our leverage ratio exceeds specified levels;

 

   

restrict our subsidiaries’ ability to pay dividends or make advances to us, which will restrict our ability to pay dividends; and

 

   

restrict our subsidiaries’ ability to agree to liens on assets or agreements (such as leases).

We cannot assure you that those covenants will not adversely affect our ability to pay dividends or repurchase stock, finance our future operations or capital needs or pursue available business opportunities. A breach of any of these covenants could result in a default with respect to the senior secured credit facility. If a default occurs, our indebtedness under the senior secured credit facility could be declared immediately due and payable. As a result of general economic conditions, conditions in the lending markets, the results of our business or for any other reason, we may elect or be required to amend or refinance our indebtedness, at or prior to maturity, or enter into additional agreements for senior indebtedness.

If interest rates increase, our net income could be negatively affected.

Our substantial debt exposes us to adverse changes in interest rates. We cannot predict whether interest rates for long term debt will increase, and thus, we cannot assure you that our future interest expense will not have a material adverse effect on our business, financial condition, operating results and cash flows. We did enter into interest rate hedges on 50% of the facility through 2014 in order to mitigate this exposure.

Lumos Networks and other industry participants are frequently involved in disputes over issues that, if decided adversely to us, could harm our financial and operational prospects.

We anticipate that we will continue to be subject to risks associated with the resolution of various disputes, lawsuits, arbitrations and proceedings affecting our business. These issues include the administration and enforcement of existing interconnection agreements and tariffs, the terms of new interconnection agreements, operating performance obligations, intercarrier compensation, treatment of different categories of traffic (for example traffic terminating via wireless or VoIP), the jurisdiction of traffic for intercarrier compensation purposes. We also may be included in proceedings and arbitrations before state and regulatory commissions, private arbitration organizations, and courts over many issues that will be important to our financial and operation success. In addition, for the Competitive segment, we face potential disputes about facilities available, the prices we will pay for these services and facilities.

Our Competitive operations face substantial competition and uncertainty relating to their interconnection agreements with the ILEC networks and Pole Attachment Agreements with ILECs and with electric utilities in the markets we serve.

Our Competitive operations compete primarily with incumbent local exchange carriers, or ILECs, including Verizon, Frontier Communications Corporation (“Frontier”) and CenturyLink, and, to a lesser extent, CLECs, including Level 3, Zayo, Windstream and Comcast, Cox and other cable companies. We will continue to face competition from other current and future market entrants.

We have interconnection agreements with the ILEC networks covering each market in which our Competitive operations serve. Based on customer growth and our assessment of growth opportunities in these markets, we purchase wholesale voice lines, data circuits and access to collocation facilities under these agreements. From time to time, we are required to negotiate amendments to, extensions of, or replacements for these agreements.

 

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Additionally, we may be required to negotiate new interconnection agreements in order to enter new markets in the future. We may not be able to successfully negotiate amendments to existing agreements, negotiate new interconnection agreements, renew our existing interconnection agreements, opt in to new agreements or successfully arbitrate replacement agreements for interconnection on terms and conditions acceptable to us. Our inability to do so would adversely affect our existing operations and opportunities to expand our Competitive business in existing and new markets. If rates became unfavorable or we could no longer access collocation facilities, we could be forced to alter our service delivery which could reduce our customer base. As the FCC modifies, changes and implements rules related to unbundling of ILEC network elements and collocation of competitive facilities at ILEC central offices, we generally have to renegotiate our interconnection agreements to implement those new or modified rules.

Under federal law, our Competitive operations have a right to use the poles, ducts, and conduits of investor-owned utilities (electric and telephone) at regulated rates for our cables, including fiber optic facilities. Some of the poles we use are exempt from federal regulation because they are owned by utility cooperatives and municipal entities. If the rates, terms and conditions imposed by utilities are unreasonable, or if the utilities do not allow us access to the poles, ducts, and conduits in a timely manner, our business, financial results or financial condition could suffer.

We may not be able to sustain our revenue and cash flow growth despite the acquisition of Fibernet and our investment in fiber routes and metro rings.

We must grow our business and revenue in order to generate sufficient cash flow to fund our operating requirements. We have pursued several growth initiatives including:

 

   

Acquiring Fibernet;

 

   

Increasing network investments in our core markets;

 

   

Upgrading and integrating network assets acquired from Allegheny Energy and FiberNet; and

 

   

Building fiber to wireless carrier cell sites.

Our ability to manage this expansion depends on many factors, including our ability to:

 

   

Increase revenues and manage churn in the Fibernet business;

 

   

Complete customer installations in a timely manner to meet customer demands;

 

   

Successfully train our sales force to adapt to evolutionary demand for advanced data services;

 

   

Accurately manage our capital expansion plans; and

 

   

Remain competitive with customer pricing and service expectations.

Our competitors have substantial business advantages over our Competitive operations, and we may not be able to compete successfully.

Verizon and other large ILECs such as Frontier and CenturyLink dominate the current market for business and consumer telecommunications services and have a virtual monopoly on telephone lines. These companies represent the dominant competition in much of our target service areas, and we expect this competition to intensify. The large ILECs have established brand names, can diversify their risks across markets nationwide, possess sufficient capital to upgrade existing and deploy new equipment, own their telephone lines and can bundle digital data services with their existing analog voice services and other services, such as long-distance, wireless and video services, to achieve economies of scale in serving customers. Moreover, the large ILECs are aggressively implementing “win-back” programs to regain access line customers lost to competitors and use bundled services to assist in those programs. We pose a competitive risk to the large ILECs that serve our Competitive markets and, as both our competitors and our suppliers, they have little motivation to respond in a timely manner to our requests or to assist in the enhancement of the services we provide to our Competitive customers.

We face substantial competition in our Internet and data services business and face regulatory uncertainty, each of which may adversely affect our business and results of operations.

We currently offer our Internet and data services in rural markets and face competition from other Internet and data service providers, including cable companies. The Internet industry is characterized by the absence of significant barriers to entry and rapid growth in Internet usage among customers. As a result, we expect that our competition

 

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will increase from market entrants offering high-speed data services, including DSL, cable and wireless access. Our competition includes cable modem services offered by cable providers; ILECs, such as Verizon, Frontier and CenturyLink in our Competitive territories; and local, regional and national ISPs, both wireline and wireless, including Zayo and Windstream. In addition, wireless carriers are offering 3G and 4G services for internet access.

Many of our competitors have financial resources, corporate backing, customer bases, marketing programs and brand names that are greater than ours. Additionally, competitors may charge less than we do for Internet services, causing us to reduce, or preventing us from raising, our fees.

Our rights to the use of fiber that are part of our network may be affected by the ability to continue long term contracts and the financial stability of our Indefeasible Rights to Use fiber providers.

As of December 31, 2011, approximately 83% of our approximately 5,800 route-mile network is under long term leases or Indefeasible Rights to Use, or IRU, agreements that provide us access to fiber owned by other network providers. These agreements are generally long term and no such agreements are due to expire in 2012. Less than 1% of the IRUs have terms that expire within the next five years. In these agreements, the network owner is responsible for network maintenance for which we pay such network owners. If our network provider under IRU agreements has financial troubles, it could adversely affect our costs, especially maintenance costs and ability to deliver service. We could also incur material expenses if we were required to relocate to alternative network assets.

If we cannot obtain and maintain necessary rights-of-way for our network, our operations may be interrupted and we would likely face increased costs.

We need to obtain and maintain the necessary rights-of-way for our network from governmental and quasi-governmental entities and third parties, such as railroads, utilities, state highway authorities, local governments, transit authorities and private landowners. We may not be successful in obtaining and maintaining these rights-of-way or obtaining them on acceptable terms. Some agreements relating to rights-of-way may be short-term or revocable at will, and we cannot be certain that we will continue to have access to existing rights-of-way after the governing agreements are terminated or expire. If any of our right-of-way agreements were terminated or could not be renewed, we may be forced to remove our network facilities from the affected areas, relocate or abandon our networks. This would interrupt our operations and force us to find alternative rights-of-way and make unexpected capital expenditures. In addition, our failure to maintain the necessary rights-of-way, franchises, easements, licenses and permits may result in an event of default under our credit agreement and may subject us to legal complaints or claims.

Losses or a decrease in usage from certain key customers may result in lower revenues or higher expenses.

We generated approximately 9% and 12% of our operating revenue from Verizon in the years ended December 31, 2011 and 2010, respectively. In addition, we have substantial business relationships with seven other telecommunications carriers. Carriers in the aggregate accounted for approximately 38% of our operating revenues for the year ended December 31, 2011 and approximately 44% of our operating revenues for the year ended December 31, 2010. If we were to lose Verizon or one of these other customers, our revenues would decline, which could have a material adverse effect on our business, financial condition and operating results.

We may require additional capital to respond to customer demand and to competition, and if we fail to raise the capital or fail to have continued access to the capital required to build out and operate our planned networks, we may experience a material adverse effect on our business.

We require additional capital to build out and operate our network and for general working capital needs. Our aggregate capital expenditures for 2011 were approximately $62 million, approximately $19 million of which represents network infrastructure and integration costs related to the FiberNet acquisition and approximately $2 million of which represents costs related to the Business Separation. We estimate that our capital expenditures for 2012 will be approximately $52 million to approximately $60 million.

Because of our intensely competitive market, we may be required to expand the technical requirements of our network or to build out additional areas within our territories that could result in increased capital expenditures. Any such unplanned capital expenditures may adversely affect our business, financial condition and operating results.

 

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We rely on a limited number of key suppliers and vendors for timely supply of equipment and services relating to our network infrastructure. If these suppliers or vendors experience problems or favor our competitors, we could fail to obtain sufficient quantities of the products and services we require to operate our businesses successfully.

We depend on a limited number of suppliers and vendors for equipment and services relating to our network infrastructure. If these suppliers experience interruptions or other problems delivering these network components on a timely basis, our subscriber growth and operating results could suffer significantly. Our initial choice of a network infrastructure supplier can, where proprietary technology of the supplier is an integral component of the network, cause us effectively to be locked into one or a few suppliers for key network components. As a result, we have become reliant upon a limited number of network equipment manufacturers, including Alcatel-Lucent, Cisco Systems, Inc. and others. If alternative suppliers and vendors become necessary, we may not be able to obtain satisfactory and timely replacement supplies on economically attractive terms, or at all.

A system failure could cause delays or interruptions of service, which could cause us to lose customers.

To be successful, we must provide our customers reliable network service. Some of the risks to our network and infrastructure include: physical damage to outside plant facilities; power surges or outages; software defects; human error; disruptions beyond our control, including disruptions caused by terrorist activities or severe weather; and failures in operational support systems.

Network disruptions may cause interruptions in service or reduced capacity for customers, either of which could cause us to lose customers and incur additional expenses.

We are dependent on third-party vendors for our information and billing systems. Any significant disruption in our relationship with these vendors could increase our cost and affect our operating efficiencies.

Sophisticated information and billing systems are vital to our ability to monitor and control costs, bill customers, process customer orders, provide customer service and achieve operating efficiencies. We currently rely on internal systems and third-party vendors to provide all of our information and processing systems. Some of our billing functions will be provided on a transitional basis by NTELOS. Some of our billing, customer service and management information systems have been developed by third parties and may not perform as anticipated or the third parties may experience interruptions or other problems delivering these systems. In addition, our plans for developing and implementing our information and billing systems rely to some extent on the delivery of products and services by third-party vendors. Our right to use these systems is dependent upon license agreements with third-party vendors. Some of these agreements are cancelable by the vendor, and the cancellation or nonrenewable nature of these agreements could impair our ability to process customer information and/or bill our customers. Since we rely on third-party vendors to provide some of these services, any switch in vendors could be costly and affect operating efficiencies.

If we fail to extend or renegotiate our collective bargaining agreements with our labor union when they expire, or if our unionized employees were to engage in a strike or other work stoppage, our business and operating results could be materially harmed.

We are a party to collective bargaining agreements with our labor union, which represented 67 employees as of December 31, 2011. Although we believe that relations with our employees are satisfactory, no assurance can be given that we will be able to successfully extend or renegotiate our collective bargaining agreements when they expire. If we fail to extend or renegotiate our collective bargaining agreements, if disputes with our union arise, or if our unionized workers engage in a strike or a work stoppage, we could experience a significant disruption of operations or incur higher ongoing labor costs, either of which could have an adverse effect to the business. Our collective bargaining agreement expires June 30, 2014.

If or when we lose a member or members of our senior management, our business may be adversely affected.

The success of our business is largely dependent on our senior management team, as well as on our ability to attract and retain other highly qualified technical and management personnel, including talented sales personnel.

We believe that there is, and will continue to be, intense competition for qualified personnel in the telecommunications industry, and we cannot assure you that we will be able to attract and retain the personnel necessary for the development of our business. The unexpected loss of key personnel or the failure to attract additional personnel as required could have a material adverse effect on our business, financial condition and operating results.

 

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Unauthorized use of, or interference with, our network could disrupt service and increase our costs.

We may incur costs associated with the unauthorized use of our network including administrative and capital costs associated with detecting, monitoring and reducing the incidence of fraud. Fraudulent use of our network may impact interconnection costs, capacity costs, administrative costs, fraud prevention costs and payments to other carriers for fraudulent use.

Security breaches related to our physical facilities, computer networks, and informational databases may cause harm to our business and reputation and result in a loss of customers.

Our physical facilities and information systems may be vulnerable to physical break-ins, computer viruses, theft, attacks by hackers, or similar disruptive problems. If hackers gain improper access to our databases, they may be able to steal, publish, delete or modify confidential personal information concerning our subscribers. In addition, misuse of our customer information could result in more substantial harms perpetrated by third parties. This could damage our business and reputation, and result in a loss of customers.

Our future financial performance may be worse than the performance reflected in our historical financial information included in this annual report on Form 10-K.

The historical financial information we have included in this annual report on Form 10-K does not reflect what our results of operations, financial position and cash flows would have been had we been an independent company during the periods presented or may not be indicative of what our results of operations, financial position and cash flows may be in the future now that we are an independent company. This is primarily a result of the following four factors:

 

   

Prior to the Business Separation, our business was operated by NTELOS as part of its broader corporate organization, rather than as an independent company. NTELOS or one of its affiliates performed various corporate functions for us, including, but not limited to, tax administration, treasury activities, accounting, information technology services, human resources, legal, ethics and compliance program administration, investor relations, certain governance functions (including internal audit) and external financial reporting. Our historical and pro forma financial statements reflect allocations of corporate expenses from NTELOS for these and similar functions. These allocations may be more or less than the comparable expenses we would have incurred had we operated as an independent, publicly-traded company;

 

   

Our historical financial information does not reflect the increased level of debt and the related increase in interest expense that we incurred as part of the Business Separation;

 

   

Historically, we have shared economies of scope and scale in costs, employees, vendor relationships and customer relationships with the other businesses of NTELOS. The short-term transition agreements that govern certain relationships between us and NTELOS may not capture all the benefits our business enjoyed as a result of being integrated with the other businesses of NTELOS. The loss of some or all of these benefits could have an adverse effect on our business, results of operations and financial condition; and

 

   

Other significant changes may occur in our cost structure, management, financing and business operations as a result of our operation as a company separate from NTELOS.

For these reasons, our future financial performance may be worse than the performance implied by the historical financial information we have presented in this annual report on Form 10-K.

For additional information about the past financial performance of our business and the basis of the presentation of the historical combined financial statements, see “Selected Combined Financial Data,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and the historical consolidated financial statements and the accompanying notes included elsewhere in this Form 10-K.

We may be unable to achieve some or all of the benefits that we expect to achieve from our separation from NTELOS.

As an independent, publicly-traded company, we believe that our business will benefit from, among other things, allowing us to pursue the business strategies that best suit our long-term interests, to more efficiently develop and finance expansion plans, to appeal to a different investor base, to create effective incentives for our management and employees that are more closely tied to our business performance and to effectively advocate with respect to regulatory matters without internal corporate conflict. However, as a separate company from NTELOS, we may be more susceptible to market fluctuation and other adverse events. In addition, we may not be able to achieve some or

 

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all of the benefits that we expect to achieve as an independent company in the time we expect, if at all. For example, it is possible that investors and securities analysts will not place a greater value on our business as an independent company than on our business as a part of NTELOS.

We may be unable to make, on a timely or cost-effective basis, the changes necessary to operate as an independent company, and we will experience increased costs as a result of the Business Separation.

NTELOS is contractually obligated to provide to us only those transition services specified in the transition services agreement and the other agreements we entered into with NTELOS in connection with the Business Separation. NTELOS has historically performed many important corporate functions for our operations, including information technology support, customer bill printing and mailing services, treasury, accounting, finance and tax administration, human resources, legal, regulatory, public relations and strategic development functions. Following the Business Separation, NTELOS has provided support to us with respect to most of these functions. The expiration date of the transition services agreement varies by service provided, but is generally no longer than 24 months from October 31, 2011. In addition, the transition services agreement contains provisions that permit either party to terminate the agreement in certain circumstances. Upon the expiration or early termination of the transition services agreement or other agreements, many of the services that are covered in such agreements will be provided internally or by unaffiliated third-parties, and we expect that, in some instances, we will incur higher costs to obtain such services than we incurred prior to the Business Separation or under the terms of such agreements. The amount and timing of when we incur such additional expenses may increase the variability of our earnings and cash flows. If we are unable to lower other expenses or increase revenues, these additional expenses also will lower our earnings and our cash flows.

There may be an adverse operational impact on our business as a result of the significant time of our management and other employees and internal resources that will need to be dedicated to building these capabilities during the first few years following the Business Separation that otherwise would be available for other business initiatives and opportunities. If NTELOS does not effectively perform the transition services and the other services that are called for under the transition services agreement and other agreements, we may not be able to operate our business effectively and our profitability may decline. After the expiration or early termination of the transition services agreement and the other agreements, we may be unable to replace the services specified in such agreements in a timely manner or on comparable terms.

Similarly, we historically purchased a wide variety of products and services, including software licenses, from third-parties as part of NTELOS. We may experience some increased costs as a result of our inability to continue to purchase products and services on terms that are as favorable to us as those obtained under these combined purchasing arrangements. Although we cannot predict the extent of any such increased costs, it is possible that such costs could have a negative impact on our business and results of operations.

Our separation from NTELOS could adversely affect our business and profitability due to our loss of NTELOS’s brand and reputation.

As a business unit of NTELOS, we previously marketed our products and services using the “NTELOS” brand name and logo, and we believe the association with NTELOS provided us with goodwill among our customers due to NTELOS’s regionally recognized brands and perceived high-quality products and services.

We may not be able to achieve or maintain comparable name recognition or status under our new “Lumos” brand, which could adversely affect our ability to attract and retain customers, resulting in reduced sales and revenues. We will also incur capital and other costs associated with launching and marketing our new brand.

We may have been able to receive better terms from unaffiliated third-parties than the terms provided in our agreements with NTELOS.

The agreements related to our separation from NTELOS, including the separation and distribution agreement, transition services agreement, commercial services agreements, intellectual property agreements, tax matters agreement, employee matters agreement and other agreements, were negotiated in the context of our separation from NTELOS while we were still part of NTELOS and, accordingly, may not reflect terms that would have been reached between unaffiliated parties. The terms of the agreements we negotiated in the context of our separation relate to, among other things, allocation of assets, liabilities, rights, indemnifications and other obligations between NTELOS and us as well as certain ongoing arrangements between NTELOS and us. Had these agreements been negotiated with unaffiliated third-parties, they might have been more favorable to us. Upon the expiration or early termination of these agreements, many of the services that are covered in such agreements will be provided internally or by

 

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unaffiliated third-parties, and we expect that, in some instances, we will incur higher costs to obtain such services than we incurred prior to the Business Separation or under the terms of such agreements. The amount and timing of when we incur such additional expenses may increase the variability of our earnings and cash flows. If we are unable to lower other expenses or increase revenues, these additional expenses also will lower our earnings and our cash flows.

If the Distribution does not qualify as a tax-free transaction, tax could be imposed on NTELOS and we may be required to indemnify NTELOS for such tax.

If the Distribution were not to be tax-free to NTELOS, NTELOS would be required to recognize gain in an amount up to the fair market value of our common stock that NTELOS distributed on the distribution date.

Furthermore, events subsequent to the Distribution could cause NTELOS to recognize gain on the Distribution. For example, under Code Section 355(e), even minimal acquisitions of either our equity securities or NTELOS’s equity securities that are deemed to be part of a plan or a series of related transactions that include the Distribution could cause NTELOS to recognize gain on the Distribution.

Under the tax matters agreement entered into between NTELOS and us, we are generally required to indemnify NTELOS against any tax resulting from the Distribution to the extent that such tax resulted from any of the following events (among others): (1) an acquisition of all or a portion of our stock or assets, whether by merger or otherwise, (2) any negotiations, understandings, agreements or arrangements with respect to transactions or events that cause the Distribution to be treated as part of a plan pursuant to which one or more persons acquire, directly or indirectly, stock representing a 50% or greater interest in Lumos Networks, (3) certain other actions or failures to act by us, or (4) any breach by us of certain of our representations or undertakings. Our indemnification obligations to NTELOS and its subsidiaries, officers and directors are not limited by any maximum amount.

We are agreeing to certain restrictions to preserve the tax-free treatment of the Distribution to NTELOS, which may reduce our strategic and operating flexibility.

To preserve the tax-free treatment to NTELOS of the Distribution, under the tax matters agreement that we entered into with NTELOS, we are prohibited from taking or failing to take any action that prevents the Distribution and related transactions from being tax-free. Further, for the two-year period following the Distribution, we may be prohibited, except in specified circumstances, from: entering into any transaction resulting in the acquisition of 40% or more of our stock or 60% or more of our assets, whether by merger or otherwise; merging, consolidating or liquidating; issuing equity securities beyond certain thresholds; repurchasing our common stock; and ceasing to actively conduct our wireline business.

These restrictions may limit our ability to pursue strategic transactions or engage in new business or other transactions that may maximize the value of our business.

The agreements that we entered into with NTELOS may involve, or may appear to involve, conflicts of interest.

In connection with the Business Separation, we entered into certain agreements with NTELOS to provide a framework for our initial relationship with NTELOS following the Business Separation. We negotiated these agreements with NTELOS while we were still a wholly owned subsidiary of NTELOS. Accordingly, our executive officers and some of our directors were employees, officers or directors of NTELOS or its subsidiaries at the time of the negotiations and, as such, had an obligation to serve the interests of NTELOS and its subsidiaries. As a result, they could be viewed as having had a conflict of interest.

Certain of our directors and officers may have actual or potential conflicts of interest because of their cross officerships, directorships and stock ownership with NTELOS.

We continue to have overlap in directors and executive officers with NTELOS, which may lead to conflicting interests. James A. Hyde, the Chief Executive Officer and President of NTELOS, is serving as our Chief Executive Officer for a transition period. Our board of directors includes Mr. Hyde and representatives of Quadrangle Capital Partners LLP and certain of its affiliates (“Quadrangle”) who are members of the board of directors of NTELOS. Mr. Hyde and the members of our board of directors who overlap with NTELOS have fiduciary duties to both NTELOS’s and our stockholders. These individuals may have actual or apparent conflicts of interest with respect to matters involving or affecting each company. This arrangement may also subject us to regulation under state and federal affiliated interest’s regulatory requirements.

 

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Because of their current or former positions with NTELOS, certain of our directors and executive officers may continue to own shares of NTELOS common stock and the individual holdings may be significant for some of these individuals compared to their total assets. This ownership may create, or, may create the appearance of, conflicts of interest when these directors and officers are faced with decisions that could have different implications for NTELOS and Lumos Networks.

For example, potential conflicts of interest could arise in connection with the resolution of any dispute that may arise between us and NTELOS regarding the terms of the agreements governing the Business Separation and the relationship thereafter between the companies. Potential conflicts of interest could also arise if we enter into additional commercial arrangements with NTELOS in the future.

In connection with our separation from NTELOS, NTELOS will indemnify us for certain liabilities and we will indemnify NTELOS for certain liabilities. If we are required to indemnify NTELOS, we may need to divert cash to meet those obligations and our financial position could be negatively impacted. In the case of NTELOS’s indemnity, there can be no assurance that the indemnity will be sufficient to insure us against the full amount of such liabilities, or as to NTELOS’s ability to satisfy its indemnification obligations in the future.

Pursuant to the separation and distribution agreement and certain other agreements with NTELOS, NTELOS agreed to indemnify us from certain liabilities, and we agreed to indemnify NTELOS for certain liabilities, in each case for uncapped amounts. Indemnities that we may be required to provide NTELOS are not subject to any cap, may be significant and could negatively impact our business, particularly indemnities relating to our actions that could impact the tax-free nature of the Distribution. Third-parties could also seek to hold us responsible for any of the liabilities that NTELOS has agreed to retain. Further, there can be no assurance that the indemnity from NTELOS will be sufficient to protect us against the full amount of such liabilities, or that NTELOS will be able to fully satisfy its indemnification obligations. Moreover, even if we ultimately succeed in recovering from NTELOS any amounts for which we are held liable, we may be temporarily required to bear these losses ourselves. Each of these risks could negatively affect our business, results of operations and financial condition.

The Quadrangle entities continue to have significant influence over our business and could delay, deter or prevent a change of control, change in management or business combination that may not be beneficial to our stockholders and as a result, may depress the market price of our stock.

As of December 31, 2011, Quadrangle beneficially owns approximately 27% of our outstanding common stock. Additionally, in accordance with a shareholders agreement between Quadrangle and us, three of the eight directors that will serve on our board of directors are representatives or designees of Quadrangle. By virtue of such stock ownership and representation on the board of directors, Quadrangle will have a significant influence over day-to-day corporate and management policies and all matters submitted to our stockholders, including the election of the directors, and may exercise significant control over our business, policies and affairs. Quadrangle’s interests as a stockholder may not always coincide with the interests of other stockholders. Additionally, such concentration of voting power could have the effect of delaying, deterring or preventing a change of control, change in management or business combination that might otherwise be beneficial to our stockholders and as a result, may depress the market price of our stock.

Our stock price may decline due to the large number of shares eligible for future sale.

Sales of substantial amounts of our common stock, or the possibility of such sales, may adversely affect the market price of our common stock. These sales may also make it more difficult for us to raise capital through the issuance of equity securities at a time and at a price we deem appropriate.

In our shareholders agreement with Quadrangle, we have granted Quadrangle the right to require us to register their shares of our common stock, representing approximately 5.7 million shares of our common stock. Accordingly, the number of shares subject to registration rights is substantial and the sale of these shares and any other shares with tag-along registration rights may have a negative impact on the market price for our common stock.

Provisions in our charter documents and the General Corporation Law of Delaware could discourage potential acquisition proposals, could delay, deter or prevent a change in control and could limit the price certain investors might be willing to pay for our common stock.

Certain provisions of the General Corporation Law of Delaware, the state in which we are organized, and our certificate of incorporation and bylaws may inhibit a change of control not approved by our board of directors or changes in the composition of our board of directors, which could result in the entrenchment of current management. These provisions include:

 

   

advance notice requirements for stockholder proposals and director nominations;

 

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limitations on the ability of stockholders to amend, alter or repeal our bylaws;

 

   

limitations on the removal of directors;

 

   

the inability of the stockholders to act by written consent; and

 

   

the authority of the board of directors to issue, without stockholder approval, preferred stock with such terms as the board of directors may determine and additional shares of our common stock.

A portion of our current investor base may be required to sell our stock.

A portion of our common stock is held by index funds tied to broad stock indices in which we are included as a component. If at any time we are not included as a component in those indices, the corresponding index funds will likely be required to sell their shares of our common stock and the price of our common stock could be depressed by those sales.

We may not be able to pay dividends on our common stock in the future.

We intend to pay regular quarterly dividends on our common stock. However, any decision to declare future dividends will be made at the discretion of the board of directors and will depend on, among other things, our results of operations, cash requirements, investment opportunities, financial condition, contractual restrictions, and other factors that our board of directors may deem relevant. We are a holding company that does not operate any business of our own. As a result, we are dependent on cash dividends and distributions and other transfers from our subsidiaries to make dividend payments to our stockholders. Amounts that can be made available to us to pay cash dividends or repurchase stock are permitted by our credit agreement within the parameters of a restricted payment basket.

Our certificate of incorporation designates the Court of Chancery of the State of Delaware as the sole and exclusive forum for certain litigation that may be initiated by our stockholders, which could limit our stockholders’ ability to obtain a favorable judicial forum for disputes with the Company.

Our certificate of incorporation provides that, unless we consent in writing to the selection of an alternative forum, the Court of Chancery of the State of Delaware shall be the sole and exclusive forum for (i) any derivative action or proceeding brought on our behalf, (ii) any action asserting a claim of breach of fiduciary duty owed by any of our directors, officers or other employees or our stockholders, (iii) any action asserting a claim arising pursuant to any provision of the DGCL or our certificate of incorporation or bylaws, or (iv) any action asserting a claim governed by the internal affairs doctrine. Our certificate of incorporation further provides that any person or entity purchasing or acquiring any interest in shares of our capital stock shall be deemed to have notice of and to have consented to the provisions described above. This forum selection provision in our certificate of incorporation may limit our stockholders’ ability to obtain a favorable judicial forum for disputes with the Company.

 

Item 1B. Unresolved Staff Comments.

None.

 

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Item 2. Properties.

We are headquartered in Waynesboro, Virginia and own offices and facilities in a number of locations within our operating markets. We believe that our current facilities are adequate to meet our needs in our existing markets for the foreseeable future. The table below provides the location, description and approximate square footage of our material owned properties.

 

Location

  

Property Description

   Approximate Square
Footage
 

Harrisonburg, VA

  

Competitive POP

     2,500   

Troutville, VA

  

Switch and Video Headend Building

     11,400   

Clifton Forge, VA

  

Switch Building

     12,000   

Covington, VA

  

Service Center

     13,000   

Waynesboro, VA

  

Service Center

     20,000   

Daleville, VA

  

Regional Operations Center

     21,000   

Covington, VA

  

Switch Building

     32,000   

Waynesboro, VA

  

Corporate Headquarters

     30,000   

Waynesboro, VA

  

Switch Building

     33,920   

Daleville, VA

  

Service Center

     9,400   

We also lease the following material properties:

 

   

Our Charleston, West Virginia regional operations center (wireline switching) under a sub-lease from NTELOS Inc. for approximately 3,200 square feet of this space;

 

   

Our Daleville, Virginia customer care facility under a lease agreement from The Layman Family, LLC. for approximately 34,000 square feet of space with approximately 15,750 square feet sub-leased to NTELOS Inc.;

 

   

Our Charleston, West Virginia switch building under a lease agreement by and between Nelson Trust and FiberNet, LLC dated April 19, 2005;

 

   

Our Charleston, West Virginia office and switch building under a lease agreement by and between Williams Land Company and Mountaineer Telecommunications, LLC dated April 12, 2005; and

 

   

Our Charleston, West Virginia office building under a lease agreement by and between Williams Land Company and FiberNet, LLC dated October 16, 2007.

 

Item 3. Legal Proceedings.

We are involved in routine litigation in the ordinary course of our business, including litigation involving disputes relating to our billings to other carriers for access to our network (see Note 12 to Notes to Audited Consolidated Financial Statements included herein). We do not believe that any pending or threatened litigation of which we are aware will have a material adverse effect on our financial condition, results of operations or cash flows.

 

Item 4. Mine Safety Disclosures.

Not applicable.

 

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PART II

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

Market Information

Our common stock is traded on the NASDAQ Global Market under the symbol “LMOS.” On March 16, 2012, the last reported sale price for our common stock was $10.49 per share.

Our common stock has been traded on the NASDAQ Global Market under the symbol “LMOS” since November 1, 2011. Prior to that time, there was no established public trading market for our common stock. The following table sets forth the high and low prices per share of our common stock and the cash dividends declared per common share for the fourth quarter of 2011, which corresponds to our quarterly fiscal periods for financial reporting purposes:

 

     2011  
     Stock Price per Share      Cash
Dividends
Declared per
Common
 
     High      Low      Share  

Fourth Quarter

   $ 17.99       $ 11.70       $ 0.14   

 

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Stock Performance Graph

The following indexed line graph indicates our total return to stockholders from our initial public offering on November 1, 2011 (the first day our Common Stock began trading on the Nasdaq stock exchange) to December 31, 2011, as compared to the total return for the Nasdaq Composite Index and the Nasdaq Telecommunications Index for the same period. The calculations in the graph assume that $100 was invested on November 1, 2011 in our Common Stock and each index and also assume dividend reinvestment.

Cumulative Total Shareholder Return

Lumos Networks, NASDAQ Stock Market

and Nasdaq Telecommunications Index

(11/1/11 - 12/31/11)

 

LOGO

 

     November 1,
2011
     November 30,
2011
     December 31,
2011
 

Lumos Networks Corp.

   $ 100       $ 98       $ 103   

NASDAQ Composite Index

   $ 100       $ 101       $ 100   

NASDAQ Telecommunications Index

   $ 100       $ 105       $ 103   

Holders

There were approximately 4,700 holders of our common stock on March 9, 2012.

Dividends/Dividend Policy

We intend to continue to pay regular quarterly dividends on our common stock. On November 4, 2011, our board of directors declared a dividend in the amount of $0.14 per share (totaling $3.0 million) which was paid on January 14, 2012 to stockholders of record on December 16, 2011. On February 23, 2012, our board of directors declared a dividend in the amount of $0.14 per share, which is to be paid on April 12, 2012 to stockholders of record on March 14, 2012. All decisions to declare dividends will be made at the discretion of the board of directors and will depend on, among other things, our results of operations, cash requirements, investment opportunities, financial condition, credit agreement and contractual restrictions and other factors that the board of directors may deem relevant. We are a holding company that does not operate any business of our own. As a result, we are dependent on cash dividends

 

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and distributions and other transfers from our subsidiaries to make dividend payments or to make other distributions to our stockholders. Amounts that can be made available to us to pay cash dividends will be permitted by our credit agreement within the parameters of a restricted payment basket.

 

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Item 6. Selected Financial Data

SELECTED HISTORICAL FINANCIAL INFORMATION(6)

 

     Lumos Networks Corp.
Year Ended December 31,
 

(In thousands, except per share amounts)

   2011     2010     2009     2008     2007  

Consolidated Statements of Operations Data

          
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Operating Revenues

   $ 207,414      $ 145,964      $ 130,595      $ 128,806      $ 126,075   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Operating Expenses

          

Cost of sales and services(1) (exclusive of items shown separately below)

     78,484        46,407        40,158        38,857        37,490   

Customer operations(1)

     19,551        13,243        12,598        13,112        13,821   

Corporate operations(1)(2)

     16,251        13,809        8,582        10,836        11,588   

Depreciation and amortization and accretion of asset retirement obligations

     43,206        31,376        28,719        27,033        27,030   

Asset impairment charges

     86,295        —          —          —          —     
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
     243,787        104,835        90,057        89,838        89,929   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Operating (Loss) Income

     (36,373     41,129        40,538        38,968        36,146   

Other Income (Expenses)

          

Interest expense(3)

     (11,993     (5,752     (1,478     (1,393     (2,025

Other income, net

     105        43        105        97        192   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
     (11,888     (5,709     (1,373     (1,296     (1,833
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
     (48,261     35,420        39,165        37,672        34,313   

Income Tax (Benefit) Expense

     (4,383     14,477        15,768        14,887        13,725   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net (Loss) Income

     (43,878     20,943        23,397        22,785        20,588   

Net (Income) Loss Attributable to Noncontrolling Interests

     (52     (119     (39     (48     33   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net (Loss) Income Attributable to Lumos Networks Corp.

   $ (43,930   $ 20,824      $ 23,358      $ 22,737      $ 20,621   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Pro Forma Basic and Diluted (Loss) Earnings per Common Share Attributable to Lumos Networks Corp. Stockholders:

          

(Loss) Income per Share – Basic and Diluted (4)

   $ (2.11        

Cash Dividends Declared per Share – Common Stock

   $ 0.14           

 

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     As of December 31,  

(In thousands)

   2011      2010      2009      2008      2007  

Balance Sheet Data:

              

Cash and cash equivalents

   $ 10,547       $ 489       $ 3       $ 3       $ 15   

Property and equipment, net

     299,958         273,906         203,239         158,829         141,550   

Total assets

     498,600         540,793         347,151         350,299         354,187   

Total debt(5)

     326,576         180,721         651         546         543   

Stockholders’ equity attributable to Lumos Networks Corp.

   $ 52,383       $ 265,794       $ 272,681       $ 280,194       $ 288,415   

 

(1) 

We record equity-based compensation expense related to our share-based awards. The following table shows the allocation of equity-based compensation expense to cost of sales and services, customer operations and corporate operations for the years ended December 31, 2011, 2010, 2009, 2008 and 2007.

 

     Year Ended December 31,  

(In thousands)

   2011      2010      2009      2008      2007  

Cost of sales and services

   $ 314       $ 230       $ 148       $ 59       $ 86   

Customer operations

     419         297         143         99         128   

Corporate operations

     1,650         1,002         503         423         709   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Equity-based compensation expense

   $ 2,383       $ 1,529       $ 794       $ 581       $ 923   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

(2) 

Corporate operations expense for 2010 includes $3.0 million of charges representing legal and professional fees related to the acquisition of FiberNet (Note 1 to our audited consolidated financial statements included herein).

(3) 

Interest expense for 2011 and 2010 increased significantly from prior years as a result of the Allegheny asset acquisition on December 31, 2009 and the FiberNet purchase on December 1, 2010 (Note 1 to our audited consolidated financial statements included herein) which were financed by intercompany borrowings from NTELOS Inc., and as a result of the $340 million senior credit facility that was funded on October 31, 2011 (Note 5 to our audited consolidated financial statements included herein).

(4) 

Basic earnings per share for the year ended December 31, 2011 is computed by dividing net loss for the year by the weighted average number of common shares outstanding during the two month post-Business Separation period beginning November 1, 2011 and ending December 31, 2011. Diluted earnings per share is calculated in a similar manner, but includes the dilutive effect of actual stock options and restricted shares outstanding as of December 31, 2011. Since these securities are anti-dilutive in 2011, they are excluded from the calculation of earnings per share. Prior to the Business Separation, we did not have any common stock outstanding.

(5) 

Of the total debt outstanding as of December 31, 2010, $178.6 million represented a long-term obligation to NTELOS Inc. This obligation was reflected as a long-term obligation as there was no current maturity. However, we settled this obligation with cash proceeds from a new long-term credit facility at the consummation of the Business Separation on October 31, 2011. The total debt outstanding as of December 31, 2011 includes $324.5 million from this credit facility (Note 5 to our audited consolidated financial statements included herein).

(6) 

The financial statements of Lumos Networks for the period January 1, 2011 through October 31, 2011 and as of and for the years ended December 31, 2010, 2009, 2008 and 2007 have been adjusted to reflect certain corporate expenses, including equity-based compensation expense, of NTELOS which were not previously allocated to the NTELOS segments (see Note 3 to the audited consolidated financial statements included herein). These adjustments have been reflected beginning January 1, 2006. Equity attributable to Lumos Networks has not been adjusted to reflect these corporate expenses for periods prior to January 1, 2006.

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

You should read the following discussion of our financial condition in conjunction with our consolidated financial statements and the related notes included herein (Item 8). This discussion contains forward looking statements that involve risks and uncertainties. For additional information regarding some of these risks and uncertainties that affect our business and the industry in which we operate, please see “Risk Factors” and “Forward-Looking Statements” elsewhere in this report.

Overview

On October 14, 2011, NTELOS announced a distribution date of October 31, 2011 for the spin-off of all of the issued and outstanding shares of common stock of Lumos Networks, which operated NTELOS’s wireline operations. Prior to and in connection with the Business Separation, following the market close on October 31, 2011, NTELOS effectuated a 1-for-2 reverse stock split of its shares of common stock. The spin-off of Lumos Networks was in the form of a tax-free stock distribution to NTELOS’s stockholders of record as of the close of business on October 24, 2011, the record date. On October 31, 2011, NTELOS distributed one share of Lumos Networks common stock for every share of NTELOS common stock outstanding, on a post-Reverse Stock Split basis. As of November 1, 2011, we are publicly traded on NASDAQ under the ticker symbol “LMOS.”

In connection with the Business Separation, we paid $315 million to NTELOS (i) to settle with cash the intercompany debt owed to NTELOS as of the Business Separation date ($177.1 million) and, with the balance, (ii) to fund a mandatory repayment on NTELOS’s senior secured credit facility resulting from the Business Separation.

Lumos Networks is a fiber-based network service provider in the Mid-Atlantic region supported by an extensive fiber optic network, with approximately 5,800 route-miles in western Virginia, West Virginia, and portions of Pennsylvania, Maryland, Ohio and Kentucky. We serve carrier, business and residential customers over a dense fiber network offering data, voice, and IP services using an on-network service strategy. Our product offerings include voice services, high speed transport, private line and wavelength high-bandwidth services, which provides a means to efficiently utilize fiber in broadband applications and to provide high-capacity bandwidth, and Metro Ethernet, which provides Ethernet connectivity among multiple locations in the same city or region over our fiber optic network.

Our strategy is to (i) leverage our network assets with sales of data and IP based services to new and existing regional enterprise and government customers; (ii) expand the Competitive segment to add additional on-net locations and connect additional wireless carrier cell sites and networks; (iii) continue to provide high quality customer service with low churn and a compelling value proposition; and (iv) generate cash flow from the additional sales of fiber based broadband and IP video services to our RLEC customer base and targeted non-RLEC developments.

Central to our strategy is being first to the regional markets with advanced technology and services first introduced in metropolitan areas by national service providers. Our tradition of service and creative and tailored service solutions with a diversified portfolio of products is attractive to carriers with needs for transport and fiber to the cell site and to regional enterprise customers seeking high quality data and IP services and interconnection to data centers in the region.

Our growth into a regional service provider has been achieved by pursuing organic growth opportunities and complementary acquisitions. On December 31, 2009, we closed on an agreement to purchase certain fiber optic and network assets and related transport and data service contracts from Allegheny Energy, Inc. The purchase included approximately 2,200 route-miles of fiber located primarily in central and western Pennsylvania and West Virginia, with portions also in Maryland, Kentucky and Ohio. With this expansion of our fiber optic network, we began to accelerate our growth initiatives in our Competitive segment’s enterprise business in certain West Virginia, Maryland and Pennsylvania local markets. On December 1, 2010, we closed on a purchase agreement with One Communications Corp. to acquire its FiberNet business for net cash consideration of approximately $163 million. The FiberNet fiber optic network covers all of West Virginia and extends into surrounding areas in Ohio, Maryland, Pennsylvania, Virginia and Kentucky, providing further diversity and density in several of our existing markets, particularly in West Virginia. FiberNet offered retail voice and data services and transport and IP-based services primarily to regional retail and wholesale business customers. We are offering additional data and other broadband services to existing FiberNet customers and are attracting new customers in our existing and new markets with our enterprise data products in order to grow top line revenue and further leverage our operational and back office platforms while fully realizing the operational synergies available. In all markets, we will continue to extend our network to customers in order to improve network quality, eliminate access-related expenses and control the customer experience. We have no future payment obligations related to either of these acquisitions.

 

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Business Separation

As described above, NTELOS decided to separate its wireline business into a new independent, publicly-traded company through the distribution of all of our common stock to the NTELOS stockholders, which we refer to as the Business Separation. We have entered into a separation and distribution agreement containing key provisions related to the Business Separation and assets transferred, liabilities assumed and contracts assigned to us. For a period of time, we will utilize NTELOS for transition services for certain corporate and information technology functions under a transition services agreement (“TSA”). We anticipate our annualized cost of TSA services to be approximately $2.0 million and anticipate that we will provide TSA services to NTELOS for certain corporate functions for an annualized charge of approximately $0.7 million.

Our capital structure changed at the date of the Business Separation (October 31, 2011). On September 8, 2011, we closed on a $370 million post-Business Separation credit facility (the “Credit Facility”). Funding under the Credit Facility occurred upon consummation of the Business Separation. The Credit Facility consists of a $60 million senior secured five year revolving credit facility (the “Revolver”), $30 million of which was drawn upon funding; a $110 million senior secured five year amortizing term loan (the “Term Loan A”); and a $200 million senior secured six year amortizing term loan (the “Term Loan B”). The proceeds of the Credit Facility were received on October 31, 2011 and were used to fund a working capital cash reserve and to pay $315 million to NTELOS (i) to settle with cash the intercompany debt owed to NTELOS as of the Business Separation date ($177.1 million) and, with the balance, (ii) to fund a mandatory repayment on NTELOS’s credit facility resulting from the Business Separation. Pricing of the Credit Facility will be Eurodollar rate (“LIBOR”) plus 3.25% for the Revolver and the Term Loan A and LIBOR plus 3.50% for the Term Loan B. The Credit Facility does not require a minimum LIBOR rate. The terms of the Credit Facility include customary covenants that require us to meet certain financial tests, maintain certain financial ratios, adhere to guidelines for dividend payments, and requires us to hedge 50% of the Term Loan A and Term Loan B outstanding balance in order to reduce our exposure to fluctuations in variable interest rates.

Financial data included in this Form 10-K reflects Lumos Networks as a standalone public company. Revenue includes services sold to the NTELOS wireless segment that was previously eliminated, which amounted to $6.6 million for the period January 1, 2011 through October 31, 2011 and $7.0 million and $5.9 million for the years ended December 31, 2010 and 2009, respectively. Expenses include items previously unallocated by NTELOS, inclusive of legal and professional fees, equity-based compensation expense and certain expenses related to acquisitions. These additional expenses for the period January 1, 2011 through October 31, 2011 totaled $2.6 million and for the years ended December 31, 2010 and 2009 totaled $5.1 million (inclusive of $2.8 million of FiberNet acquisition costs) and $1.8 million, respectively.

We are incurring additional expenses as a result of the Business Separation, including higher interest expense. We also are incurring expenses related to transition services from NTELOS and will continue to incur such expenses for a period of time not to exceed two years as specified in the transition services agreement with NTELOS. Upon the expiration or early termination of the transition services agreement or other agreements, many of the services that are covered in such agreements will be provided internally or by unaffiliated third-parties, and we expect that, in some instances, we will incur higher costs to obtain such services than we incurred prior to the Business Separation or under the terms of such agreements. While we do not expect these higher costs to be material, the amount and timing of when we incur such additional costs may increase the variability of our earnings and cash flows. If we are unable to lower other expenses or increase revenues, these additional expenses also will lower our earnings and our cash flows. We incurred one-time costs for customer and marketing communications, and are incurring additional costs of being a public company and costs associated with creating a new information technology infrastructure. On a recurring basis, we will incur additional costs to maintain independent systems and to continue brand support, and we will incur incremental costs related to being a public entity in excess of previously allocated corporate expenses. However, we do not expect these additional and incremental costs to be material to our earnings and cash flows.

We offer benefits similar to those provided by NTELOS to our employees prior to the Business Separation. The primary benefits include a pension plan, other postretirement benefit plans (“OPEBs”), medical benefits and a 401(k) plan. A separate pension plan and OPEB plan were established at the effective date of the Business Separation and the related assets and liabilities attributable to our current employees, as well as former employees in NTELOS’s wireline operations, were transferred to and assumed by us. The pension plan covers all employees who meet eligibility requirements and who were employed by NTELOS Inc. prior to October 1, 2003. The OPEBs plan includes certain health care and life benefits for retired employees who meet eligibility requirements and for current employees that were hired before April 1993.

 

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Obligations under NTELOS’s pension and OPEBs were transferred to our company based on the eligible employees who transferred to our company and former retirees currently receiving (or eligible to receive) benefits. In our historical financial statements, we recognized allocated costs for pension and OPEB benefits with the offsetting obligation recorded as a payable to NTELOS. Medical benefit and 401(k) match costs have historically been allocated to the business. In the future, these benefit costs will be based on our independent plans and actual costs incurred by Lumos Networks employees, which will vary from historical allocated costs.

Business Segments

We operate our business as two segments: a competitive network service provider and a traditional RLEC. The Competitive segment derives revenue from the sale of data, Internet-based services, traditional voice services primarily to enterprise customers and carrier transport services to other carriers. Our Competitive business serves Virginia, West Virginia, and Pennsylvania, Maryland, Kentucky and Ohio over an approximately 5,800 route-mile fiber network as of December 31, 2011. We market and sell data transport, IP-based services and voice services almost exclusively to business, government and carrier customers. Revenues from the Competitive segment accounted for approximately 75%, 61% and 54% of our total revenue for the years ended December 31, 2011, 2010 and 2009, respectively. Pro forma to include the FiberNet acquisition for the year ended December 31, 2010, the Competitive segment accounted for approximately 73% of our total revenue.

We experienced higher than anticipated churn in the Competitive segment from the residential and small business customer base in the FiberNet markets of West Virginia. This was largely due to competitive actions and service issues prior to closing and ongoing tied to the incumbent local exchange carrier from whom we purchase network elements on a wholesale basis. We also have generated lower than expected new sales as we further develop these markets. We anticipate that these churn and new sales trends may continue into 2012. However, we also have been and continue to take proactive measures to further enhance our growth in West Virginia such as strengthening the network serving West Virginia to improve service and facilitate the sale of our data and IP-based services, and focusing our sales efforts on upgrading the former FiberNet large customer base to metro-Ethernet facilities.

The RLEC provides service to the rural Virginia cities of Waynesboro and Covington, and portions of Alleghany, Augusta and Botetourt counties. The RLEC utilizes an Alcatel-Lucent 5ESS digital switch serving as a tandem switch to our local region. We have enhanced network functionality in the RLEC by offering high speed broadband to 98% of our service region. We have also invested in fiber-to-the-home, which passed approximately 14,800 homes as of December 31, 2011. The fiber network provides the foundation for IP-based video services, currently up to 20 Mbps high speed Internet services and will allow us to offer future high-bandwidth applications as they evolve. While the RLEC owns the fiber, the products are sold through the Competitive segment. The Competitive segment purchases basic fiber services from the RLEC but provides its own sales, customer service and customer equipment to these RLEC customers. The intercompany revenue is eliminated in our consolidated statements of operations.

In the RLEC market, our fiber-to-the-home deployment significantly reduces churn in the areas where it is offered. In 2010, we received a federal broadband stimulus award to bring broadband services and infrastructure to Alleghany County, Virginia. The total project is $16 million, of which 50% ($8 million) is being funded by the grant from the federal government. We commenced this project in 2010 and began offering higher speed broadband services in Alleghany County in the fourth quarter of 2010, and we have incurred $6.7 million of total project costs through December 31, 2011. The project is required to be completed in 2015.

As of December 31, 2011, we operated approximately 33,200 RLEC telephone access lines. We have experienced access line losses in each of the last three years due to cable competition, wireless substitution and the economic climate. We lost approximately 2,200 access lines during 2011. These line losses, coupled with mid-year 2011 rate reductions as a result of our biennial tariff filing with the FCC for one of our RLECs, access reconfigurations and network grooming by carriers, contributed to an 8.4% decline in RLEC revenues from 2010 to 2011.

We anticipate significant further access revenue declines in the RLEC segment as a result of recent actions taken by applicable regulatory authorities, principally the FCC and the SCC. Access revenue also will be negatively impacted by network grooming by carriers, which commenced in 2011 and is expected to continue in 2012 and beyond. On October 27, 2011, the FCC adopted, but did not release, an order comprehensively reforming its Universal Service Fund and intercarrier compensation systems. On November 18, 2011, the FCC released the order.

 

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In the order, the FCC determined that interstate and intrastate access charges, as well as local reciprocal compensation, should be eliminated entirely over time (see Access Charges and Universal Service in “Regulation”). Our combined RLEC revenues from access and the USF was $33.0 million ($18.7 million of which was from intra-state access revenues and $5.3 million was from USF) for 2011 as compared to access revenues of $36.8 million for 2010 and $38.3 million for 2009. As a result of these factors, we updated our impairment testing of goodwill and the franchise rights indefinite-lived intangible asset and determined that both the RLEC goodwill and the franchise rights were fully impaired. Accordingly, we recorded a $65.4 million asset impairment charge ($53.0 million after tax). We determined that there was no impairment of the Competitive segment goodwill based on this testing.

We performed recovery testing of our long-lived tangible and finite-lived intangible assets as of October 27, 2011 utilizing the methodology noted above in ASC 360-10-35. We passed step one of this recoverability testing and therefore, no further testing for impairment of these assets on either segment was considered necessary. However, on October 31, 2011, in connection with the Business Separation and the related transfer of all of the wireline assets in the tax-free exchange, we assessed the fair value of the asset groups transferred. To the extent that the carrying value of each of the asset groups exceeds the fair value, a pro-rata writedown of these assets to fair value is required. Although the RLEC segment assets passed the undiscounted cash flow recoverability test in ASC 360-10-35 on October 27, 2011, the fair value of the RLEC segment assets was determined to be lower than the carrying value by $20.9 million ($12.7 million net of tax) and an impairment charge was recorded accordingly.

Excluding the impact of the aforementioned asset impairment charges in 2011, our operating income margins were approximately 24%, 28% and 31% for the years ended December 31, 2011, 2010 and 2009, respectively. The decrease in the margin is primarily due to a shift in the composition of the business to a higher percentage being represented by Competitive after the FiberNet acquisition (Note 1) and the RLEC access reconfigurations discussed above. The products from the Competitive segment generally yield a lower margin than the RLEC business. The decrease in the margin is also due to certain of the FiberNet intangible assets having heavier amortization charges in the initial years (Note 3) and due to the fact that the FiberNet business currently contains a higher percentage of lower margin residential customers as compared to the Competitive segment’s legacy higher margin business and other enterprise accounts.

Market Risks

Many of the market risk factors described above which affected our results of operations in 2011 are expected to continue into 2012.

Operating Revenues

Our revenues are generated from the following categories:

 

   

Competitive segment revenues, including revenues from Enterprise Data (Dedicated Internet, Metro Ethernet, and private line), Residential and Small Business Broadband (Integrated Access, DSL, Broadband XL, and IP based video), Wholesale Transport, Voice (local lines, PRI, and Long Distance) and other legacy Competitive products and revenue streams (dial-up Internet services, switched access and reciprocal compensation); and

 

   

RLEC segment revenues, including local service, network access, toll and directory advertising.

Operating Expenses

Our operating expenses are incurred from the following categories:

 

   

cost of sales and services, including usage-based access charges, long distance and other direct costs incurred in accessing other telecommunications providers’ networks in order to provide telecommunication services to our end-user customers, leased facility expenses for connection to other carriers and engineering and repairs and maintenance expenses related to network property, plant and equipment;

 

   

customer operations expenses, including marketing, product management, product advertising, selling, billing, publication of regional telephone directories, customer care, directory services, customer retention and bad debt expenses;

 

   

corporate operations expenses, including taxes other than income, executive services, accounting, legal, purchasing, information technology, human resources and other general and administrative expenses, including earned bonuses and equity-based compensation expense related to stock and option instruments held by certain members of corporate management and expenses related to acquisitions;

 

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depreciation and amortization, including depreciable long-lived property, plant and equipment and amortization of intangible assets where applicable, and accretion of asset retirement obligations; and

 

   

asset impairment charges relating to the impairment of the RLEC segment goodwill and franchise rights intangible asset.

Other Income (Expenses)

Our other incomes (expenses) are generated (incurred) from interest expense on debt instruments and capital lease obligations, interest expense on accounts due to NTELOS (prior to the Business Separation) and other income (expense), which includes interest income and fees, expenses related to our senior secured credit facility and, as appropriate, related charges or amortization of debt issuance fees.

Income Taxes

Prior to the Business Separation, our income taxes were included in the NTELOS consolidated federal income tax return and certain unitary or consolidated state income tax returns of NTELOS. However, our income taxes were calculated and provided for on an “as if separate” tax return basis. Our income tax expense and effective tax rate increases or decreases based upon changes in a number of factors, including our pre-tax income or loss, state minimum tax assessments, and non-deductible expenses.

Noncontrolling Interests in Losses (Earnings) of Subsidiaries

We have an RLEC segment partnership with a 46.3% noncontrolling interest that owns certain signaling equipment and provides service to a number of small RLECs and to TNS.

Results of Operations

Year ended December 31, 2011 compared to year ended December 31, 2010

Operating revenues increased $61.5 million, or 42.1%, from 2010 to 2011 resulting from an increase in Competitive segment revenues of $66.3 million and partially offset by a decrease in RLEC revenues of $4.8 million. Pro forma to include FiberNet (which is included in the Competitive segment) for the year ended December 31, 2010, total operating revenues were $213.1 million, compared to $207.4 million for the year ended December 31, 2011, representing a decrease of $5.6 million.

Pro forma Competitive segment revenues decreased $0.8 million, or 0.5%, from 2010 to 2011 primarily from declines in voice and other products related to FiberNet operations, partially offset by increased revenues from Enterprise Data and wholesale services. As noted above, RLEC segment revenues declined $4.8 million from the prior year due primarily to the loss of access lines described in the overview above, a biennial reset (reduction) of our interstate access rates in the third quarter of 2011 and revenue reductions related to interexchange carrier network grooming.

Operating income decreased $77.5 million from income of $41.1 million in 2010 to a loss of $36.4 million in 2011 due primarily to $86.3 million of asset impairment charges recorded in 2011, as described in the overview section above. Excluding the 2011 asset impairment charges, operating income increased $8.8 million from 2010 to 2011 due to the $61.5 million increase in revenue discussed above, partially offset by an increase in operating expenses of $52.7 million. Operating expenses for 2011 include $58.9 million of operating expenses from FiberNet, while operating expenses for 2010 include $4.9 million of operating expenses from FiberNet, representing one month of expenses post-acquisition. Excluding the operating expenses from FiberNet and the aforementioned asset impairment charges, operating expenses were down 1.3% from 2010 to 2011. Variances in the individual line items on the condensed combined statements of operations are described in the operating expenses section below.

Net income attributable to Lumos Networks decreased $64.8 million due in large part to the $86.3 million of asset impairment charges ($65.7 million net of tax) discussed above. Excluding the effects of the 2011 asset impairment charges, net income attributable to Lumos Networks increased $1.0 million, or 4.7%, from 2010 to 2011 as the $8.8 million increase in operating income was primarily offset by (1) $6.2 million increase in interest expense related to the additional debt from NTELOS Inc. incurred in December 2010 to fund the FiberNet acquisition and interest related to our $340 million borrowing under our senior secured credit facility on October 31, 2011 in connection with the Business Separation (Notes 1 and 5) $1.7 million increase in income tax expense.

 

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OPERATING REVENUES

The following table identifies our external operating revenues by business segment for years ended December 31, 2011 and 2010:

 

     Year Ended
December 31,
     $     %  

Operating Revenues

   2011      2010      Variance     Variance  

(Dollars in thousands)

          

Competitive

   $ 154,757       $ 88,471       $ 66,286        74.9

RLEC

     52,657         57,493         (4,836     (8.4 %) 
  

 

 

    

 

 

    

 

 

   

Total

   $ 207,414       $ 145,964       $ 61,450        42.1
  

 

 

    

 

 

    

 

 

   

Revenues for 2011 increased $61.5 million, or 42.1%, over 2010, with revenues from the Competitive segment increasing approximately 75% driven by the new revenues from FiberNet. Pro forma to include FiberNet for the year ended December 31, 2010, total revenues decreased by $5.6 million, or 2.6%, as described by segment below.

 

 

Competitive Revenues. Competitive revenues, pro forma to include FiberNet for year ended December 31, 2010, decreased $0.8 million, or 0.5%, from 2010 to 2011. This decrease was primarily due to a $7.5 million decline in voice and long distance revenues, principally associated with FiberNet, and a $2.6 million decline in other non-strategic revenues, including dial-up Internet and reciprocal compensation. These decreases were partially offset by increased revenues from Enterprise Data and Residential and Small Business Broadband services of $4.4 million over 2010 and a $4.9 million increase in wholesale revenues over 2010.

 

 

RLEC Revenues. RLEC revenues decreased $4.8 million, or 8.4%, from 2010 to 2011 primarily due to decreased access and local service revenues resulting from a 6.3% decrease in access lines. Also contributing to the decrease was network grooming by our carrier customers with whom we interconnect and for whom we provide access services. Finally, on July 1, 2011, our interstate access rates were subject to a biennial reset (reduction), which resulted in a $1.2 million reduction in revenue during the second half of 2011. We anticipate that this rate reset will result in a comparable monthly reduction in revenue during 2012.

Additionally, as noted in the overview section above, recent actions from regulatory authorities will cause rate declines in future years which are more significant than what we have experienced in recent years. We also are being negatively impacted by carriers’ network grooming that began in the fourth quarter of 2011.

Access lines totaled approximately 33,200 as of December 31, 2011 and approximately 35,400 as of December 31, 2010, a 2,200 line decline. This access line loss is reflective of residential wireless substitution, the effect of current economic conditions on businesses and competitive voice service offerings from cable operators in our RLEC markets.

 

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OPERATING EXPENSES

The following table identifies our operating expenses by business segment, consistent with the table presenting operating revenues above, for the years ended December 31, 2011 and 2010:

 

     Year Ended
December 31,
     $     %  

Operating Expenses

   2011      2010      Variance     Variance  

(Dollars in thousands)

          

Competitive

   $ 94,045       $ 51,155       $ 42,890        83.8

RLEC

     16,429         17,755         (1,326     (7.5 %) 
  

 

 

    

 

 

    

 

 

   

Operating expenses, before equity-based compensation expense, acquisition related charges, Business Separation related charges, depreciation and amortization and accretion of asset retirement obligations and asset impairment charges

     110,474         68,910         41,564        60.3

Equity-based compensation expense

     2,383         1,529         854        55.9

Acquisition related charges

     71         3,020         (2,949     (97.6 %) 

Business Separation related charges

     1,358         —           1,358        N/M   

Depreciation and amortization

     43,090         31,365         11,725        37.4

Accretion of asset retirement obligations

     116         11         105        N/M   

Asset impairment charges

     86,295         —           86,295        N/M   
  

 

 

    

 

 

    

 

 

   

Total operating expenses

   $ 243,787       $ 104,835       $ 138,952        132.5
  

 

 

    

 

 

    

 

 

   

The following describes our operating expenses by segment and on a basis consistent with our financial statement presentation.

 

   

Competitive—The increase noted in the table above was driven by a $42.7 million increase in expenses related to our FiberNet operations, which increase reflects the inclusion of FiberNet for the full twelve months of 2011 as opposed to one month in 2010 as a result of the acquisition of FiberNet in December 2010.

 

   

RLEC—The decrease of $1.3 million was driven primarily by a reduction in corporate expense allocations which have been shifted to the Competitive segment which is a reflection of the change in the relative sizes of the segments.

COST OF SALES AND SERVICES—Cost of sales and services increased $32.1 million, or 69.1%, over 2010. FiberNet accounted for $31.5 million of this increase. Other expenses contributing to the net increase was access expense and compensation and benefits. We expect network expenses related to the original FiberNet customer base to decline due to churn of residential and other narrowband customers and as we groom this network by pruning leased facilities and by servicing more customers on our network to eliminate lease access expenses and improve the quality of the service.

CUSTOMER OPERATIONS EXPENSES—Customer operations expenses increased $6.3 million, or 47.6%, over 2010 primarily due to FiberNet. The remainder of the increase is primarily attributable to increased compensation and benefits, including equity-based compensation expense and sales commissions. These increases were partially offset by a decrease in directory expenses.

CORPORATE OPERATIONS EXPENSES—Corporate operations expense increased $2.4 million, or 17.7% over 2010. Included in this increase is an increase of $4.5 million in expenses related to FiberNet. Also included in the increase over 2010 are charges of $1.4 million incurred during 2011 related to the Business Separation, and increases in compensation and benefits, including equity-based compensation expense. Partially offsetting these increases was a decrease of $2.9 million from 2010 representing charges incurred during 2010 for the acquisition of FiberNet. Also decreasing from 2010 to 2011 were legal and professional fees allocated from NTELOS.

 

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DEPRECIATION AND AMORTIZATION—Depreciation and amortization increased $11.7 million, or 37.4%, over 2010. This increase is primarily attributable to a $63.1 million increase in average depreciable assets (20%) due to the increase from the FiberNet acquisition and the $61.5 million of 2011 capital expenditures and a $6.8 million increase in amortization expense. The increases in amortization expense related to the addition of customer and other amortizable intangible assets from the FiberNet acquisition, a majority of the amortization expense for which is escalated in the early years of the asset lives based on these assets’ estimated pattern of benefit.

ASSET IMPAIRMENT CHARGES—In 2011, we recorded asset impairment charges which totaled $86.3 million ($65.7 million after tax) in its RLEC segment related to the impairment of the RLEC franchise rights and goodwill ($65.4 million; $53.0 million after tax) due to the aforementioned significant future access revenue decline related to interconnection carrier’s network grooming and the regulatory rate reform. Additionally, we recorded a $20.9 million ($12.7 million after tax) asset impairment charge related to the excess of carrying value over book value of the RLEC property, plant and equipment, customer intangible and trademarks on the date of the transfer. The projected effect of both the rate reform and carrier’s network grooming have occurred or are predicted to occur much sooner and the impact is substantially greater than previously estimated.

OTHER INCOME (EXPENSES)

Interest expense for the years ended December 31, 2011 and 2010 was $12.0 million and $5.8 million, respectively, a $6.2 million, or 109%, increase. This increase was due primarily to the increase in the obligation to NTELOS Inc. on December 1, 2010 relating to the FiberNet acquisition and the $340 million new credit facility drawn on October 31, 2011, a portion of which was used to pay off the obligation to NTELOS Inc. in connection with the Business Separation. The annual interest expense related to the new credit facility is projected to be approximately $13 million.

INCOME TAXES

Income tax expense/(benefit) for the years ended December 31, 2011 and 2010 was $(4.4) million and $14.5 million, respectively, representing the statutory tax rate applied to pre-tax income and the effects of certain non-deductible compensation. We expect our recurring non-deductible expenses to relate primarily to certain non-cash equity-based compensation . For 2012, the amount of these charges is expected to be approximately $0.3 million.

We have prior year unused net operating losses, including certain built-in losses (“NOLs”) totaling $5.6 million as of December 31, 2011. These NOLs are subject to an adjusted annual maximum limit (the “IRC 382 Limit”) of $0.3 million. Based on the IRC 382 Limit, we expect to use NOLs of approximately $3.9 million as follows: $0.7 million in 2012 and $0.3 million per year in 2013 through 2022. In addition, we expect to realize an NOL in 2011 as a result of the significant increase in bonus depreciation due to the passage of the “Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010.” We believe that it is more likely than not that the results of future operations will generate sufficient taxable income to realize the deferred tax assets.

Year ended December 31, 2010 compared to year ended December 31, 2009

Total revenue increased $15.4 million, or 11.8%, over 2009 despite a $2.0 million decline in RLEC revenues. The Competitive segment increase of $17.4 million resulted from (i) a 26% organic growth rate in Metro Ethernet services, (ii) an 18% organic growth rate in carrier transport and (iii) revenues associated with the fiber optic assets acquired from Allegheny Energy, Inc. on December 31, 2009 and revenues associated with the purchase of FiberNet on December 1, 2010. Organic growth is fueled by success-based fiber builds which are often leveraged by adding additional customers in close proximity and serve to reduce third party access expense and control service quality.

Operating expenses increased $14.8 million driven by increases of approximately $3.0 million and nearly $4.0 million related to the new Allegheny markets and the FiberNet acquisition, respectively, $5.2 million from corporate operations for transaction and legal expenses and $2.7 million for higher depreciation and amortization. Excluding the $3.0 million of FiberNet acquisition costs, operating income increased 8.9% over 2009.

Net income attributable to Lumos Networks decreased $2.5 million, or 10.5%, from 2009 to 2010. Offsetting the $0.6 million increase in operating income is additional interest expense of $4.3 million for the additional debt from NTELOS Inc. primarily to fund the Allegheny and FiberNet acquisitions, partially offset by $1.3 million of lower tax expense.

 

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OPERATING REVENUES

The following table identifies our external operating revenues by business segment for the years ended December 31, 2010 and 2009:

 

     Year Ended
December 31,
     $     %  

Operating Revenues

   2010      2009      Variance     Variance  

(Dollars in thousands)

          

Competitive

   $ 88,471       $ 71,086       $ 17,384        24.5

RLEC

     57,493         59,509         (2,016     (3.4 %) 
  

 

 

    

 

 

    

 

 

   

Total

   $ 145,964       $ 130,595       $ 15,369        11.8
  

 

 

    

 

 

    

 

 

   

Revenues increased $15.4 million, or 11.8%, over 2009, with revenues from the Allegheny asset acquisition of nearly $7 million in 2010 and revenues from the FiberNet acquisition of nearly $6 million in 2010. Excluding the revenue from the aforementioned acquisitions, success based investments in Enterprise Data, broadband services and transport services led to a $6.3 million, or 14.1%, increase in revenues from these products within the Competitive segment. These increases were partially offset by a $2.0 million, or 3.4%, decrease in RLEC revenues and a $1.7 million decrease in voice and legacy other Competitive segment revenues. Excluding the Allegheny and FiberNet revenues, Competitive revenue grew 6.6% and total revenue grew 2.0% over 2009.

 

 

Competitive Revenues. Competitive revenue increased $17.4 million over 2009, which includes approximately $13 million from the Allegheny and FiberNet acquisitions. Excluding these new revenues from acquisitions, Enterprise Data and Residential and Small Business Broadband revenue from our markets increased $3.3 million while wholesale revenue increased $3.0 million. Additionally, excluding new revenues from acquisitions, Metro Ethernet revenue increased 26% due to an increase in customer connections of 23%, but revenues from voice and other legacy products, including dial-up Internet, reciprocal compensation and switched access, decreased $1.3 million from 2009. We expect to introduce the additional Enterprise Data and Broadband services to our new customers acquired in the FiberNet acquisition and into the FiberNet and Allegheny markets that are new to us.

 

 

RLEC Revenues. RLEC revenues decreased $2.0 million, or 3.4%, from 2009 primarily due to decreased access and local service revenues resulting from a 7.4% decrease in access lines. On July 1, 2009, our interstate access rates were subject to a regulatory biennial reset (reduction). This rate reset coupled with network grooming contributed to the revenue reduction.

Access lines totaled approximately 35,400 as of December 31, 2010 and approximately 38,200 as of December 31, 2009. This access line loss is reflective of residential wireless substitution, competition from cable companies and the effect of current economic conditions on businesses.

 

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OPERATING EXPENSES

The following table identifies our operating expenses by business segment, consistent with the table presenting operating revenues above, for the years ended December 31, 2010 and 2009:

 

     Year Ended
December 31,
     $     %  

Operating Expenses

   2010      2009      Variance     Variance  

(Dollars in thousands)

          

Competitive

   $ 51,155       $ 43,277       $ 7,878        18.2

RLEC

     17,755         17,208         547        3.2
  

 

 

    

 

 

    

 

 

   

Operating expenses, before equity-based compensation expense, voluntary early retirement and workforce reduction plans, acquisition related charges, depreciation and amortization and accretion of asset retirement obligations

     68,910         60,485         8,425        13.9

Equity-based compensation expense

     1,529         794         735        92.5

Voluntary early retirement and workforce reduction plans

     —           59         (59     (100.0 %) 

Acquisition related charges

     3,020         —           3,020        N/M   

Depreciation and amortization

     31,365         28,641         2,724        9.5

Accretion of asset retirement obligations

     11         78         (67     (85.9 %) 
  

 

 

    

 

 

    

 

 

   

Total operating expenses

   $ 104,835       $ 90,057       $ 14,778        16.4
  

 

 

    

 

 

    

 

 

   

The following describes our operating expenses by segment and on a basis consistent with our financial statement presentation. This discussion relates to our operating expenses by segment before equity-based compensation expense, voluntary early retirement plan and workforce reductions, expenses related to acquisitions, depreciation and amortization and accretion of asset retirement obligations:

 

   

Competitive— The increase noted in the table above was driven by additional expenses related to FiberNet operations of approximately $4.0 million in December 2010 and additional expenses related to the December 2009 Allegheny asset acquisition of approximately $3.0 million. For 2011, we believe we will achieve network efficiencies with FiberNet and improve the customer mix to more on-net customers.

 

   

RLEC—The increase of $0.5 million was driven by professional fees associated with access revenue disputes and higher operating taxes.

COST OF SALES AND SERVICES—Cost of sales and services increased $6.3 million primarily attributable to increases of approximately $2.8 million and $3.1 million related to the new Allegheny network and the FiberNet acquisition, respectively. The remaining increase of $0.4 million is incremental access expense as a result of Competitive growth. Overall, direct access expense as a percentage of revenue decreased from 24% in 2009 to 22% in 2010.

CUSTOMER OPERATIONS EXPENSES—Customer operations expenses increased $0.6 million primarily for incremental costs of FiberNet operations.

CORPORATE OPERATIONS EXPENSES—Corporate operations expense increased $5.1 million from 2009 to 2010. Results for 2010 include $3.0 million of legal and professional fees related to the acquisition of FiberNet. The increase over 2009 is also attributable to a $0.9 million increase in expense related to a discretionary annual cash bonus and an increase in equity-based compensation expense. Other increases include legal and professional fees, operating taxes and regulatory fees, which collectively increased $1.1 million over 2009.

DEPRECIATION AND AMORTIZATION EXPENSES—Depreciation and amortization expenses increased $3.0 million, or 8.5%, from 2009 to 2010. This increase is primarily attributable to a 30% increase in the asset base which contributed to an increase in depreciation expense of $1.8 million. Amortization expense increased $1.2 million, or 16.5%, related to the addition of a customer list intangible asset from the Allegheny asset acquisition on December 31, 2009 and customer and other amortizable intangible assets from the FiberNet acquisition on December 1, 2010.

 

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OTHER INCOME (EXPENSES)

Interest expense increased $4.3 million, or 289%, from 2009 due primarily to the increase in the payable to NTELOS to support the FiberNet acquisition. Interest is charged to us by NTELOS based on NTELOS weighted average borrowing rate without the inclusion of debt issuance cost and original issue discount amortization. Other income (expense) was flat between 2009 and 2010.

INCOME TAXES

Income tax expense for 2010 was $14.5 million, with an effective rate of 40.9% representing the statutory tax rate applied to pre-tax income and the effects of certain non-deductible compensation, noncontrolling interests and other non-deductible expenses. Income taxes for 2009 were $15.8 million with an effective rate of 40.2%.

Quarterly Results

The following table sets forth selected unaudited consolidated quarterly statement of operations data for the four quarters in 2010 and 2011. This unaudited information has been prepared on substantially the same basis as our consolidated financial statements appearing elsewhere in this report and includes all adjustments (consisting of normal recurring adjustments) we believe necessary for a fair statement of the unaudited consolidated quarterly data. The unaudited consolidated quarterly statement of operations data should be read together with the consolidated financial statements and related notes thereto included elsewhere in this report. The results for any quarter are not necessarily indicative of results for any future period, and you should not rely on them as such.

 

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Summary Operating Results (Unaudited)(1)

(In thousands, except per share amounts)

  December 31,
2011
    September 30,
2011
    June 30,
2011
    March 31,
2011
    December 31,
2010
    September 30,
2010
    June 30,
2010
    March 31,
2010
 

Operating Revenues

               

Competitive

  $ 39,401      $ 38,494      $ 38,473      $ 38,389      $ 27,071      $ 20,957      $ 20,248      $ 20,195   

RLEC

    11,706        13,107        13,589        14,255        13,942        14,596        14,095        14,860   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total Operating Revenues

    51,107        51,601        52,062        52,644        41,013        35,553        34,343        35,055   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Operating Expenses

               

Competitive

    24,367        22,764        23,002        23,912        15,678        11,931        11,670        11,876   

RLEC

    3,736        4,190        4,035        4,468        4,257        4,208        4,264        5,026   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Operating expenses, before depreciation and amortization and accretion of asset retirement obligations, asset impairment charges, equity-based compensation expense and acquisition related charges

    28,103        26,954        27,037        28,380        19,935        16,139        15,934        16,902   

Depreciation and amortization and accretion of asset retirement obligations

    10,217        10,934        11,025        11,030        9,073        7,403        7,601        7,299   

Asset impairment charges

    86,295        —          —          —          —          —          —          —     

Equity-based compensation expense

    237        784        674        688        422        387        377        343   

Acquisition related charges

    1        (10     39        41        2,171        849        —          —     

Business Separation related charges

    1,358        —          —          —          —          —          —          —     
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total Operating Expenses

    126,211        38,662        38,775        40,139        31,601        24,778        23,912        24,544   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Operating (Loss) Income

    (75,104     12,939        13,287        12,505        9,412        10,775        10,431        10,511   

Other Income (Expenses)

               

Interest expense

    (3,153     (2,559     (2,563     (3,718     (1,931     (1,065     (1,373     (1,383

Other income (expense)

    32        66        (7     14        18        9        11        5   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
    (3,121     (2,493     (2,570     (3,704     (1,913     (1,056     (1,362     (1,378
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
    (78,225     10,446        10,717        8,801        7,499        9,719        9,069        9,133   

Income Tax (Benefit) Expense

    (16,527     4,249        4,157        3,738        3,175        3,973        3,706        3,623   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net (Loss) Income

    (61,698     6,197        6,560        5,063        4,324        5,746        5,363        5,510   

Net Loss (Income) Attributable to Noncontrolling Interests

    35        (2     (37     (48     (28     (13     (71     (7
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net (Loss) Income Attributable to Lumos Networks Corp.

  $ (61,663   $ 6,195      $ 6,523      $ 5,015      $ 4,296      $ 5,733      $ 5,292      $ 5,503   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Basic and Diluted Loss per Common Share Attributable to Lumos Networks Corp. Stockholders:

               

Earnings (loss) per share – basic and diluted (2)

  $ (2.96   $ 0.30      $ 0.31      $ 0.24           

Weighted average shares outstanding – basic and diluted (2)

    20,815        20,815        20,815        20,815           

Cash Dividends Declared per Share – Common Stock

  $ 0.14      $ —        $ —        $ —             

 

(1) The operating results for fiscal year 2010 include the results of the Allegheny acquisition effective January 1, 2010 and the results of the FiberNet acquisition effective December 1, 2010 (Note 1 of our audited consolidated financial statements included herein).
(2) Basic earnings per share for the quarter ended December 31, 2011 is computed by dividing net loss for the quarter by the weighted average number of common shares outstanding during the two month post-Business Separation period beginning November 1, 2011 and ending December 31, 2011. Diluted earnings per share is calculated in a similar manner, but includes the dilutive effect of actual stock options and restricted shares outstanding as of December 31, 2011. Since these securities are anti-dilutive, they are excluded from the calculation of earnings per share. Prior to the Business Separation, we did not have any common stock outstanding.

 

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Liquidity and Capital Resources

For the years ended December 31, 2011 and 2010, our working capital requirements, capital expenditures (excluding acquisitions) and cash dividends were funded by cash on hand and net cash provided from operating activities. We funded the acquisition from Allegheny and the purchase of FiberNet (Note 1) with approximately $27 million and $163 million of borrowings from NTELOS Inc. and using net cash provided from operating activities. We believe our cash generated from operations will continue to fund our working capital requirements, capital expenditures and anticipated interest and principal payments on our $370 million post-Business Separation Credit Facility that we borrowed $340 million against on the effective date of the Business Separation.

As of December 31, 2011, we had $406.3 million in aggregate long term liabilities, consisting of $322.5 million in borrowings under our Credit Facility ($324.5 including the current portion) and $83.8 million in other long-term liabilities, inclusive of deferred income tax liabilities of $41.2 million and other long-term liabilities of $42.6 million. Our credit agreement also includes a revolving credit facility of $60 million (the “Revolver”), $45 million of which is available for our working capital requirements and other general corporate purposes as of December 31, 2011.

In addition to the Credit Facility, we have also entered into capital leases on vehicles and equipment used in our operations with lease terms of four to ten years. We also assumed $1.6 million of capital leases primarily on telephony equipment with the FiberNet acquisition. As of December 31, 2011, the total net present value of our future minimum lease payments is $2.1 million. As of December 31, 2011, the principal portion of these capital lease obligations is due as follows: $0.6 million in 2012, $0.6 million in 2013, $0.4 million in 2014, $0.3 million in 2015 and $0.2 million thereafter.

We have a maximum distributable amount under the terms of our credit agreement that can be used to make certain restricted payments including dividends. The distributable amount was initially set at $5 million on the date of funding and is increased every January 1st by the greater of $12 million or 75% of excess cash flow, as defined. The distributable amount as of December 31, 2011 was $5 million.

Under the credit agreement governing the Credit Facility, we are also bound by certain financial covenants. Noncompliance with any one or more of the debt covenants may have an adverse effect on our financial condition or liquidity in the event such noncompliance cannot be cured or should we be unable to obtain a waiver from the lenders of the Credit Facility. As of December 31, 2011, we are in compliance with all of our debt covenants, and our ratios at December 31, 2011 are as follows:

 

     Actual    Covenant Requirement at
December 31, 2011

Total debt outstanding to EBITDA (as defined in the credit agreement)

   3.40    Not more than 4.00

Minimum interest coverage ratio

   8.10    Not less than 3.25

The actual leverage and interest coverage ratios noted above are based on actual results for 2011.

During the year ended December 31, 2011, net cash provided by operating activities was $82.9 million. Net loss during this period was $43.9 million which included $120.3 million of depreciation, amortization, asset impairment charges, deferred taxes and other non-cash charges (net). Total net changes in operating assets and liabilities provided $6.5 million. The principal changes in operating assets and liabilities from December 31, 2010 to December 31, 2011 were as follows: accounts receivable increased $2.1 million; current assets decreased $0.3 million; changes in income taxes provided $3.7 million; accounts payable and other current liabilities increased $5.0 million primarily related to the $3.0 million dividend that was payable as of December 31, 2011 and retirement benefit contributions and distributions totaled $0.5 million.

During the year ended December 31 2010, net cash provided by operating activities was $59.0 million. Net income during this period was $20.9 million. We recognized $34.2 million of depreciation, amortization, deferred taxes and other non-cash charges (net). Total net changes in operating assets and liabilities provided $3.8 million. The principal changes in operating assets and liabilities from December 31, 2009 to December 31, 2010 were as follows: accounts receivable decreased $1.2 million; other current assets increased $0.3 million; changes in income taxes provided $0.6 million; accounts payable increased $0.9 million; and other current liabilities increased $1.5 million.

Our cash flows used in investing activities for the year ended December 31, 2011 were $62.8 million, of which approximately $61.5 million was used for the purchase of property and equipment comprised of (i) $18.9 million for

 

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the FiberNet network infrastructure and integration, (ii) $22.3 million for success-based customer and network expansion, (iii) $14.3 million for infrastructure upgrades and network sustainment, (iv) $3.7 million for expansion and upgrades related to the RUS grant, and (v) $2.3 million for IT and facilities renovations associated with the Business Separation. Our cash flows used in investing activities for the year ended December 31, 2011 also included $1.0 million received from Rural Utilities Service (“RUS”) for reimbursement of the grant portion of capital spent on the projects and the return of a portion of the required pledged deposit and $2.2 million of capital spending on the RUS project for which RUS is obligated to reimburse us.

Our cash flows used in investing activities for the year ended December 31, 2010 were $211.3 million, including $162.3 million used for the purchase of FiberNet and $40.3 million used for routine capital outlays and facility upgrades supporting our RLEC operations, for the actual and projected growth of our voice and data offerings, including those in our new territories from the Allegheny Energy, Inc. fiber acquisition, and for fiber deployment in the RLEC territory related to an infrastructure upgrade to offer, among other services, enhanced broadband services and IPTV-based video services.

Excluding additional capital expenditures relating to information technology discussed below, we currently expect capital expenditures for 2012 to be in the range of $52 million to $60 million. These capital expenditures will be targeted to leverage our extensive investment in our fiber network backbone and fiber rings with enterprise customer fiber builds, fiber to the cell site deployments and other wholesale revenue opportunities with attractive return on investment profiles. Additionally, we will provide normal network facility upgrades for our RLEC and Competitive operations, and fund fiber deployment in the RLEC territory related to an infrastructure upgrade to offer, among other services, continued deployment of fiber-to-the-home and growth in IPTV-based video subscribers and revenues. We also will incur additional one-time investments as a result of the Business Separation to split systems that we shared with NTELOS and to create new and improved information technology infrastructure.

Net cash provided by financing activities for the year ended December 31, 2011 aggregated $10.1 million, which primarily represents the following:

 

   

$340.0 million of proceeds from issuance of long-term debt;

 

   

$315.0 million paid to NTELOS Inc. associated with the Business Separation;

 

   

$14.4 million net repayments to NTELOS Inc. prior to the Business Separation;

 

   

$4.9 million used to pay debt issuance costs;

 

   

$15.5 million repayments on our Credit Facility; and

 

   

$0.3 million payments under capital lease obligations and $0.1 million of other financing activities.

Net cash provided by financing activities for the year ended December 31, 2010 aggregated $152.8 million, which primarily represents the following:

 

   

$153.1 million net borrowings from NTELOS Inc.; and

 

   

$0.3 million payments under capital lease obligations.

As of December 31, 2011, we had approximately $18.1 million in cash and restricted cash and working capital (current assets minus current liabilities) of approximately $6.9 million. Of the total cash on hand as of December 31, 2011, $7.6 million represents previously mentioned pledged deposits for our RUS grant and $10.5 million represents unrestricted cash.

Our RLEC paid dividends of $14.1 million and $29.2 million to NTELOS Communications Inc., a subsidiary of NTELOS, in the years ended December 31, 2011 and 2010, respectively, in accordance with the requirements of NTELOS Inc.’s senior secured credit facility. After the Business Separation, the RLEC is no longer a subsidiary of NTELOS Communications Inc. and will therefore no longer make this dividend payment. The RLEC will pay a dividend to us in accordance with the Credit Facility. There was no dividend during the last two months of 2011.

As discussed in Note 3 of the footnotes to the consolidated financial statements and previously in this Management’s Discussion and Analysis, certain events and actions taken by the FCC and telecommunication carriers that we interconnect with are projected to have a significant negative impact on our future cash flows from the RLEC segment. However, we believe that the growth of our cash flows in the Competitive segment will offset the decline in the RLEC cash flows over time. We expect that our cash flows from operations will be sufficient to satisfy our foreseeable working capital requirements and capital expenditures for more than 12 months. If our growth opportunities result in unforeseeable capital expenditures, we may need to seek additional financing in the future.

 

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On October 31, 2011, we received $340 million of the $370 million new senior secured credit facility (leaving $30 million of undrawn revolver), $315 million of which was used to settle intercompany debt obligations owed to NTELOS Inc. and to fund NTELOS Inc.’s mandatory repayment on its credit facility. After paying approximately $4.9 million in arrangement fees, upfront fees, legal fees and other customary expenses, we netted $20.2 million of cash which we are using as normal working capital reserves. In December 2011, we paid $15 million against the revolver, leaving the revolver balance at $15 million (and $45 million available) at December 31, 2011. In 2012, we have a required principal payment of $2.0 million due on this facility.

On November 4, 2011, our Board of Directors declared the company’s first quarterly cash dividend on our common stock in the amount of $0.14 per share (totaling $3.0 million) which was paid on January 12, 2012 to stockholders of record on December 16, 2011. On February 23, 2011, our Board of Directors declared a quarterly cash dividend on our common stock in the amount of $0.14 per share, which is to be paid on April 12, 2012 to stockholders of record on March 14, 2012.

After considering the cost to service the Credit Facility as well as fund the anticipated level of capital expenditures and fund other routine items such as income taxes, interest and scheduled principal payments, we anticipate that we will generate sufficient cash flow to enable us to pay a regular quarterly dividend. All decisions regarding the declaration and payment of dividends will be at the discretion of our board of directors and will be evaluated from time to time in light of our financial condition, earnings, growth prospects, funding requirements and restrictions under our credit agreement, applicable law and other factors our board deems relevant.

Contractual Obligations and Commercial Commitments

We have contractual obligations and commercial commitments that may affect our financial condition. The following table summarizes our significant contractual obligations and commercial commitments as of December 31, 2011:

 

     Payments Due by Period  

(In thousands)

   Total(2)      Less than
one year
     Two to three
years
     Four to five
years
     After five
years
 

Long-term debt obligations (1),(3)

   $ 324,500       $ 2,000       $ 15,000       $ 118,000       $ 189,500   

Capital lease obligations (3)

     2,076         643         1,038         378         17   

Operating lease obligations

     13,268         1,913         3,076         2,905         5,374   

Purchase obligations

   $ 2,900       $ 2,900       $ —         $ —         $ —     

 

(1) 

Represents the borrowings under the Credit Facility. See Note 5 to the audited consolidated financial statements contained herein.

(2) 

Excludes certain benefit obligation projected payments under our qualified and non-qualified pension and other post retirement benefit plans. See Note 11 to the audited consolidated financial statements contained herein.

(3) 

Excludes interest.

Off Balance Sheet Arrangements

We do not have any off balance sheet arrangements or financing activities with special purpose entities.

Critical Accounting Policies and Estimates

The fundamental objective of financial reporting is to provide useful information that allows a reader to comprehend our business activities. To aid in that understanding, management has identified our critical accounting policies for discussion herein. These policies have the potential to have a more significant impact on our financial statements, either because of the significance of the financial statement item to which they relate, or because they require judgment and estimation due to the uncertainty involved in measuring, at a specific point in time, events which are continuous in nature.

 

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Principles of Consolidation

The consolidated financial statements principally represent the financial results reflected by NTELOS Holdings Corp. constituting the companies comprising the Competitive and Rural Local Exchange Carrier (“RLEC”) Wireline segments and all of these companies’ wholly-owned subsidiaries and one limited liability corporation where NTELOS or certain of its subsidiaries, as managing member, exercised control. All significant intercompany accounts and transactions have been eliminated. These financial results as of and for the periods prior to the date of the Business Separation have been adjusted to reflect certain corporate expenses which were not previously allocated to the segments. These allocations primarily represent corporate support functions, including but not limited to accounting, human resources, information technology and executive management, as well as corporate legal and professional fees, including audit fees, and equity-based compensation expense related to equity-based awards granted to employees in corporate support functions (Note 2 to the audited consolidated financial statements). We believe that these costs would not have been materially different had they been calculated on a standalone basis. However, such expenses may not be indicative of the actual level of expense and exclude certain expenses that would have been incurred by us if we had operated as an independent, publicly traded company or of the costs expected to be incurred in the future. As such, the financial information herein may not necessarily reflect our financial position, results of operations, and cash flows in the future or what it would have been had we been an independent, publicly traded company through October 31, 2011.

Revenue Recognition

We recognize revenue when services are rendered or when products are delivered, installed and functional, as applicable. Certain of our services require payment in advance of service performance. In such cases, we record a service liability at the time of billing and subsequently recognize revenue ratably over the service period. We bill customers certain transactional taxes on service revenues. These transactional taxes are not included in reported revenues as they are recognized as liabilities at the time customers are billed.

We earn revenue by providing access to and usage of our networks. Local service and airtime revenues are recognized as services are provided. Wholesale revenues are earned by providing switched access and other switched and dedicated services, including wireless roamer management, to other carriers. Revenues for equipment sales are recognized at the point of sale.

We periodically make claims for recovery of access charges on certain minutes of use terminated by us on behalf of other carriers. We recognize revenue in the period that we are able to estimate the amount and when the collection of such amount is considered probable.

Trade Accounts Receivable

We sell our services to residential and commercial end-users and to other communication carriers primarily in Virginia, West Virginia and in parts of Maryland, Pennsylvania, Ohio and Kentucky. We have credit and collection policies to maximize collection of trade receivables and we require deposits on certain sales. We maintain an allowance for doubtful accounts based on historical results, current and expected trends and changes in credit policies. Management believes the allowance adequately covers all anticipated losses with respect to trade receivables. Actual credit losses could differ from such estimates. We include bad debt expense in customer operations expense in our consolidated statements of operations.

Long-lived Asset Recovery

Long-lived assets include property, plant and equipment, long-term deferred charges, goodwill and intangible assets to be held and used. Long-lived assets, excluding goodwill and intangible assets with indefinite useful lives, are recorded at cost and are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount should be evaluated pursuant to the subsequent measurement guidance described in Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 360-10-35. Impairment is determined by comparing the carrying value of these long-lived assets to management’s best estimate of future undiscounted cash flows expected to result from the use of the assets. If the carrying value exceeds the estimated undiscounted cash flows, the excess of the asset’s carrying value over the estimated fair value is recorded as an impairment charge.

We passed step one of this recoverability testing and therefore, no further testing for impairment of these assets on either segment was considered necessary. However, on October 31, 2011, in connection with the Business Separation and the related transfer of all of the wireline assets in the tax-free exchange, we assessed the fair value of

 

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the asset groups transferred. To the extent that the carrying value of each of the asset groups exceeds the fair value, a pro-rata writedown of these assets to fair value is required. Although the RLEC segment assets passed the undiscounted cash flow recoverability test in ASC 360-10-35, the fair value of the RLEC segment assets was determined to be lower than the carrying value by $20.9 million ($12.7 million net of tax) and an impairment charge was recorded accordingly.

Depreciation of property, plant and equipment is calculated on a straight-line basis over the estimated useful lives of the assets, which we review and update based on historical experiences and future expectations. Buildings are depreciated over a 50-year life and leasehold improvements, which are categorized in land and buildings, are depreciated over the shorter of the estimated useful lives or the remaining lease terms. Network plant and equipment are depreciated over various lives from 3 to 50 years, with a weighted average life of approximately 14 years. Furniture, fixtures and other equipment are depreciated over various lives from 2 to 24 years.

Goodwill and Indefinite-Lived Intangibles

Goodwill, franchise rights and radio spectrum licenses are indefinite-lived intangible assets. Indefinite-lived intangible assets are not subject to amortization but are instead tested for impairment annually or more frequently if an event indicates that the asset might be impaired. We assess the recoverability of indefinite-lived assets annually on October 1 and whenever adverse events or changes in circumstances indicate that impairment may have occurred.

We use a two-step process to test for goodwill impairment. Step one requires a determination of the fair value of each of the reporting units and, to the extent that this fair value of the reporting unit exceeds its carrying value (including goodwill), the step two calculation of implied fair value of goodwill is not required and no impairment loss is recognized. In testing for goodwill impairment, we utilize a combination of a discounted cash flow model and an analysis which allocates enterprise value to the reporting units. Our annual testing is performed as of October 1 of each year.

Based on the FCC order adopted on October 27, 2011 and actions taken or projected to be taken by carriers related to network interconnections, we remeasured our RLEC goodwill and franchise rights effective October 27, 2011 and determined that both the RLEC goodwill and franchise rights intangible asset were fully impaired. Accordingly, we recorded a $65.4 million asset impairment charge ($53.0 million after tax). We determined that there was no impairment of the Competitive segment goodwill.

Pension Benefits and Retirement Benefits Other Than Pensions

We sponsor a non-contributory defined benefit pension plan (“Pension Plan”) covering all employees who meet eligibility requirements and were employed by the NTELOS Inc. prior to October 1, 2003. The Pension Plan was closed to NTELOS Inc. employees hired on or after October 1, 2003. Pension benefits vest after five years of plan service and are based on years of service and an average of the five highest consecutive years of compensation subject to certain reductions if the employee retires before reaching age 65 and elects to receive the benefit prior to age 65.

Sections 412 and 430 of the Internal Revenue Code and ERISA Sections 302 and 303 establish minimum funding requirements for defined benefit pension plans. The minimum required contribution is generally equal to the target normal cost plus the shortfall amortization installments for the current plan year and each of the six preceding plan years less any calculated credit balance. If plan assets (less calculated credits) are equal to or exceed the funding target, the minimum required contribution is the target normal cost reduced by the excess funding, but not below zero. Our policy is to make contributions to stay at or above the threshold required in order to prevent benefit restrictions and related additional notice requirements and is intended to provide not only for benefits based on service to date, but also for those expected to be earned in the future. Also, we have nonqualified pension plans that are accounted for similar to its Pension Plan.

We provide certain health care and life benefits for retired employees that meet eligibility requirements. We have two qualified nonpension postretirement benefit plans. The health care plan is contributory, with participants’ contributions adjusted annually. The life insurance plan is also contributory. These obligations, along with all of the pension plans and other post retirement benefit plans, are assumed by us. Eligibility for the life insurance plan is restricted to active pension participants age 50-64 as of January 5, 1994. Neither plan is eligible to employees hired after April 1993. The accounting for the plans anticipates that we will maintain a consistent level of cost sharing for the benefits with the retirees. Our share of the projected costs of benefits that will be paid after retirement is generally being accrued by charges to expense over the eligible employees’ service periods to the dates they are fully eligible for benefits.

 

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We also sponsor a contributory defined contribution plan under Internal Revenue Code Section 401(k) for substantially all employees. Our policy is to match 100% of each participant’s annual contributions for contributions up to 1% of each participant’s annual compensation and 50% of each participant’s annual contributions up to an additional 5% of each participant’s annual compensation. Company contributions vest after two years of service. We fund our 401(k) matching contributions in shares of our common stock.

Income Taxes

Deferred income taxes are provided on an asset and liability method whereby deferred tax assets are recognized for deductible temporary differences and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax bases. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. We accrue interest and penalties related to unrecognized tax benefits in interest expense and income tax expense, respectively. Prior to the Business Separation, our income taxes were included in the NTELOS consolidated federal income tax return and certain unitary or consolidated state income tax returns of NTELOS Holdings Corp. However, our income taxes were calculated and provided for on an “as if separate” tax return basis.

Recent Accounting Pronouncements

In May 2011, the FASB issued ASU 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS. ASU No. 2011-04 was issued concurrently with IFRS 13, Fair Value Measurement, to provide largely identical guidance about fair value measurement and disclosure requirements. The new standards do not extend the use of fair value but, rather, provide guidance on how fair value should be applied where it already is required or permitted under IFRS or U.S. GAAP. For U.S. GAAP, most of the changes are clarifications of existing guidance or wording changes to align with IFRS 13. We are required to apply this ASU prospectively for interim and annual reporting periods beginning after December 15, 2011. Early adoption is not permitted. In the period of adoption, a reporting entity will be required to disclose a change, if any, in valuation technique and related inputs that result from applying the ASU and to quantify the total effect, if practicable.

In June 2011, the FASB issued ASU 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income. This ASU increases the prominence of other comprehensive income in financial statements. Under this ASU, an entity will have the option to present the components of net income and comprehensive income in either one or two consecutive financial statements. The ASU eliminates the option in U.S. GAAP to present other comprehensive income in the statement of changes in equity. An entity should apply this ASU retrospectively. This ASU is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. Early adoption is permitted. We will apply the requirements of this ASU to our financial statements for the fiscal year beginning January 1, 2012.

In September 2011, the FASB issued ASU 2011-08, Intangibles – Goodwill and Other (Topic 350): Testing Goodwill for Impairment. This ASU permits an entity to make a qualitative assessment of whether it is more likely than not that a reporting unit’s fair value is less than its carrying amount before applying the two-step goodwill impairment test. If an entity concludes it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, it need not perform the two-step impairment test. The ASU is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. Early adoption is permitted. We will apply the requirements of this ASU to our goodwill impairment testing beginning with the fiscal year beginning January 1, 2012.

 

Item 7A. Quantitative and Qualitative Disclosures About Market Risk.

We are exposed to market risks primarily related to interest rates. We paid the $177.1 million balance due to NTELOS Inc. on the effective date of the Business Separation (October 31, 2011) by entering into the $370 million post-Business Separation credit facility. As of December 31, 2011, $324.5 million was outstanding under our Credit Facility. As of December 31, 2011, we had a leverage ratio of 3.40:1.00 and an interest coverage ratio 8.10:1.00, both of which are favorable to any future covenant requirement. We have other fixed rate, long-term debt in the form of capital leases totaling $2.1 million as of December 31, 2011.

 

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Under the terms of our Credit Facility, we were required to enter into an interest rate hedge for three years on 50% of the term loans (approximately $155 million). In February 2012, we entered into a 3% interest rate CAP for February 2012 through December 31, 2012 and a delayed interest rate swap agreement from December 31, 2012 through December 31, 2015 whereby we swap three-month LIBOR with a fixed rate of approximately 0.8% on 50% of the term loan balances outstanding. We will be exposed to interest rate risk on the remaining 50% of the term loan balances and 100% of the revolver outstanding balance. We do not purchase or hold any financial derivative instruments for trading purposes.

At December 31, 2011, our financial assets in the combined balance sheets included unrestricted cash of $10.5 million. Other securities and investments totaled $0.1 million at December 31, 2011.

The following sensitivity analysis indicates the impact at December 31, 2011, on the fair value of certain financial instruments, which would be potentially subject to material market risks, assuming a ten percent increase and a ten percent decrease in the levels of our interest rates:

 

(In thousands)

   Book Value      Fair Value      Estimated fair
value assuming
noted decrease
in market
pricing
     Estimated fair
value assuming
noted increase
in market
pricing
 

Credit Facility

   $ 324,500       $ N/M       $ 356,950       $ 292,050   

Capital lease obligations

   $ 2,076       $ 2,076       $ 2,284       $ 1,868   

 

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Item 8. Financial Statements and Supplementary Data.

LUMOS NETWORKS CORP.

INDEX TO AUDITED CONSOLIDATED FINANCIAL STATEMENTS

 

Report of Independent Registered Public Accounting Firm

     50   

Consolidated Balance Sheets as of December 31, 2011 and 2010

     51   

Consolidated Statements of Operations for the years ended December 31, 2011, 2010 and 2009

     53   

Consolidated Statements of Cash Flows for the years ended December 31, 2011, 2010 and 2009

     54   

Consolidated Statements of Equity for the years ended December 31, 2011, 2010 and 2009

     55   

Notes to Consolidated Financial Statements

     56   

 

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Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders

Lumos Networks Corp.:

We have audited the accompanying consolidated balance sheets of Lumos Networks Corp. (the Company) as of December 31, 2011 and 2010, and the related consolidated statements of operations, cash flows, and equity for each of the years in the three-year period ended December 31, 2011. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). 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 Lumos Networks Corp. as of December 31, 2011 and 2010, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2011, in conformity with U.S. generally accepted accounting principles.

/s/ KPMG LLP

Richmond, Virginia

March 23, 2012

 

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Consolidated Balance Sheets

Lumos Networks Corp.

 

(In thousands)

   December 31,
2011
     December 31,
2010
 

Assets

     

Current Assets

     

Cash

   $ 10,547       $ 489   

Restricted cash

     7,554         8,062   

Accounts receivable, net of allowance of $2,822 ($2,117 in 2010)

     23,555         21,171   

Other receivables

     2,390         1,238   

Prepaid expenses and other

     2,278         2,021   
  

 

 

    

 

 

 
     46,324         32,981   
  

 

 

    

 

 

 

Securities and Investments

     128         71   
  

 

 

    

 

 

 

Property, Plant and Equipment

     

Land and buildings

     22,833         22,597   

Network plant and equipment

     365,101         328,234   

Furniture, fixtures and other equipment

     13,069         10,097   
  

 

 

    

 

 

 

Total in service

     401,003         360,928   

Under construction

     18,200         8,350   
  

 

 

    

 

 

 
     419,203         369,278   

Less accumulated depreciation

     119,245         95,372   
  

 

 

    

 

 

 
     299,958         273,906   
  

 

 

    

 

 

 

Other Assets

     

Goodwill

     100,297         133,735   

Franchise rights

     —           32,000   

Other intangibles, less accumulated amortization of $61,742 ($46,355 in 2010)

     45,696         65,904   

Deferred charges and other assets

     6,197         2,196   
  

 

 

    

 

 

 
     152,190         233,835   
  

 

 

    

 

 

 
   $ 498,600       $ 540,793   
  

 

 

    

 

 

 

See accompanying Notes to Consolidated Financial Statements.

 

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Consolidated Balance Sheets

Lumos Networks Corp.

 

(In thousands, except par value per share amounts)

   December 31,
2011
    December 31,
2010
 

Liabilities and Equity

    

Current Liabilities

    

Current portion of long-term debt

   $ 2,679      $ 688   

Accounts payable

     12,432        12,298   

Dividends payable

     2,980        —     

Advance billings and customer deposits

     12,623        11,653   

Accrued compensation

     2,832        930   

Accrued operating taxes

     2,624        844   

Other accrued liabilities

     3,262        1,322   
  

 

 

   

 

 

 
     39,432        27,735   
  

 

 

   

 

 

 

Long-term Liabilities

    

Long-term debt

     323,897        1,417   

Obligation to NTELOS Inc.

     —          178,616   

Retirement benefits

     35,728        —     

Deferred income taxes

     41,204        61,217   

Other long-term liabilities

     5,028        5,122   

Income tax payable

     484        500   
  

 

 

   

 

 

 
     406,341        246,872   
  

 

 

   

 

 

 

Commitments and Contingencies

    

Equity

    

Preferred stock, par value $0.01 per share, authorized 100 shares; 0 issued and outstanding in 2011 and 2010

     —          —     

Common stock, par value $0.01 per share, authorized 55,000 shares; 21,235 shares issued and 21,170 shares outstanding (0 shares issued and outstanding in 2010)

     212        —     

Additional paid in capital

     126,427        —     

Accumulated deficit

     (57,416     —     

Accumulated other comprehensive loss

     (16,840     —     

Business equity

     —          265,794   
  

 

 

   

 

 

 

Total Lumos Networks Corp. Stockholders’ Equity

     52,383        265,794   

Noncontrolling interests

     444        392   
  

 

 

   

 

 

 
     52,827        266,186   
  

 

 

   

 

 

 
   $ 498,600      $ 540,793   
  

 

 

   

 

 

 

See accompanying Notes to Consolidated Financial Statements.

 

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Table of Contents

Consolidated Statements of Operations

Lumos Networks Corp.

 

     Year Ended December 31,  

(In thousands, except per share amounts)

   2011     2010     2009  

Operating Revenues

   $ 207,414      $ 145,964      $ 130,595   

Operating Expenses

      

Cost of sales and services (exclusive of items shown separately below)

     78,484        46,407        40,158   

Customer operations

     19,551        13,243        12,598   

Corporate operations

     16,251        13,809        8,582   

Depreciation and amortization

     43,090        31,365        28,641   

Asset impairment charges

     86,295        —          —     

Accretion of asset retirement obligations

     116        11        78   
  

 

 

   

 

 

   

 

 

 
     243,787        104,835        90,057   
  

 

 

   

 

 

   

 

 

 

Operating (Loss) Income

     (36,373     41,129        40,538   

Other Income (Expenses)

      

Interest expense

     (11,993     (5,752     (1,478

Other income, net

     105        43        105   
  

 

 

   

 

 

   

 

 

 
     (11,888     (5,709     (1,373
  

 

 

   

 

 

   

 

 

 
     (48,261     35,420        39,165   

Income Tax (Benefit) Expense

     (4,383     14,477        15,768   
  

 

 

   

 

 

   

 

 

 

Net (Loss) Income

     (43,878     20,943        23,397   

Net Income Attributable to Noncontrolling Interests

     (52     (119     (39
  

 

 

   

 

 

   

 

 

 

Net (Loss) Income Attributable to Lumos Networks Corp.

   $ (43,930   $ 20,824      $ 23,358   
  

 

 

   

 

 

   

 

 

 

Pro Forma Basic and Diluted (Loss) Earnings per Common Share Attributable to Lumos Networks Corp. Stockholders (Unaudited):

      

Pro Forma (Loss) Earnings per Share – Basic and Diluted

   $ (2.11    

Pro forma weighted average shares outstanding – basic and diluted

     20,815       

Cash Dividends Declared per Share – Common Stock

   $ 0.14       

See accompanying Notes to Consolidated Financial Statements.

 

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Consolidated Statements of Cash Flows

Lumos Networks Corp

 

     Year Ended December 31,  

(In thousands)

   2011     2010     2009  

Cash flows from operating activities

      

Net (loss) income

   $ (43,878   $ 20,943      $ 23,397   

Adjustments to reconcile net (loss) income to net cash provided by operating activities:

      

Depreciation

     27,703        22,738        21,239   

Amortization

     15,387        8,627        7,402   

Accretion of asset retirement obligations

     116        11        78   

Asset impairment charges

     86,295        —          —     

Deferred income taxes

     (8,110     3,463        3,646   

Equity-based compensation expense

     2,383        1,529        794   

Amortization of loan origination costs

     132        —          —     

Retirement benefits and other

     (3,594     (2,156     (2,551

Changes in assets and liabilities from operations:

      

(Increase) decrease in accounts receivable

     (2,082     1,175        237   

Decrease (increase) in other current assets

     297        (320     (162

Changes in income taxes

     3,727        593        100   

Increase in accounts payable

     425        901        79   

Increase in other current liabilities

     4,572        1,473        130   

Retirement benefit contributions and distributions

     (465     —          —     
  

 

 

   

 

 

   

 

 

 

Net cash provided by operating activities

     82,908        58,977        54,389   
  

 

 

   

 

 

   

 

 

 

Cash flows from investing activities

      

Purchases of property, plant and equipment

     (61,536     (40,254     (37,011

Purchase of FiberNet, net of cash acquired of $221 and working capital and other adjustments of $6,440

     —          (162,283     —     

Acquisition of assets from Allegheny Energy, Inc.

     —          —          (26,708

Pledged deposit for Rural Utilities Service grant

     —          (8,062     —     

Return of pledged deposit for Rural Utilities Service grant

     508        —          —     

Cash reimbursement received from Rural Utilities Service grant

     508        —          —     

Other

     (2,248     (692     —     
  

 

 

   

 

 

   

 

 

 

Net cash used in investing activities

     (62,768     (211,291     (63,719
  

 

 

   

 

 

   

 

 

 

Cash flows from financing activities

      

Proceeds from issuance of long-term debt

     310,000        —          —     

Proceeds from issuance of revolving credit facility

     30,000        —          —     

Payment of debt issuance costs

     (4,854     —          —     

Cash paid to NTELOS Inc. associated with the Business Separation

     (315,000     —          —     

Payments on senior secured term loans

     (500     —          —     

Payments on revolving credit facility

     (15,000     —          —     

(Payment to) borrowings from NTELOS Inc., net

     (14,357     153,106        9,737   

Capital distributions to noncontrolling interests

     —          —          (184

Payments under capital lease obligations

     (317     (306     (223

Other

     (54     —          —     
  

 

 

   

 

 

   

 

 

 

Net cash (used in) provided by financing activities

     (10,082     152,800        9,330   
  

 

 

   

 

 

   

 

 

 

Increase in cash

     10,058        486        —     

Cash:

      

Beginning of year

     489        3        3   
  

 

 

   

 

 

   

 

 

 

End of year

   $ 10,547      $ 489      $ 3   
  

 

 

   

 

 

   

 

 

 

See accompanying Notes to Consolidated Financial Statements.

 

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Consolidated Statements of Equity

Lumos Networks Corp.

 

(In thousands, except
per share amounts)

  Common
Shares
    Treasury
Shares
    Common
Stock
    Additional
Paid-in Capital
    Treasury
Stock
    Accumulated
Deficit
    Accumulated
Other
Comprehensive
Loss
    Business
Equity
    Total Lumos
Networks Corp.
Stockholders’
Equity
    Noncontrolling
Interests
    Total
Equity
 

Balance, December 31, 2008

    —          —        $ —        $ —        $ —        $ —        $ —        $ 280,194      $ 280,194      $ 418      $ 280,612   

Equity-based compensation expense

                  794        794          794   

Dividends paid to NTELOS Communications Inc.

                  (31,665     (31,665       (31,665

Capital distributions to noncontrolling interests

                    —          (184     (184

Comprehensive Income:

                     

Net income attributable to Lumos Networks Corp.

                     

Comprehensive income attributable to Lumos Networks Corp.

                  23,358        23,358       

Comprehensive income attributable to noncontrolling interests

                      39     

Total Comprehensive Income

                        23,397   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance, December 31, 2009

    —          —          —          —          —          —          —          272,681        272,681        273        272,954   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Equity-based compensation expense

                  1,529        1,529          1,529   

Dividends paid to NTELOS Communications Inc.

                  (29,240     (29,240       (29,240

Comprehensive Income:

                     

Net income attributable to Lumos Networks Corp.

                     

Comprehensive income attributable to Lumos Networks Corp.

                  20,824        20,824       

Comprehensive income attributable to noncontrolling interests

                      119     

Total Comprehensive Income

                        20,943   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance, December 31, 2010

    —          —          —          —          —          —          —          265,794        265,794        392        266,186   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Allocation of beginning of year business equity in connection with the Business Separation

          262,155          3,639          (265,794     —            —     

Spin-off from NTELOS Holdings Corp.

    21,223          212        (138,107         (14,113       (152,008       (152,008

Equity-based compensation expense

          1,694                1,694          1,694   

Restricted shares issued, shares issued through the employee stock purchase plan and 401(k) matching contributions and stock options exercised

    12            685                685          685   

Common shares reacquired through restricted stock forfeits

      65                    —            —     

Cash dividends declared ($0.14 per share)

              (2,980         (2,980       (2,980

Dividends paid to NTELOS Communications Inc.

              (14,145         (14,145       (14,145

Comprehensive Loss:

                     

Net loss attributable to Lumos Networks Corp.

              (43,930          

Unrecognized loss (net) from defined benefit plans, net of $10,798 of deferred income tax asset

                (2,847        

Amortization of unrecognized loss from defined benefit plans, net of $77 of deferred income tax asset

                120           

Comprehensive loss attributable to Lumos Networks Corp.

                    (46,657    

Comprehensive income attributable to noncontrolling interests

                      52     

Total Comprehensive Loss

                        (46,605
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance, December 31, 2011

    21,235        65      $ 212      $ 126,427      $ —        $ (57,416   $ (16,840   $ —        $ 52,383      $ 444      $ 52,827   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

See accompanying Notes to Consolidated Financial Statements.

 

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Notes to Consolidated Financial Statements

Lumos Networks Corp.

Note 1. Organization

On October 14, 2011, NTELOS Holdings Corp. (“NTELOS”) announced a distribution date of October 31, 2011 for the spin-off of all of the issued and outstanding shares of common stock of Lumos Networks, which operated NTELOS’s wireline operations (the “Business Separation”). Prior to and in connection with the Business Separation, following the market close on October 31, 2011, NTELOS effectuated a 1-for-2 reverse stock split (the “Reverse Stock Split”) of its shares of Common Stock, $0.01 par value (the “Common Stock”). The spin-off of Lumos Networks was in the form of a tax-free stock distribution to NTELOS stockholders of record as of the close of business on October 24, 2011, the record date (the “Distribution”). On October 31, 2011, NTELOS distributed one share of Lumos Networks common stock for every share of NTELOS’s common stock outstanding, on a post-Reverse Stock Split basis.

In connection with the Business Separation, Lumos Networks paid $315 million to NTELOS on October 31, 2011 (i) to settle with cash the intercompany debt owed to NTELOS as of the Business Separation date ($177.1 million) and, with the balance, (ii) to fund a mandatory repayment on NTELOS’s credit facility resulting from the Business Separation.

Lumos Networks is a fiber-based network service provider in the Mid-Atlantic region. The Company serves carrier, business and residential customers over a dense fiber network offering data, IP services and voice services utilizing an on-network service strategy. Following a contiguous regional expansion strategy, the Company has expanded from the base rural local exchange carrier (“RLEC”) service territory in rural western Virginia to its current six state regional presence including western Virginia, West Virginia, and portions of Pennsylvania, Maryland, Ohio and Kentucky. The Company’s growth into a regional service provider has been achieved by pursuing organic growth opportunities and complementary acquisitions.

On December 1, 2010, the Company acquired from One Communications Corp. (“OCC”) all of the membership interest of Mountaineer Telecommunication, LLC (hereinafter referred to as “FiberNet”) for net cash consideration at closing of $162.5 million. FiberNet is a facility-based Competitive Local Exchange Carrier (“CLEC”) headquartered in Charleston, West Virginia. FiberNet offers voice, data, and IP-based services in West Virginia and portions of Ohio, Maryland, Pennsylvania, Virginia and Kentucky and had approximately 30,000 customer accounts as of the acquisition date and has an extensive fiber network. The FiberNet network provides enhancements that add diversity and capacity to the Company’s combined network of approximately 5,800 route-miles and the increased density provides immediate access to more enterprise customers in new tier two and three markets. NTELOS Inc. funded the acquisition through a combination of a $125 million incremental term loan under its existing senior secured credit facility and cash on hand. The $162.5 million net cash outlay for this purchase transaction was funded by Lumos Networks through an increase to its intercompany obligation with NTELOS Inc., which obligation was settled on October 31, 2011 through the aforementioned $315 million cash payment to NTELOS. Under the terms of the purchase agreement, $5.0 million of the purchase price was put in escrow.

 

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The Company finalized its acquisition accounting related to the purchase of FiberNet prior to December 1, 2011 and recorded the following adjustments, which are reflected in the consolidated balance sheet as of December 31, 2010:

 

(In thousands)

   Increase
(decrease)
 

Assets acquired

  

Current assets

   $ 386   

Property, plant and equipment

     50   

Goodwill

     (844

Total assets acquired

     (408

Liabilities assumed

  

Current liabilities

     (400

Long-term debt (capital leases)

     (8

Total liabilities assumed

   $ (408

Note 2. Relationship with NTELOS

In connection with the Business Separation, the Company entered into a series of agreements with NTELOS which are intended to govern the relationship between the Company and NTELOS going forward. These agreements include commercial service agreements, a separation and distribution agreement, an employee matters agreement, a tax matters agreement and intellectual property agreements. The Company also entered into a transition services agreement with NTELOS. During the year ended December 31, 2011, the net expense to the Company related to the transition services agreement was $0.4 million. See Note 13 regarding related party transactions with NTELOS.

Under the tax matters agreement entered into between NTELOS and the Company, the Company is generally required to indemnify NTELOS against any tax resulting from the Distribution to the extent that such tax resulted from any of the following events (among others): (1) an acquisition of all or a portion of our stock or assets, whether by merger or otherwise, (2) any negotiations, understandings, agreements or arrangements with respect to transactions or events that cause the Distribution to be treated as part of a plan pursuant to which one or more persons acquire, directly or indirectly, stock representing a 50% or greater interest in Lumos Networks, (3) certain other actions or failures to act by the Company, or (4) any breach by the Company of certain of its representations or undertakings. The Company’s indemnification obligations to NTELOS and its subsidiaries, officers and directors are not limited by any maximum amount.

Pursuant to the separation and distribution agreement and certain other agreements with NTELOS, NTELOS agreed to indemnify the Company from certain liabilities, and the Company agreed to indemnify NTELOS for certain liabilities.

Note 3. Significant Accounting Policies

Accounting Estimates

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. Additionally, the financial information included herein may not necessarily reflect the Company’s financial position, results of operations and cash flows in the future or what the Company’s financial position, results of operations and cash flows would have been had Lumos Networks been an independent, publicly traded company through October 31, 2011. Lumos Networks’ management believes that all historical costs of operations have been reflected in the consolidated financial statements.

Principles of Consolidation

The consolidated financial statements principally represent the financial results reflected by NTELOS constituting the companies comprising the Competitive and RLEC wireline segments for all periods prior to the Business Separation on October 31, 2011. All significant intercompany accounts and transactions have been eliminated. These financial results as of and for the periods prior to the date of the Business Separation have been adjusted to

 

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reflect certain corporate expenses which were not previously allocated to the segments. These allocations primarily represent corporate support functions, including but not limited to accounting, human resources, information technology and executive management, as well as corporate legal and professional fees, including audit fees, and equity-based compensation expense related to equity-based awards granted to employees in corporate support functions. These additional expenses for the ten months ended October 31, 2011 were $2.6 million and for the years ended December 31, 2010 and 2009 were $5.1 million (inclusive of $2.8 million of FiberNet acquisition-related costs) and $1.8 million, respectively. The Company believes that these costs would not have been materially different had they been calculated on a standalone basis. However, such expenses may not be indicative of the actual level of expense and exclude certain expenses that would have been incurred by the Company if it had operated as an independent, publicly traded company or of the costs expected to be incurred in the future. Refer to Note 13 for further information regarding allocated expenses.

Revenue Recognition

The Company recognizes revenue when services are rendered or when products are delivered, installed and functional, as applicable. Certain services of the Company require payment in advance of service performance. In such cases, the Company records a service liability at the time of billing and subsequently recognizes revenue ratably over the service period. The Company bills customers certain transactional taxes on service revenues. These transactional taxes are not included in reported revenues as they are recognized as liabilities at the time customers are billed.

The Company earns revenue by providing access to and usage of its networks. Local service revenues are recognized as services are provided. Wholesale revenues are earned by providing switched access and other switched and dedicated services, including wireless roamer management, to other carriers. Revenues for equipment sales are recognized at the point of sale.

The Company periodically makes claims for recovery of access charges on certain minutes of use terminated by the Company on behalf of other carriers. The Company recognizes revenue in the period that it is able to estimate the amount and when the collection of such amount is considered probable.

Cash and Cash Equivalents/Centralized Cash Management Systems

The Company considers its investment in all highly liquid debt instruments with an original maturity of three months or less to be cash equivalents. The Company places its temporary cash investments with high credit quality financial institutions with a maturity date of not greater than 90 days from acquisition and all are investments held by commercial banks. At times, such investments may be in excess of the FDIC insurance limit. The commercial bank that holds significantly all of the Company’s cash at December 31, 2011 has maintained a high rating by Standard & Poor’s and Moody’s. At December 31, 2011 and 2010, the Company did not have any cash equivalents.

As of December 31, 2011, all of the Company’s cash was held in non-interest bearing deposit accounts which are fully insured by the FDIC. Total interest income related to cash was negligible for the years ended December 31, 2011, 2010 and 2009.

Prior to the Business Separation, NTELOS Inc. used a centralized cash management program where NTELOS Inc. held a majority of the cash for NTELOS and its subsidiaries, including Lumos Networks. NTELOS Inc. funded the majority of cash disbursements and received the majority of cash receipts for all of its subsidiaries. Cash received by NTELOS Inc. and payments made by NTELOS Inc. which related to Lumos Networks were accounted for by the Company as due to/from NTELOS Inc. and were classified as a non-current asset or long-term borrowing as appropriate and bore interest at a rate that was substantially equal to NTELOS Inc.’s weighted average long-term borrowing rate excluding the effect of debt issuance cost and original issue discount amortization (for balances due to NTELOS Inc.) and NTELOS Inc.’s average earnings rate (for amounts due from NTELOS Inc.).

Restricted Cash

During 2010, the Company received a federal broadband stimulus award to bring broadband services and infrastructure to Alleghany County, Virginia. The total project is $16.1 million, of which 50% (approximately $8 million) is being funded by a grant from the federal government. The project is expected to be completed in or before 2013. The Company was required to deposit 100% of its portion for the grant (approximately $8 million) into a pledged account in advance of any reimbursements, which can be drawn down ratably following the grant reimbursement approvals which are contingent on adherence to the program requirements. The Company received $0.5 million in the fourth quarter of 2011 for the reimbursable portion of the qualified recoverable expenditures

 

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through September 30, 2011, and the Company has a $2.4 million receivable for the reimbursable portion of the qualified recoverable expenditures through December 31, 2011. At December 31, 2011, the Company reduced its pledged account to $7.6 million. This escrow account is a non-interest bearing, fully insured account with its primary commercial bank.

Trade Accounts Receivable

The Company sells its services to residential and commercial end-users and to other communication carriers primarily in Virginia, West Virginia and in parts of Maryland, Pennsylvania, Ohio and Kentucky. The Company has credit and collection policies to maximize collection of trade receivables and requires deposits on certain sales. The Company maintains an allowance for doubtful accounts based on historical results, current and expected trends and changes in credit policies. Management believes the allowance adequately covers all anticipated losses with respect to trade receivables. Actual credit losses could differ from such estimates. The Company includes bad debt expense in customer operations expense in the consolidated statements of operations. Bad debt expense for the years ended December 31, 2011, 2010 and 2009 was $1.0 million, $0.3 million and $0.1 million, respectively. The Company’s allowance for doubtful accounts was $2.8 million and $2.1 million as of December 31, 2011 and 2010, respectively.

Property, Plant and Equipment and Other Long-Lived Assets

Long-lived assets include property, plant and equipment, long-term deferred charges, goodwill and intangible assets to be held and used. Long-lived assets, excluding goodwill and intangible assets with indefinite useful lives, are recorded at cost and are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount should be evaluated pursuant to the subsequent measurement guidance described in Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 360-10-35. Impairment is determined by comparing the carrying value of these long-lived assets to management’s best estimate of future undiscounted cash flows expected to result from the use of the assets. If the carrying value exceeds the estimated undiscounted cash flows, the excess of the asset’s carrying value over the estimated fair value is recorded as an impairment charge.

Goodwill, franchise rights and radio spectrum licenses are indefinite-lived intangible assets. Indefinite-lived intangible assets are not subject to amortization but are instead tested for impairment annually or more frequently if an event indicates that the asset might be impaired. The Company policy is to assess the recoverability of indefinite-lived assets annually on October 1 and whenever adverse events or changes in circumstances indicate that impairment may have occurred.

The Company performed its impairment testing related to its RLEC and Competitive business segments’ indefinite lived intangible assets, goodwill and long-lived assets, including these segments’ amortizable intangible assets, as of October 1, 2011. However, a significant update was required on October 27, 2011 based on actions taken by the Federal Communications Commission (“FCC”). On this date, the FCC adopted, but did not release, an order comprehensively reforming its Universal Service Fund and intercarrier compensation systems. On November 18, 2011, the FCC released the order. In the order, the FCC determined that interstate and intrastate access charges, as well as local reciprocal compensation, should be eliminated entirely over time. The Company updated its future revenue and cash flow projections based on our understanding of the order at this time. In addition to this, actions were taken or we project will be taken by carriers relating to network interconnections and interconnection rates which had or are projected to have a significant impact to our future access revenues. In performing the impairment testing as of October 27, 2011, the Company’s projections reflected estimations of all of the above factors.

The franchise rights in the RLEC reporting unit largely reflects the value associated with revenues generated from its customers (including other carriers with which the Company interconnects) and future customers based on being the incumbent local exchange carrier and tandem access provider in these rural markets. The Company utilized the Greenfield cash flow valuation method in its impairment testing for this asset. The Greenfield method is an income approach which isolates value to the specific assets being valued and then compares the values to the calculated enterprise value as a validity test. The method is based on a number of assumptions under a start-up scenario but considers the Company’s future projects in modeling the operating results as the business matures.

The Company used a two-step process to test for goodwill impairment for its Competitive and RLEC business segments. Step one requires a determination of the fair value of each of the reporting units and, to the extent that the fair value of the reporting unit exceeds its carrying value (including goodwill), the step two calculation of implied fair value of goodwill is not required and no impairment loss is recognized. In testing for goodwill impairment, the Company utilizes a combination of a discounted cash flow model and an analysis which allocates enterprise value to the reporting units.

 

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Based on its ASC 360-10-35 testing, the Company determined that both the goodwill on the RLEC segment and the RLEC franchise rights were fully impaired. Accordingly, the Company recorded a $65.4 million asset impairment charge ($53.0 million after tax), which is included in the line item “asset impairment charges” on the consolidated statement of operations for the year ended December 31, 2011. The Company determined that there was no impairment of the Competitive segment goodwill as the fair value of the reporting unit substantially exceeded its carrying value.

The Company performed recovery testing of its long-lived tangible and finite-lived intangible assets as of October 27, 2011 utilizing the methodology noted above in ASC 360-10-35. The Company passed step one of this recoverability testing and therefore, no further testing for impairment of these assets on either segment was considered necessary. However, on October 31, 2011, in connection with the Business Separation and the related transfer of all of the wireline assets in the tax-free exchange, the Company assessed the fair value of the asset groups transferred. To the extent that the carrying value of each of the asset groups exceeds their fair value, a pro-rata writedown of these assets is required. Although the RLEC segment assets passed the undiscounted cash flow recoverability test in ASC 360-10-35, the fair value of the RLEC segment assets was determined to be lower than the carrying value by $20.9 million ($12.7 million net of tax) and an impairment charge was recorded for the amount of this difference. The asset impairment charge is included in the line item “asset impairment charges” on the consolidated statement of operations for the year ended December 31, 2011. The allocation of this charge was as follows:

 

(In thousands)

   2011  

Property, Plant and Equipment

   $ 16,032   

Customer Intangible

     4,661   

Trademark

     164   
  

 

 

 

Total impairment

   $ 20,857   
  

 

 

 

The following table presents the activity in goodwill for the years ended December 31, 2011 and 2010.

 

     2011     2010  

(In thousands)

   Gross
Goodwill
     Accumulated
Impairment
Loss
    Net
Goodwill
    Goodwill  

Beginning balance

   $ 133,735       $ —        $ 133,735      $ 49,341   

Excess of cash paid over value of tangible assets acquired from the FiberNet business (Competitive segment)

     —           —          —          84,394   

Impairment of goodwill in the RLEC segment

     —           (33,438     (33,438     —     
  

 

 

    

 

 

   

 

 

   

 

 

 

Ending balance

   $ 133,735       $ (33,438   $ 100,297      $ 133,735   
  

 

 

    

 

 

   

 

 

   

 

 

 

Depreciation of property, plant and equipment is calculated on a straight-line basis over the estimated useful lives of the assets, which the Company reviews and updates based on historical experiences and future expectations.

Intangibles with a finite life are classified as other intangibles on the consolidated balance sheets. At December 31, 2011 and 2010, other intangibles were comprised of the following:

 

          2011     2010  

(Dollars in thousands)

   Estimated Life    Gross
Amount
     Accumulated
Amortization
    Gross
Amount
     Accumulated
Amortization
 

Customer relationships

   3 to 15 yrs    $ 103,153       $ (59,286   $ 107,809       $ (45,186

Trademarks

   0.5 to 15 yrs      3,186         (1,884     3,350         (1,125

Non-compete agreement

   2 yrs      1,100         (572     1,100         (44
     

 

 

    

 

 

   

 

 

    

 

 

 

Total

      $ 107,439       $ (61,742   $ 112,259       $ (46,355
     

 

 

    

 

 

   

 

 

    

 

 

 

 

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The Company amortizes its finite-lived intangible assets using the straight-line method unless it determines that another systematic method is more appropriate. The amortization for the FiberNet customer relationship intangible is being amortized using an accelerated amortization method based on the pattern of estimated earnings from these assets.

The estimated life of amortizable intangible assets is determined from the unique factors specific to each asset and the Company reviews and updates estimated lives based on current events and future expectations. The Company capitalizes costs incurred to renew or extend the term of a recognized intangible asset and amortizes such costs over the remaining life of the asset. No such costs were incurred during the years ended December 31, 2011, 2010 or 2009. Amortization expense for the years ended December 31, 2011, 2010 and 2009 was $15.4 million, $8.6 million and $7.4 million, respectively.

Amortization expense for the next five years is expected to be as follows:

 

(In thousands)

   Customer
Relationships
     Trademarks      Non-Compete      Total  

2012

   $ 10,450       $ 159       $ 528       $ 11,137   

2013

     9,664         159         —           9,823   

2014

     9,028         159         —           9,187   

2015

     4,647         159         —           4,806   

2016

   $ 2,416       $ 159       $ —         $ 2,575   

Accounting for Asset Retirement Obligations

An asset retirement obligation is evaluated and recorded as appropriate on assets for which the Company has a legal obligation to retire. The Company records a liability for an asset retirement obligation and the associated asset retirement cost at the time the underlying asset is acquired. Subsequent to the initial measurement of the asset retirement obligation, the obligation is adjusted at the end of each period to reflect the passage of time and changes in the estimated future cash flows underlying the obligation.

The Company enters into various facility co-location agreements and is subject to locality franchise ordinances. The Company constructs assets at these locations and, in accordance with the terms of many of these agreements, the Company is obligated to restore the premises to their original condition at the conclusion of the agreements, generally at the demand of the other party to these agreements. The Company recognizes the fair value of a liability for an asset retirement obligation and capitalizes that cost as part of the cost basis of the related asset, depreciating it over the useful life of the related asset.

Included in certain of the franchise ordinances under which the RLECs and CLECs operate are clauses that require the removal of the RLEC’s and CLEC’s equipment at the termination of the franchise agreement. The Company has not recognized an ARO for these liabilities as the removal of the equipment is not estimable due to an indeterminable end date and the fact that the equipment is part of the public switched telephone network and it is not reasonable to assume the jurisdictions would require its removal.

The following table indicates the changes to the Company’s asset retirement obligation liability, which is included in other long-term liabilities, for the years ended December 31, 2011 and 2010:

 

(In thousands)

   2011     2010  

Asset retirement obligations, beginning

   $ 1,070      $ 865   

Asset retirement obligations acquired from purchase of FiberNet

     —          105   

Additional asset retirement obligations recorded, net of adjustments in estimates

     (72     89   

Accretion of asset retirement obligations

     116        11   
  

 

 

   

 

 

 

Asset retirement obligations, ending

   $ 1,114      $ 1,070   
  

 

 

   

 

 

 

Deferred Financing Costs

The Company incurred and paid $4.9 million of issuance costs related to the $370 million post-Business Separation credit facility, which was funded on October 31, 2011. These costs were deferred and are being amortized over the life of the related debt instrument using the effective interest method (Note 5).

 

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Advertising Costs

The Company expenses advertising costs and marketing production costs as incurred (included within customer operations expenses in the consolidated statements of operations). Advertising expense for the years ended December 31, 2011, 2010 and 2009 was $0.9 million, $0.5 million and $0.6 million, respectively.

Pension Benefits and Retirement Benefits Other Than Pensions

Prior to the Business Separation, Lumos Networks participated in several qualified and nonqualified pension plans and other postretirement benefit plans (“OPEBs”) sponsored by NTELOS Inc. On the effective date of the Business Separation, Lumos Networks assumed its portion of the assets and liabilities for these pension benefits and OPEBs. Lumos Networks sponsors a non-contributory defined benefit pension plan (“Pension Plan”) covering all employees who meet eligibility requirements and were employed by NTLEOS prior to October 1, 2003. The Pension Plan was closed to NTELOS employees hired on or after October 1, 2003. Pension benefits vest after five years of plan service and are based on years of service and an average of the five highest consecutive years of compensation subject to certain reductions if the employee retires before reaching age 65 and elects to receive the benefit prior to age 65.

Sections 412 and 430 of the Internal Revenue Code and ERISA Sections 302 and 303 establish minimum funding requirements for defined benefit pension plans. The minimum required contribution is generally equal to the target

normal cost plus the shortfall amortization installments for the current plan year and each of the six preceding plan years less any calculated credit balance. If plan assets (less calculated credits) are equal to or exceed the funding target, the minimum required contribution is the target normal cost reduced by the excess funding, but not below zero. The Company’s policy is to make contributions to stay at or above the threshold required in order to prevent benefit restrictions and related additional notice requirements and is intended to provide not only for benefits based on service to date, but also for those expected to be earned in the future. Also, Lumos Networks has nonqualified pension plans that are accounted for similar to its Pension Plan.

Lumos Networks provides certain health care and life benefits for retired employees that meet eligibility requirements. The Company has two qualified nonpension postretirement benefit plans. The health care plan is contributory, with participants’ contributions adjusted annually. The life insurance plan is also contributory. These obligations, along with all of the pension plans and other post retirement benefit plans, are assumed by the Company. Eligibility for the life insurance plan is restricted to active pension participants age 50-64 as of January 5, 1994. Neither plan is eligible to employees hired after April 1993. The accounting for the plans anticipates that the Company will maintain a consistent level of cost sharing for the benefits with the retirees. The Company’s share of the projected costs of benefits that will be paid after retirement is generally being accrued by charges to expense over the eligible employees’ service periods to the dates they are fully eligible for benefits.

Lumos Networks sponsors a contributory defined contribution plan under Internal Revenue Code Section 401(k) for substantially all employees. In connection with the Business Separation, NTELOS transferred to the Company’s 401(k) plan an amount equal to the account balances of the Company’s employees and former employees in NTELOS’s 401(k) plan. Each of the Company’s participating employees was credited for all service accrued with NTELOS prior to such transfer for all purposes under the Company’s 401(k) plan. The Company’s policy is to match 100% of each participant’s annual contributions for contributions up to 1% of each participant’s annual compensation and 50% of each participant’s annual contributions up to an additional 5% of each participant’s annual compensation. Company contributions vest after two years of service.

Operating Leases

The Company has operating leases for administrative office space and equipment, certain of which have renewal options. These leases, with few exceptions, provide for automatic renewal options and escalations that are either fixed or based on the consumer price index. Any rent abatements, along with rent escalations, are included in the computation of rent expense calculated on a straight-line basis over the lease term. The Company’s minimum lease term for most leases includes the initial non-cancelable term and at least one renewal period to the extent that the exercise of the related renewal option or options is reasonably assured. A renewal option or options is determined to be reasonably assured if failure to renew the leases imposes an in-substance economic penalty on the Company. Leasehold improvements are depreciated over the shorter of the assets’ useful life or the lease term, including renewal option periods that are reasonably assured.

 

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Income Taxes

Deferred income taxes are provided on an asset and liability method whereby deferred tax assets are recognized for deductible temporary differences and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax bases. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. The Company accrues interest and penalties related to unrecogn ized tax benefits in interest expense and income tax expense, respectively. Prior to the Business Separation, the Company’s income taxes were included in the NTELOS consolidated federal income tax return and certain unitary or consolidated state income tax returns of NTELOS Holdings Corp. However, the Company’s income taxes were calculated and provided for on an “as if separate” tax return basis.

Equity-based Compensation

The Company accounts for share-based employee compensation plans under FASB ASC 718, Stock Compensation. Equity-based compensation expense from share-based equity awards is recorded with an offsetting increase to additional paid-in capital on the consolidated balance sheet. For equity awards with only service conditions, the Company recognizes compensation cost on a straight-line basis over the requisite service period for the entire award.

Equity awards prior to the Business Separation were granted in NTELOS stock instruments and the related expense was allocated to the Company. Unvested NTELOS stock instruments were converted to commensurate Lumos Networks stock instruments in connection with and at the time of the Business Separation. The fair value of the common stock options granted during the years ended December 31, 2011, 2010 and 2009 was estimated at the respective measurement date using the Black-Scholes option-pricing model with assumptions related to risk-free interest rate, expected volatility, dividend yield and expected terms.

Total equity-based compensation expense related to all of the share-based awards (Note 8) for the years ended December 31, 2011, 2010 and 2009 and the Company’s 401(k) matching contributions was allocated as follows:

 

(In thousands)

   2011      2010      2009  

Cost of sales and services

   $ 314       $ 230       $ 148   

Customer operations

     419         297         143   

Corporate operations

     1,650         1,002         503   
  

 

 

    

 

 

    

 

 

 

Equity-based compensation expense

   $ 2,383       $ 1,529       $ 794   
  

 

 

    

 

 

    

 

 

 

Future charges for equity-based compensation related to instruments outstanding at December 31, 2011 for the years 2012 through 2015 are estimated to be $2.1 million, $1.3 million, $0.4 million and $0.1 million, respectively.

Pro Forma Earnings per Share (Unaudited)

The Company computes pro forma earnings per share based on the weighted number of shares of common stock and dilutive potential common share equivalents outstanding. Prior to the Business Separation, the Company did not have any common stock outstanding and therefore, pro forma earnings per share is calculated based on the two month post-Business Separation period beginning November 1, 2011 and ending December 31, 2011 for 2011 and is not applicable for prior years.

Recent Accounting Pronouncements

In June 2011, the FASB issued Accounting Standards Update (“ASU”) 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income. This ASU increases the prominence of other comprehensive income in financial statements. Under this ASU, an entity will have the option to present the components of net income and comprehensive income in either one or two consecutive financial statements. The ASU eliminates the option in U.S. GAAP to present other comprehensive income in the statement of changes in equity. An entity should apply this ASU retrospectively. This ASU is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. Early adoption is permitted. The Company will apply the requirements of this ASU to its financial statements for the fiscal year beginning January 1, 2012.

 

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Note 4. Disclosures About Segments of an Enterprise and Related Information

The Company manages its business with separate products and services in two segments as described below.

Competitive: The Company directly or indirectly owns approximately 5,800 route-miles of fiber optic network which it utilizes to provide high capacity transport, data services and broadband Internet access. The Competitive segment offers services in more than 100 geographic markets as well as transport services to retail and carrier customers across the network that reaches portions of Virginia, West Virginia, southwestern Pennsylvania, Maryland, Ohio and Kentucky. The Competitive segment focuses on providing “on-net” fiber-based services, including integrated voice and data service, Metro Ethernet, dedicated high speed Internet access and carrier transport services. As noted in the RLEC section below, revenue and operating expenses from services sold in the RLEC service areas that relate to unregulated services, such as integrated access, DSL, broadband over fiber and video, are reported in the Competitive segment. The Competitive segment pays the RLEC tariff and prevailing market rates for these services, the revenue and expense of which are eliminated in consolidation.

RLEC: The Company has two RLEC businesses subject to the regulations of the State Corporation Commission of Virginia. These businesses serve several areas in western Virginia, are fully integrated and are managed as one consolidated operation. The Company’s primary RLEC services are voice services and broadband Internet access but also offers IPTV-based video services and high speed broadband Internet in areas where it has deployed fiber to the home. Revenues and operating expenses related to video and Internet services are reported in the Competitive segment.

Revenues from Verizon accounted for approximately 12% of the Company’s total revenue for the years ended December 31, 2010 and 2009, respectively. Revenue from Verizon was derived from RLEC and Competitive segments’ network access.

Summarized financial information concerning the Company’s reportable segments is shown in the following table.

 

(In thousands)

   Competitive      RLEC     Eliminations     Total  

As of and for the year ended December 31, 2011

         

Operating revenues

   $ 154,757       $ 52,657      $ —        $ 207,414   

Intersegment revenues(1)

     644         4,632        (5,276     —     

Depreciation and amortization and accretion of asset retirement obligations

     29,579         13,627        —          43,206   

Asset impairment charges

     —           86,295        —          86,295   

Equity-based compensation expense

     1,474         909        —          2,383   

Business Separation charges(2)

     1,019         339        —          1,358   

Acquisition related charges

     71         —          —          71   

Operating (loss) income

     29,955         (66,328     —          (36,373

Capital expenditures

     45,720         15,816        —          61,536   

Goodwill

     100,297         —          —          100,297   

Total assets

   $ 355,979       $ 142,621      $ —        $ 498,600   

 

(1) 

Intersegment revenues consist primarily of telecommunications services such as local exchange services, inter-city and local transport voice and data services, and leasing of various network elements. Intersegment revenues are primarily recorded at tariff and prevailing market rates.

(2) 

Business Separation charges include audit, legal and other professional fees incurred during the period related to the Company’s separation from NTELOS Holdings Corp. into a separate publicly traded company (Note 1). These charges are included in corporate operations expense on the statement of operations.

 

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(In thousands)

   Competitive      RLEC      Eliminations     Total  

As of and for the year ended December 31, 2010

          

Operating revenues

   $ 88,471       $ 57,493       $ —        $ 145,964   

Intersegment revenues(1)

     1,036         4,254         (5,290     —     

Depreciation and amortization and accretion of asset retirement obligations

     17,272         14,104         —          31,376   

Equity-based compensation expense

     816         713         —          1,529   

Acquisition related charges(2)

     3,020         —           —          3,020   

Operating income

     16,208         24,921         —          41,129   

Capital expenditures

     27,950         12,304         —          40,254   

Goodwill

     100,297         33,438         —          133,735   

Total assets

   $ 345,259       $ 195,534       $ —        $ 540,793   

 

(In thousands)

   Competitive      RLEC      Eliminations     Total  

For the year ended December 31, 2009

          

Operating revenues

   $ 71,086       $ 59,509       $ —        $ 130,595   

Intersegment revenues(1)

     963         4,216         (5,179