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QWEST CORP - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(Edgar Glimpses Via Acquire Media NewsEdge)
Unless the context requires otherwise, references in this report to "QC"
refer to Qwest Corporation on an unconsolidated basis, stand-alone bases,
references to "Qwest," "we," "us" and "our" refer to Qwest Corporation and its
consolidated subsidiaries, references to "QSC" refer to our direct parent
company, Qwest Services Corporation, and its consolidated subsidiaries,
references to "QCII" refer to QSC's direct parent company and our indirect
parent company, Qwest Communications International Inc., and its consolidated
subsidiaries, and references to "CenturyLink" refer to QCII's direct parent
company and our ultimate parent company, CenturyLink, Inc., and its consolidated
subsidiaries.
All references to "Notes" in this Item 2 refer to the Notes to Consolidated
Financial Statements included in Item 1 of this quarterly report.
Certain statements in this report constitute forward-looking statements. See
"Risk Factors" in Item 1A of Part II of this report for a discussion of certain
factors that could cause our actual results to differ from our anticipated
results.
Overview
Management's Discussion and Analysis of Financial Condition and Results of
Operations ("MD&A") included herein should be read in conjunction with MD&A and
the other information included in our Annual Report on Form 10-K for the year
ended December 31, 2011. The results of operations for the first nine months of
the year are not indicative of the results of operations that might be expected
for the entire year.
We are an integrated communications company engaged primarily in providing
an array of communications services to our residential, business, governmental
and wholesale customers. Our communications services include local, network
access, private line (including special access), broadband, data, wireless and
video services. In certain local and regional markets, we also provide local
access and fiber transport services to competitive local exchange carriers. We
strive to maintain our customer relationships by, among other things, bundling
our service offerings to provide our customers with a complete offering of
integrated communications services.
We generate the majority of our revenues from services provided in the
14-state region of Arizona, Colorado, Idaho, Iowa, Minnesota, Montana, Nebraska,
New Mexico, North Dakota, Oregon, South Dakota, Utah, Washington and Wyoming. We
refer to this region as our local service area.
As discussed in Note 2-Acquisition of QCII by CenturyLink, on April 1, 2011,
our indirect parent, QCII, became a wholly owned subsidiary of CenturyLink.
Since April 1, 2011, our consolidated results of operations have been
included in the consolidated results of operations of our ultimate parent,
CenturyLink. CenturyLink has accounted for its acquisition of QCII and us under
the acquisition method of accounting, which resulted in the assignment of the
purchase price to the assets acquired and liabilities assumed based on estimates
of their acquisition date fair values. The aggregate consideration payable to
QCII's stockholders that is attributable to us exceeded the aggregate estimated
fair value of the assets acquired and liabilities assumed by $9.369 billion,
which we have recognized as goodwill. This goodwill is attributable to strategic
benefits, including enhanced financial and operational scale, market
diversification and leveraged combined networks that we expect CenturyLink and
its consolidated subsidiaries, including us, to realize. None of the goodwill
associated with this acquisition is deductible for income tax purposes. The
recognition of assets and liabilities at fair value is reflected in our
consolidated financial statements and therefore has resulted in a new basis of
accounting for the "successor period" beginning on April 1, 2011. This new basis
of accounting means that our consolidated financial statements for the successor
periods will not
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be comparable to our previously reported consolidated financial statements,
including the predecessor period consolidated financial statements in this
report.
We have accounted for CenturyLink's acquisition of us under the acquisition
method of accounting, which resulted in the assignment of the aggregate
consideration to the assets acquired and liabilities assumed based on their
acquisition date fair values. The fair value of the aggregate consideration
transferred exceeded the acquisition date fair value of the recorded tangible
and intangible assets, and assumed liabilities by $9.369 billion, which has been
recognized as goodwill. The impairment testing is done at the reporting unit
level; in reviewing the criteria for reporting units when allocating the
goodwill resulting from our acquisition by CenturyLink, it was determined that
we are one reportable unit, Qwest. We are required to review goodwill recorded
in business combinations for impairment at least annually, or more frequently if
events or circumstances indicate there may be impairment. Our annual measurement
date for testing goodwill impairment is September 30. We are required to
write-down the value of goodwill only in periods in which the recorded amount of
goodwill exceeds the fair value.
The discussion in MD&A of our performance for the nine months ended
September 30, 2011 is presented on a combined basis for the predecessor and
successor periods in 2011. We believe this presentation allows the consolidated
results of operations for this period to be more readily compared to the
comparable nine-month period in 2012.
We have incurred operating expenses related to CenturyLink's indirect
acquisition of us, which consist primarily of integration and severance
expenses. The table below summarizes our acquisition-related expenses:
Successor Predecessor Combined
Three Months Three Months Nine Months Six Months Three Months Nine Months
Ended Ended Ended Ended Ended Ended
September 30, September 30, September 30, September 30, March 31, September 30,
2012 2011 2012 2011 2011 2011
(Dollars in millions)
Acquisition-related
expenses $ 9 16 33 139 2 141
CenturyLink has cash management arrangements between certain of its
subsidiaries, including us, under which the majority of our cash balance is
transferred on a daily basis to CenturyLink. We report the balance of these
transfers on our consolidated balance sheet as advances to affiliates.
Since the April 1, 2011 closing of CenturyLink's indirect acquisition of us,
our operations have been integrated into and reported as part of the segments of
CenturyLink. CenturyLink's chief operating decision maker ("CODM") has become
our CODM, but reviews our financial information on an aggregate basis only in
connection with our quarterly and annual reports that we file with the
Securities and Exchange Commission ("SEC"). Consequently, we do not provide our
discrete financial information to the CODM on a regular basis.
We currently categorize our products, services and revenues among the
following three categories:
º •
º Strategic services, which include primarily private line (including
special access), broadband, video (including resold satellite video
services) and Verizon Wireless services;
º •
º Legacy services, which include primarily local, integrated services
digital network ("ISDN") (which uses regular telephone lines to
support voice, video and data applications), switched access and
traditional wide area network ("WAN") services (which allows a local
communications network to link to networks in remote locations); and
º • º Affiliates and other services, which consist primarily of universal
service funds ("USF") revenues and surcharges and services we provide
to our non-consolidated affiliates. We provide to our affiliates
telecommunications services that we also provide to external
customers. In addition, we
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provide to our affiliates computer system development and support
services and network support and technical services.
During the first quarter of 2012, we reclassified certain prior period
revenues between the aforementioned three categories to conform to the current
period presentation.
As of the successor date of September 30, 2012, we operated approximately
8.2 million access lines, which are telephone lines reaching from the customers'
premises to a connection with the public switched telephone network. We count
access lines when we install the service. Our methodology includes only those
access lines that we use to provide services to external customers and excludes
lines used solely by us and our affiliates. It also excludes unbundled loops and
includes stand-alone broadband subscribers. Our methodology for counting our
access lines may not be comparable to those of other companies. As of the
successor date of September 30, 2012, we also served approximately 3.3 million
broadband subscribers. As described below, during the second quarter of 2012, we
updated our methodology for counting broadband subscribers to include
residential, business and wholesale subscribers instead of only residential and
small business subscribers.
Our analysis presented below is organized to provide the information we
believe will be useful for understanding the relevant trends affecting our
business. This discussion should be read in conjunction with our consolidated
financial statements and the notes thereto in Item 1 of this report.
Business Trends
Our financial results were impacted by several significant trends, which are
described below. We expect that these trends will continue to affect our
consolidated results of operations, cash flows or financial position.
º •
º Strategic services. We continue to see shifts in the makeup of our
total revenues as customers move to strategic services, such as
private line, broadband and video services, from legacy services, such as local and access services. Revenues from our strategic services
represented 38% and 36% of our total revenues for the successor three
months ended September 30, 2012 and 2011, respectively, and 37% and
36%of our total revenues for the successor nine months ended
September 30, 2012 and the combined nine months ended September 30, 2011, respectively, and we expect that this percentage will continue
to grow. We continue to focus on increasing subscribers of our
broadband services, particularly among consumer and small business
customers. We believe that continually increasing connection speeds is
important to remaining competitive in our industry. As a result, we
continue to invest in our fiber to the node ("FTTN") deployment, which
allows for the delivery of higher speed broadband services than would
otherwise generally be available through a more traditional
telecommunications network made up of only copper wires. In addition
to our FTTN deployment, we continue to expand our product offerings,
including Ethernet and MPLS, and enhance our marketing efforts as we
compete in a maturing market in which most consumers already have
broadband services. While traditional broadband services are
declining, they have been more than offset by growth in fiber based broadband services. We expect these efforts will improve our ability
to compete and increase our broadband revenues. Another trend
impacting our strategic services is the deployment of fiber-based
special access services provided to wireless carriers, which in many
cases replaces existing copper-based special access services. We believe the growth in fiber-based special access services provided to
wireless carriers for backhaul will, ultimately, over time, offset the
decline in copper-based special access services provided to wireless
carriers as they migrate to Ethernet services, although the timing and
magnitude of this technological migration is uncertain.
º •
º Legacy services. Revenues from our legacy services represented 39% and
42% of our total revenues for the successor three months ended
September 30, 2012 and 2011, respectively, and
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40% and 43% of our total revenues for the successor nine months ended
September 30, 2012 and the combined nine months ended September 30, 2011, respectively, and we expect that this percentage will continue
to decline. Our legacy services revenues have been, and we expect they
will continue to be, adversely affected by access line losses. Intense
competition and product substitution continue to drive our access line
losses. For example, many consumers are replacing traditional voice
telecommunications service with substitute services, including
(i) cable and wireless voice services and (ii) electronic mail, texting and social networking services. We expect that these factors
will continue to negatively impact our business. As a result of the
expected loss of access line revenues, we continue to offer service
bundling and other product promotions to help mitigate this trend, as
described below.
º •
º Service bundling and product promotions. We offer our customers the
ability to bundle multiple products and services. These customers can bundle local services with other services such as broadband, video and
wireless. While our video and wireless services are an important piece
of our customer retention strategy, they do not significantly
contribute to our strategic services revenues. However, we believe customers value the convenience of, and price discounts associated
with, receiving multiple services through a single company. While
bundle price discounts have resulted in lower average revenues for our
individual products, we believe service bundles continue to positively
impact our customer retention and our ability to compete with other
telecommunications service providers. In addition to our bundle
discounts, we also offer from time to time limited time promotions on
our broadband service, which we believe further aids our ability to
attract and retain customers and increase usage of our services.
º •
º Operating efficiencies. We continue to evaluate our operating structure and focus. This involves balancing our workforce in response
to our workload requirements, productivity improvements and changes in
industry, competitive, technological and regulatory conditions.
º •
º Pension and post-retirement benefits expenses. Our indirect parent
QCII is required to recognize in its consolidated financial statements
certain expenses relating to its pension and post-retirement health
care and life insurance benefits plans. These expenses are calculated
based on several assumptions, including among other things discount
rates and expected rates of return on plan assets that are generally
set at December 31 of each year. Changes in these assumptions can
cause significant changes in the combined net periodic benefits
expenses QCII recognizes. QCII allocates the expenses of these plans to us and certain of its other affiliates. The allocation of expenses
to us is based upon the demographics of our employees and retirees.
Changes in QCII's assumptions can cause significant changes in the net
periodic pension and post-retirement benefits expenses we recognize.
º •
º Strategic capital investment. Our capital expenditures continue to be
focused on our strategic services such as broadband and the deployment
of fiber to the tower ("FTTT"). FTTT is a type of telecommunications
network consisting of fiber-optic cables that run from a wireless
carrier's mobile telephone switching office to cellular towers to
enable the delivery of higher bandwidth services supporting mobile
technologies than would otherwise generally be available through a
more traditional copper-based telecommunications network.
While these trends are important to understanding and evaluating our
financial results, the other transactions, additional events, uncertainties and
trends discussed in "Risk Factors" in Item 1A of Part II of this report may also
materially impact our business operations and financial results.
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Results of Operations
The following table summarizes our results of operations:
Successor Predecessor Combined
Three Months Three Months Nine Months Six Months Three Months Nine Months
Ended Ended Ended Ended Ended Ended
September 30, September 30, September 30, September 30, March 31, September 30,
2012 2011 2012 2011 2011 2011
(Dollars in millions)
Operating
revenues $ 2,183 2,190 6,638 4,421 2,268 6,689
Operating
expenses 1,724 1,778 5,258 3,639 1,630 5,269
Operating
income 459 412 1,380 782 638 1,420
Other
income
(expense) (114 ) (95 ) (390 ) (184 ) (148 ) (332 )
Income
tax
expense 133 118 382 234 191 425
Net
income $ 212 199 608 364 299 663
The following table summarizes certain of our operational metrics:
Successor
As of As of
September 30, September 30, Increase/
2012 2011 (Decrease) % Change
(in thousands)
Broadband subscribers 3,282 3,134 148 5 %
Access lines 8,167 8,658 (491 ) (6 )%
Employees 21.5 25.0 (3.5 ) (14 )%
During the second quarter of 2012, we updated our methodology for counting
broadband subscribers to better align with the methodology used by our ultimate
parent company, CenturyLink. We have restated our previously reported amounts to
reflect this change. For additional information on our counting methodologies,
see "Overview" above.
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Operating Revenues
The following tables summarize our operating revenues:
Successor
Three Months Three Months
Ended Ended
September 30, September 30, Increase/
2012 2011 (Decrease) % Change
(Dollars in millions)
Strategic services $ 819 794 25 3 %
Legacy services 860 928 (68 ) (7 )%
Affiliates and other
services 504 468 36 8 %
Total operating revenues $ 2,183 2,190 (7 ) nm
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nm-Percentages greater than 200% and comparisons between positive and negative
values or to/from zero values are considered not meaningful.
Increase/
Successor Predecessor Combined (Decrease) % Change
Nine Months Six Months Three Months Nine Months Successor Successor
Ended Ended Ended Ended 2012 v 2012 v
September 30, September 30, March 31, September 30, Combined Combined
2012 2011 2011 2011 2011 2011
(Dollars in millions)
Strategic
services $ 2,442 1,585 792 2,377 65 3 %
Legacy
services 2,634 1,882 1,003 2,885 (251 ) (9 )%
Affiliates
and other
services 1,562 954 473 1,427 135 9 %
Total
operating
revenues $ 6,638 4,421 2,268 6,689 (51 ) (1 )%
Strategic Services
Strategic services revenues increased in both of the comparative periods
reflected in the tables above due primarily to increases in the volume of our
Ethernet services and increased sales of higher speed broadband services. Our
growth in revenues was partially offset by decreased sales volumes of our
private line and special access services.
Legacy Services
Legacy services revenues decreased in both of the comparative periods as a
result of lower local and long-distance services revenues due to access line
loss and reduced access services usage related to the above-described
competitive pressures and product substitution. Legacy services revenues also
decreased in both of the comparative periods due to lower revenues from our
traditional WAN services caused by customer migration, product substitution and
increased competition. Part of the decrease in legacy services revenues for the
successor nine months ended September 30, 2012 compared to the combined nine
months ended September 30, 2011 is attributable to lower amortization of
deferred revenue due to predecessor deferred installation and activation revenue
being assigned no value at the acquisition date.
Affiliates and Other Services
Affiliates and other services revenues increased in both of the comparative
periods primarily due to a change in methodology effective January 1, 2012 that
resulted in both higher affiliate revenues and expenses for us. See Note 1-Basis
of Presentation. A portion of the increase in affiliates and other
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services revenues for the successor nine months ended September 30, 2012
compared to the combined nine months ended September 30, 2011 is attributable to
telecommunications services we provided to affiliates since CenturyLink's
April 1, 2011 indirect acquisition of us. The remainder of this increase is
attributable to the increased USF rates.
Operating Expenses
The following tables summarize our operating expenses:
Successor
Three Months Three Months
Ended Ended
September 30, September 30, Increase/
2012 2011 (Decrease) % Change
(Dollars in millions)
Cost of services and
products (exclusive of
depreciation and
amortization) $ 737 731 6 1 %
Selling, general and
administrative 249 351 (102 ) (29 )%
Operating
expenses-affiliates 169 76 93 122 %
Depreciation and
amortization 569 620 (51 ) (8 )%
Total operating expenses $ 1,724 1,778 (54 ) (3 )%
Increase/
Successor Predecessor Combined (Decrease) % Change
Nine Months Six Months Three Months Nine Months Successor Successor
Ended Ended Ended Ended 2012 v 2012 v
September 30, September 30, March 31, September 30, Combined Combined
2012 2011 2011 2011 2011 2011
(Dollars in millions)
Cost of services
and products
(exclusive of
depreciation and
amortization) $ 2,174 1,444 742 2,186 (12 ) (1 )%
Selling, general
and administrative 899 803 385 1,188 (289 ) (24 )%
Operating
expenses-affiliates 474 149 52 201 273 136 %
Depreciation and
amortization 1,711 1,243 451 1,694 17 1 %
Total operating
expenses $ 5,258 3,639 1,630 5,269 (11 ) nm
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nm-Percentages greater than 200% and comparisons between positive and negative
values or to/from zero values are considered not meaningful.
Effective January 1, 2012, we changed our rates of capitalized labor as we
transitioned certain legacy systems to the historical systems of our ultimate
parent, CenturyLink. This transition resulted in an estimated $30 million to
$45 million increase in the amount of labor capitalized as an asset compared to
the amount that would have been capitalized if we had continued to use our
legacy systems and a corresponding estimated $30 million to $45 million decrease
in operating expenses for the successor nine months ended September 30, 2012.
This change is expected to result in an estimated operating expense reduction of
approximately $35 million to $60 million for the successor year ending
December 31, 2012.
Cost of Services and Products (exclusive of depreciation and amortization)
Cost of services and products (exclusive of depreciation and amortization)
are expenses incurred in providing products and services to our customers. These
expenses include: employee-related expenses directly attributable to operating
and maintaining our network (such as salaries, wages, benefits and professional
fees); facilities expenses (which are expenses we incur from using other
carriers' networks to provide services to our customers); rents and utilities
expenses; equipment sales expenses (such as
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modem expenses); costs for USF (which reflect our contributions to certain
federal and state funds that are established to promote the availability of
telecommunications services to all consumers at reasonable and affordable rates,
among other things); and other expenses directly related to our network
operations. These expenses increased slightly in the successor three months
ended September 30, 2012 compared to the successor three months ended
September 30, 2011 reflected in the tables above primarily due to increased
customer premise equipment costs, professional fees, facility costs, and USF
contribution rates partially offset by decreased salaries and wages and
benefits. These expenses decreased in the successor nine months ended
September 30, 2012 compared to the combined nine months ended September 30, 2011
reflected in the table above primarily due to decreased salaries and wages and
benefits.
Selling, General and Administrative
Selling, general and administrative expenses are expenses incurred in
selling products and services to our customers, corporate overhead and certain
other operating expenses. These expenses include: employee-related expenses
(such as salaries, wages, internal commissions, benefits and professional fees)
directly attributable to selling products or services and employee-related
expenses for administrative functions; marketing and advertising; taxes (such as
property and other taxes) and fees; external commissions; bad debt expense; and
other operating expenses.
During the first quarter of 2012, we reclassified certain operating expenses
from our selling, general and administrative expenses to our cost of services
and products (exclusive of depreciation and amortization) to better reflect our
expenses related to providing services to our affiliates. As a result, we
reclassified previously reported amounts to conform to the current period
presentation. For the predecessor three months ended March 31, 2011 and the
successor six months ended September 30, 2011, this reclassification resulted in
a reduction of selling, general and administrative expenses of $116 million and
$229 million, respectively.
These expenses decreased in both of the comparative periods reflected in the
tables above primarily due to decreased salaries and wages, benefits, and
marketing and advertising expense during both of the comparative periods
presented.
Operating Expenses-Affiliates
Effective January 1, 2012, in connection with post-acquisition systems
integration activities, we adopted the affiliate expense allocation methodology
used by our ultimate parent. This methodology results in certain overhead costs
incurred by us and by our ultimate parent that were previously assessed to us on
a net basis now being assessed on a gross basis both to and from our ultimate
parent, resulting in both higher affiliate revenues and expenses for us. We
believe this change, resulting from systems integration activities, did not have
a significant impact to our net income for the successor three and nine months
ended September 30, 2012.
Since CenturyLink's indirect acquisition of us, we have incurred affiliates
expenses related to our use of telecommunications services, marketing and
employee related support services provided to us by CenturyLink and certain of
its subsidiaries. A portion of the increase in operating expenses-affiliates for
the successor nine months ended September 30, 2012 compared to the combined nine
months ended September 30, 2011 is attributable to incurring these intercompany
expenses for the entire 2012 period compared to only six months of the 2011
period as well as an increase in the volume of intercompany transactions.
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Depreciation and Amortization
The following tables provide detail regarding depreciation and amortization
expense:
Successor
Three Months Three Months
Ended Ended
September 30, September 30, Increase/
2012 2011 (Decrease) % Change
(Dollars in millions)
Depreciation $ 295 302 (7 ) (2 )%
Amortization 274 318 (44 ) (14 )%
Total depreciation and
amortization $ 569 620 (51 ) (8 )%
Increase/
Successor Predecessor Combined (Decrease) % Change
Nine Months Six Months Three Months Nine Months Successor Successor
Ended Ended Ended Ended 2012 v 2012 v
September 30, September 30, March 31, September 30, Combined Combined
2012 2011 2011 2011 2011 2011
(Dollars in millions)
Depreciation $ 876 606 393 999 (123 ) (12 )%
Amortization 835 637 58 695 140 20 %
Total
depreciation
and
amortization $ 1,711 1,243 451 1,694 17 1 %
In connection with us being acquired as of April 1, 2011, our property,
plant and equipment was recognized at fair value, which reduced the recognized
amounts of our net property, plant and equipment. This decrease in asset value
resulted in $92 million lower depreciation expense for the successor nine months
ended September 30, 2012, as compared to the combined nine months ended
September 30, 2011. Effective January 1, 2012, we also changed our estimates of
the economic lives of certain telecommunications equipment. These changes
resulted in an additional decrease to depreciation expense of approximately
$13 million and $39 million for the successor three and nine months ended
September 30, 2012, respectively.
The accounting for CenturyLink's indirect acquisition of us also resulted in
additional amortizable intangible customer relationship assets, which increased
amortization expense approximately $173 million for the successor nine months
ended September 30, 2012, as compared to the combined nine months ended
September 30, 2011. In addition, our capitalized software was also recognized at
fair value, which resulted in an increase of $59 million in amortization expense
for the successor nine months ended September 30, 2012, as compared to the
combined nine months ended September 30, 2011.
Excluding the effects of CenturyLink's indirect acquisition of us,
depreciation and amortization expense decreased $12 million and $52 million for
the successor three and nine months ended September 30, 2012, respectively, due
to annual updates of our depreciation rates for capitalized assets.
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Other Consolidated Results
The following tables summarize our total other income (expense) and income
tax expense:
Successor
Three Months Three Months
Ended Ended
September 30, September 30, Increase/
2012 2011 (Decrease) % Change
(Dollars in millions)
Interest expense $ (113 ) (95 ) 18 19 %
Loss on early retirement
of debt (1 ) - 1 nm
Total other income
(expense) $ (114 ) (95 ) 19 20 %
Income tax expense $ 133 118 15 13 %
Increase/
Successor Predecessor Combined (Decrease) % Change
Nine Months Six Months Three Months Nine Months Successor Successor
Ended Ended Ended Ended 2012 v 2012 v
September 30, September 30, March 31, September 30, Combined Combined
2012 2011 2011 2011 2011 2011
(Dollars in millions)
Interest
expense $ (342 ) (183 ) (150 ) (333 ) 9 3 %
Loss on
early
retirement
of debt (47 ) (1 ) - (1 ) 46 nm
Other
(expense)
income (1 ) - 2 2 3 nm
Total
other
income
(expense) $ (390 ) (184 ) (148 ) (332 ) 58 17 %
Income tax
expense $ 382 234 191 425 43 10 %
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nm-Percentages greater than 200% and comparisons between positive and negative
values or to/from zero values are considered not meaningful.
Interest Expense
Interest expense for the three and nine months ended September 30, 2012
increased compared to the successor three and combined nine months ended
September 30, 2011 primarily due to a substantial reduction in the amount of
debt premium amortization recorded at acquisition primarily due to the
retirement of several issuances of debt during the affected periods. This was
substantially offset by a significant decrease in bond coupon interest due to
the retirement of several debt issuances during the nine months ended
September 30, 2012, in some cases replaced with lower coupon debt along with
increased capitalized interest. See Liquidity and Capital Resources for the
details of these net redemptions.
Loss on Early Retirement of Debt
On April 18, 2012, we completed a premium-priced cash tender offer to
purchase a portion of our $811 million of 8.375% Notes due 2016 and our
$400 million of 7.625% Notes due 2015. With respect to our 8.375% Notes due
2016, we received and accepted tenders of approximately $575 million aggregate
principal amount of these notes, or 71%, for $722 million including a premium,
fees and accrued interest. With respect to our 7.625% Notes due 2015, we
received and accepted tenders of approximately $308 million aggregate principal
amount of these notes, or 77%, for $369 million including a premium, fees and
accrued interest. The completion of this tender offer resulted in a loss of
$46 million.
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Income Tax Expense
Income tax expense for the successor nine months ended September 30, 2012
was $382 million, or an effective tax rate of 38.6%, as compared to income tax
expense for the combined nine months ended September 30, 2011 of $425 million,
or an effective tax rate of 39.1%. The decrease in the effective tax rate is
primarily due to a decrease in the state tax rate for 2012.
Liquidity and Capital Resources
Overview
We are an indirectly wholly owned subsidiary of CenturyLink. As such,
factors relating to, or affecting, CenturyLink's liquidity and capital resources
could have material impacts on us, including impacts on our credit ratings, our
access to capital markets and changes in the financial market's perception of
us.
CenturyLink has cash management arrangements between certain of its
subsidiaries that include lines of credit, affiliate obligations, capital
contributions and dividends. As part of these cash management arrangements,
affiliates provide lines of credit to certain other affiliates. Amounts
outstanding under these lines of credit and intercompany obligations vary from
time to time. Under these arrangements, the majority of our cash balance is
advanced on a daily basis to CenturyLink. From time to time we may declare and
pay dividends to QSC, using cash repaid to us under these advances, which has
the net effect of reducing the amount of these advances. Our debt covenants do
not limit the amount of dividends we can pay to QSC. Given our cash management
arrangement with our ultimate parent, CenturyLink, and the resulting amounts due
to us from CenturyLink, a significant component of our liquidity is dependent
upon CenturyLink's ability to repay its obligation to us.
As of the successor date of September 30, 2012, we had a working capital
deficit of $1.2 billion, reflecting current liabilities of $2.9 billion and
current assets of $1.7 billion, compared to a working capital deficit of
$917 million as of the successor date of December 31, 2011. The change in our
working capital position is primarily due to an increase in the current
maturities of long-term debt of $741 million and notes payable-affiliates of
$685 million which were partially offset by an increase in the amounts owed to
us by our affiliates of $533 million as of the successor date of September 30,
2012, as well as decreases in accounts payable and accounts payable-affiliates
of $345 million, and a decrease in dividends payable of $310 million. Our
current maturities of long-term debt balances were high as of the successor date
of September 30, 2012 substantially due to the scheduled maturity of our
$750 million floating rate notes on June 1, 2013. We have historically operated
with a working capital deficit due to our practice of declaring and paying
regular cash dividends to QSC. As long as we continue declaring cash dividends
to QSC, it is likely that we will continue to operate with a working capital
deficit in the future. We anticipate that any future liquidity needs not met
through our cash provided by operating activities and amounts due to us from
CenturyLink could be met through capital contributions or advances from
CenturyLink if and to the extent CenturyLink has available funds that it is
willing and able to contribute or advance.
Revolving Promissory Note
QC has a revolving promissory note with an affiliate of CenturyLink that
provides us with a funding commitment with an aggregate principle amount
available to $1.0 billion through June 30, 2022 and $685 million outstanding as
of the successor date of September 30, 2012. The revolving promissory note is
subordinated to our Senior Notes. Interest is accrued on the outstanding balance
using a weighted average per annum interest rate of CenturyLink's outstanding
borrowings for the interest period. As of September 30, 2012, the weighted
average interest rate was 6.0917%. The accrued interest and outstanding
principle balance are payable on demand, and if no demand, then on June 30,
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2022. This revolving promissory note is reflected on our consolidated balance
sheets under "Notes payable-affiliates".
Debt and Other Financing Arrangements
Subject to market conditions, we expect to continue to issue debt securities
from time to time to refinance our maturing debt. The availability, interest
rate and other terms of any new borrowings will depend on the ratings assigned
us by the three major credit rating agencies, among others.
As of the successor date of September 30, 2012, we believe we were in
compliance with the provisions and covenants of our debt agreements.
Capital Expenditures
We incur capital expenditures on an ongoing basis in order to enhance and
modernize our networks, compete effectively in our markets and expand our
service offerings. We evaluate capital expenditure projects based on a variety
of factors, including expected strategic impacts (such as forecasted revenue
growth or productivity, expense and service impacts) and our expected return on
investment. The amount of capital investment is influenced by, among other
things, demand for our services and products, cash generated by operating
activities and regulatory considerations. Our 2012 capital expenditures will be
determined in part by the strategic initiatives of our ultimate parent,
CenturyLink.
Our capital expenditures continue to be focused on primarily our broadband
services. In particular, we will continue to focus on expanding our fiber
infrastructure, including installations of "fiber to the tower", or FTTT. FTTT
is a type of telecommunications network consisting of fiber-optic cables that
run from a wireless carrier's mobile telephone switching office to cellular
towers to enable the delivery of higher bandwidth services supporting mobile
technologies than would otherwise generally be available through a more
traditional copper-based telecommunications network.
CenturyLink, our ultimate parent, has agreed to accept approximately
$35 million of the $90 million available to it from Phase 1 of the Federal
Communications Commission's ("FCC") Connect America Fund ("CAF") established by
Congress to help telecommunications carriers defray the cost of providing
broadband access to remote customers. Of the $35 million, we will receive
approximately $30 million and intend to use the funds to deploy broadband
service for up to 39,000 homes in unserved rural areas principally in Colorado,
Minnesota, New Mexico and Washington. CenturyLink has determined that
restrictions on the use of these funds have made acceptance of additional CAF
funds uneconomical. CenturyLink has, however, filed with the FCC a waiver
application, which, if granted, would allow us to deploy broadband services with
CAF funds to approximately 56,000 more homes in high-cost unserved areas in our
markets.
Pension and Post-retirement Benefit Obligations
QCII is subject to material obligations under its existing defined benefit
pension and other post-retirement benefit plans. The plans are measured annually
at December 31. As of the successor date of December 31, 2011, the accounting
unfunded status of QCII's pension and other post-retirement benefit obligations
was $650 million and $2.7 billion, respectively.
A substantial portion of our employees participate in the QCII pension plan.
Historically, QCII has only required us to pay our portion of its pension
contribution. Our contributions are not segregated or restricted to pay amounts
due to our employees and may be used to provide benefits to other employees of
QCII's affiliates.
Benefits paid by QCII's qualified pension plan are paid through a trust.
Based on current laws and circumstances, QCII will not be required to make a
cash contribution to this plan in 2012 and based on
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current funding laws and regulation it is unlikely QCII will be required to make
a cash contribution in 2013. The amount of required contributions to QCII's plan
in 2013 and beyond will depend on earnings on plan investments, prevailing
interest and discount rates, demographic experience, changes in plan benefits
and any further changes in funding laws and regulations.
Certain of QCII's post-retirement health care and life insurance benefits
plans are unfunded. A trust holds assets that are used to help cover the health
care costs of certain retirees. As of December 31, 2011, the fair value of the
trust assets was $643 million; however, a portion of these assets is comprised
of investments with restricted liquidity. QCII estimates that the more liquid
assets in the trust will be adequate to provide continuing reimbursements for
covered post-retirement health care costs for approximately four years, based on
current circumstances. Thereafter, covered benefits will be paid either directly
by QCII or from the trust as the remaining assets become liquid. This projected
four year period could be substantially shorter or longer depending on changes
in projected health care costs, returns on plan assets, the timing of maturities
of illiquid plan assets and future changes in benefits.
QCII's estimated annual long-term rate of return on the pension and
post-retirement plans trust assets is 7.5% based on the assets currently held;
however, actual returns could vary widely in any given year.
Historical Information
The following table summarizes our cash flow activities:
Increase/
Successor Predecessor Combined (Decrease)
Nine Months Six Months Three Months Nine Months Successor
Ended Ended Ended Ended 2012 v
September 30, September 30, March 31, September 30, Combined
2012 2011 2011 2011 2011
(Dollars in millions)
Net cash
provided
by
operating
activities $ 2,713 1,575 869 2,444 269
Net cash
used in
investing
activities (1,784 ) (1,403 ) (335 ) (1,738 ) 46
Net cash
used in
financing
activities (923 ) (366 ) (525 ) (891 ) 32
Net cash provided by operating activities increased in the successor nine
months ended September 30, 2012 as compared to the combined nine months ended
September 30, 2011 primarily due to changes in affiliate balances which were
somewhat offset by changes to deferred income taxes.
Net cash used in investing activities increased in the successor nine months
ended September 30, 2012 as compared to the combined nine months ended
September 30, 2011 primarily due to changes in our advances to affiliates
resulting from the majority of our cash balance being transferred on a daily
basis to CenturyLink. This increase is partially offset by proceeds from the
sale of property received in the 2012 period.
Net cash used in financing activities increased in the successor nine months
ended September 30, 2012 primarily due to a an increase in the net pay down of
debt offset by a decrease in dividends paid.
On July 20, 2012, we redeemed all $484 million of our 7.50% Notes due 2023,
which resulted in an immaterial loss.
On June 25, 2012, we issued $400 million aggregate principal amount of 7.00%
Notes due 2052 in exchange for net proceeds, after deducting underwriting
discounts and expenses, of $387 million. The Notes are unsecured obligations and
may be redeemed, in whole or in part, on or after July 1, 2017 at a redemption
price equal to 100% of the principal amount redeemed plus accrued interest.
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On April 18, 2012, we completed a cash tender offer to purchase a portion of
our $811 million of 8.375% Notes due 2016 and our $400 million of 7.625% Notes
due 2015. With respect to our 8.375% Notes due 2016, we received and accepted
tenders of approximately $575 million aggregate principal amount of these notes,
or 71%, for $722 million including a premium, fees and accrued interest. With
respect to our 7.625% Notes due 2015, we received and accepted tenders of
approximately $308 million aggregate principal amount of these notes, or 77%,
for $369 million including a premium, fees and accrued interest. The completion
of this tender offer resulted in a loss of $46 million. In connection with
consummating this tender offer, we borrowed from a CenturyLink affiliate
approximately $583 million under a revolving promissory note, payable upon
demand. The promissory note is unsecured and is pari passu to our senior notes.
On April 2, 2012, we issued $525 million aggregate principal amount of 7.00%
Notes due 2052 in exchange for net proceeds, after deducting underwriting
discounts and expenses, of $508 million. The Notes are unsecured obligations and
may be redeemed, in whole or in part, on or after April 1, 2017 at a redemption
price equal to 100% of the principal amount redeemed plus accrued interest.
Certain Matters Related to CenturyLink's Indirect Acquisition of Us
Effective after CenturyLink's indirect acquisition of us, we are included in
the consolidated federal income tax return of CenturyLink. CenturyLink is in the
process of developing a post-acquisition intercompany agreement for allocation
of consolidated income tax liabilities. We will continue to account for income
tax expense on a stand-alone basis. We are also included in certain combined
state tax returns filed by CenturyLink and the same accounting will apply.
As of the successor date of September 30, 2012, we paid certain costs that
were associated with CenturyLink's indirect acquisition of us. These costs
include compensation costs comprised of retention bonuses and severance. The
final amounts and timing of the compensation costs to be paid is partially
dependent upon personnel decisions that continue to be made as part of the
continuing integration process. These amounts may be material.
In accounting for CenturyLink's indirect acquisition of us, we recognized
our debt securities at their estimated fair values, which totaled $8.498 billion
as of April 1, 2011. Our acquisition date fair value estimates were based
primarily on quoted market prices in active markets and other observable inputs
where quoted market prices were not available. The fair value of our debt
securities exceeded their stated principal balances on the acquisition date by
$530 million, which we recorded as premium.
The table below summarizes the premiums recognized as a reduction to
interest expense or extinguished during the periods indicated:
Successor
Nine Months Nine Months
Ended Ended
September 30, December 31, Total Since
2012 2011 Acquisition
(Dollars in millions)
Amortized $ 51 135 186
Extinguished(1) 128 59 187
Total premiums recognized $ 179 194 373
--------------------------------------------------------------------------------
º (1)
º See "Debt and Other Financing Arrangements" for more information.
The remaining premium of $157 million as of the successor date of
September 30, 2012 will reduce interest expense in future periods, unless
otherwise extinguished.
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Other Matters
CenturyLink and QCII are involved in various legal proceedings that could
have a material adverse effect on their financial position. As a wholly owned
subsidiary of CenturyLink and QCII, our business and financial condition could
be similarly affected. You can find descriptions of these legal proceedings in
CenturyLink's and QCII's quarterly and annual reports filed with the SEC.
Because we are not a party to any of the matters, we have not accrued any
liabilities for these matters.
Approximately 60% of our employees are subject to collective bargaining
agreements that expired on October 6, 2012. Our ultimate parent company,
CenturyLink, is currently negotiating the terms of new agreements. In the
meantime, the predecessor agreements have been extended, and the unions have
agreed to provide us with at least a twenty-four hour advance notice before
terminating those predecessor agreements. Any strikes or other changes in our
labor relations could have a significant impact on our business. See "Risk
Factors-Other Risks" in Item 1A. of Part II of this report. If we fail to extend
or renegotiate our collective bargaining agreement with our labor unions as they
expire from time to time, or if our unionized employees were to engage in a
strike or other work stoppage, our business and operating results could be
materially harmed. To help mitigate this potential risk, we have established
contingency plans in which we would assign trained, non-represented employees to
cover jobs for represented employees in the event of a work stoppage to provide
continuity for our customers.
Off-Balance Sheet Arrangements
There were no substantial changes to our contractual obligations in the
successor nine months ended September 30, 2012, when compared to the disclosures
provided in our Annual Report on Form 10-K for the year ended December 31, 2011.
Market Risk
We are exposed to market risk from changes in interest rates on our variable
rate long-term debt obligations. We seek to maintain a favorable mix of fixed
and variable rate debt in an effort to limit interest costs and cash flow
volatility resulting from changes in rates.
From time to time, we have used derivative instruments to (i) lock-in or
swap our exposure to changing or variable interest rates for fixed interest
rates or (ii) to swap obligations to pay fixed interest rates for variable
interest rates. As of the successor date of September 30, 2012, we had no such
instruments outstanding.
There were no material changes to market risks arising from changes in
interest rates for the successor nine months ended September 30, 2012, when
compared to the disclosures provided in our Annual Report on Form 10-K for the
year ended December 31, 2011.
Other Information
Our website is the same as that of our ultimate parent company, CenturyLink,
which is www.centurylink.com. We routinely post important investor information
in the "Investor Relations" section of our website at ir.centurylink.com. The
information contained on, or that may be accessed through, our website is not
part of this quarterly report. You may obtain free electronic copies of our
annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on
Form 8-K and all amendments to those reports in the "Investor Relations" section
of our website (ir.centurylink.com) under the heading "SEC Filings." These
reports are available on our website as soon as reasonably practicable after we
electronically file them with the SEC.
In addition to historical information, this MD&A includes certain
forward-looking statements that are based on current expectations only, and are
subject to a number of risks, uncertainties and assumptions,
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many of which are beyond our control. Actual events and results may differ
materially from those anticipated, estimated or projected if one or more of
these risks or uncertainties materialize, or if underlying assumptions prove
incorrect. Factors that could affect actual results include but are not limited
to: the timing, success and overall effects of competition from a wide variety
of competitive providers; the risks inherent in rapid technological change; the
effects of ongoing changes in the regulation of the communications industry
(including those arising out of the Federal Communications Commission's
October 27, 2011 order regarding intercarrier compensation and the USF, among
other things); our ability to successfully negotiate collective bargaining
agreements on reasonable terms without work stoppages; our ability to
effectively adjust to changes in the communications industry and changes in the
composition of our markets and product mix caused by CenturyLink's recent
acquisitions of Savvis, QCII and Embarq; CenturyLink's ability to successfully
integrate the recently acquired operations of Savvis and QCII (including us)
into its incumbent operations, including the possibility that the anticipated
benefits from these recent acquisitions cannot be fully realized in a timely
manner or at all, or that integrating the acquired operations will be more
difficult, disruptive or costly than anticipated; CenturyLink's and QCII's
ability to use net operating loss carryovers in projected amounts; CenturyLink's
ability to effectively manage its expansion opportunities, including retaining
and hiring key personnel; possible changes in the demand for, or pricing of, our
products and services; our ability to successfully introduce new product or
service offerings on a timely and cost-effective basis; our continued access to
credit markets on favorable terms; our ability to collect our receivables from
financially troubled communications companies; any adverse developments in legal
proceedings involving CenturyLink or QCII; unanticipated increases or other
changes in our future cash requirements, whether caused by unanticipated
increases in capital expenditures, increases in CenturyLink's or QCII's pension
funding requirements or otherwise; the effects of adverse weather; other risks
referenced from time to time in this report (including in "Risk Factors" in
Item 1A of Part II of this report) or other of our filings with the SEC; and the
effects of more general factors such as changes in interest rates, in tax rates,
in accounting policies or practices, in operating, medical, pension or
administrative costs, in general market, labor or economic conditions, or in
legislation, regulation or public policy. You should be aware that new factors
may emerge from time to time and it is not possible for us to identify all such
factors nor can we predict the impact of each such factor on the business or the
extent to which any one or more factors may cause actual results to differ from
those reflected in any forward-looking statements. You are further cautioned not
to place undue reliance on these forward-looking statements, which speak only as
of the date of this report. We undertake no obligation to update any of our
forward-looking statements for any reason.
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