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WINDSTREAM 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, the use of the terms "Windstream," "we,"
"us" and "our" in this Management's Discussion and Analysis refers to Windstream
Corporation and its consolidated subsidiaries.
The following sections provide an overview of our results of operations and
highlight key trends and uncertainties in our business. Certain statements
constitute forward-looking statements. See "Forward-Looking Statements" at the
end of this discussion for additional factors relating to such statements, and
see "Risk Factors" in Item 1A of Part I of our Annual Report on Form 10-K for
the year ended December 31, 2011, filed with the Securities and Exchange
Commission ("SEC") on February 22, 2012, for a discussion of certain risk
factors applicable to our business, financial condition and results of
operations.
Effective during the fourth quarter of 2011, we changed our method of
recognizing actuarial gains and losses for pension benefits to recognize
actuarial gains and losses in our operating results in the year in which the
gains and losses occur. We have retrospectively adjusted financial information
for all prior periods presented to reflect our voluntary change in accounting
policy for pension benefits. We also elected to revise historical results for
certain previously unrecorded immaterial errors and concluded that the effects,
individually and in the aggregate, are immaterial to the unaudited quarterly
financial information. See Notes 2 and 8 to the consolidated financial
statements in our Annual Report on Form 10-K for the year ended December 31,
2011. Additionally, certain prior year amounts have been reclassified to conform
to the current year financial statement presentation. These reclassifications
did not impact net or comprehensive income.
OVERVIEW
We are a leading provider of advanced communications and technology solutions,
including managed services and cloud computing, to businesses nationwide. In
addition to business services, we offer broadband, voice and video services to
consumers in primarily rural markets. We have operations in 48 states and the
District of Columbia, a local and long-haul fiber network spanning approximately
115,000 miles, a robust business sales division and 23 data centers offering
managed services and cloud computing.
STRATEGY
During 2012, we continue to make significant progress on our strategy to grow
business and consumer broadband revenues to offset continuing pressure on our
consumer voice and long-distance revenues and intercarrier compensation.
Revenues from businesses and consumer broadband were 69.0 percent and 68.5
percent of total revenues for the three and nine month periods ended September
30, 2012, respectively, as compared to 60.5 percent and 60.0 percent for the
same period in 2011.
Our strategy has been and continues to be transformation of our business from a
rural, consumer-focused voice and broadband provider into a national provider of
advanced communications and technology solutions to businesses. The key elements
of this strategy include:
Transformation of our business
Today, we are a very different company from the one that was created in 2006
through the spinoff from Alltel Corporation. We operated in just 16 states with
less than 24,000 miles of fiber, a modest business sales organization and only a
handful of lower-tier data centers. We faced challenges as consumers abandoned
wireline voice connections in favor of wireless services, and cable television
companies were increasingly competing for both voice and Internet customers.
To manage these pressures and improve our size, scale and cost structure, we
completed three targeted acquisitions of other traditional telephone companies
between 2006 and 2009. In early 2010, we made a critical move to accelerate the
transformation of the company when we acquired NuVox Inc. ("NuVox"), a leading
regional business services provider based in Greenville, South Carolina. NuVox
added a broad portfolio of Internet protocol ("IP") based services and an
aggressive sales force, and this acquisition marked an important step in
positioning the company to better serve business customers.
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We completed three additional acquisitions in 2010, Iowa Telecommunications
Services, Inc. ("Iowa Telecom"), Hosted Solutions Acquisitions, LLC ("Hosted
Solutions") and Q-Comm Corporation ("Q-Comm"), which expanded our operating
presence in contiguous markets in the midwestern United States, added the
infrastructure to offer advanced data services and expanded our fiber network.
In 2011, we completed the acquisition of PAETEC Holding Corp ("PAETEC"), a
communications carrier focused on business customers. The PAETEC acquisition
creates a nationwide fiber network and advances our strategy to shift our
revenue mix towards strategic growth areas, including business and fiber
transport services. It adds an attractive base of medium-sized to large-sized
business customers, seven data centers and 36,700 fiber miles. In addition, the
PAETEC transaction provides opportunities for approximately $100.0 million in
pre-tax operating cost synergies and $10.0 million in capital synergies.
Investing for growth
We have made significant investments in
our network to expand our business
service offerings and increase
broadband speeds and capacity in our
consumer markets in response to public
demand for faster Internet speeds. The
expansion of our fiber transport
network, through acquisitions and
organic growth, enhances our ability to
provide wireless transport, or backhaul
services. We expect wireless data usage
to continue to increase, which will
drive the need for additional wireless
backhaul capacity. We are also making
significant investments in data centers
to broaden the technology-based
services we offer, including cloud [[Image Removed]]
computing and managed services.
Focus on business and broadband
services
As our consumer business remains under
pressure due to competition, we remain
squarely focused on expanding business
and broadband services, as further
discussed below, to drive top-line
growth. By doing so, we expect to
continue to create significant value
for both our customers and our
shareholders.
Together, these initiatives align our focus with the growth opportunities in our
industry and provide investors with the opportunity to combine growth and a
high-yield dividend.
EXECUTIVE SUMMARY
Key activities during the nine months ended September 30, 2012 included:
• continued activities around the integration of PAETEC, which turned us
into a national provider of business services and included an attractive
customer base of medium and large businesses and significantly enhanced
our capabilities in strategic growth areas, including IP based services,
cloud computing and managed services;
• continued focus on revenue growth opportunities in our business service areas;
• made significant success-based capital investments in our fiber network,
designed to accommodate network capacity requirements for wireless
carriers as a result of growing wireless data usage;
• completed the review of our management structure to increase the
efficiency of decision-making and position ourselves for continued success, where approximately 350 management positions were eliminated,
resulting in annualized savings of approximately $40 million;
• amended and restated our existing senior secured credit facilities effective August 8, 2012, providing for the incurrence of up to $900.0
million of additional term loans, allowing us to repay our revolving line
of credit and create sufficient liquidity to repay our 2013 debt
maturities;
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• paid off all $300.0 million of the PAETEC 2015 Notes, resulting in lower
future interest costs and amended and restated our existing senior secured
credit facilities to provide for the incurrence of $280.0 million of
additional term loans, extended the maturity of existing term loans and
increased secured debt capacity to 2.25 times adjusted Operating Income
before Depreciation and Amortization ("OIBDA"), as defined per the credit
facility;
• opened new state-of-the-art data centers in Little Rock, Arkansas, and McLean, Virginia, which meet the growing business demand for cloud-based
and dedicated managed services and underscore our commitment to our
growing business customer base nationwide;
• implemented new depreciation rates for certain subsidiaries, resulting in
a net increase to depreciation expense of $44.7 million for the nine
months ended September 30, 2012.
These activities, in conjunction with the strategic acquisitions we completed in
prior years, further our transformation from a traditional telephone company
into an advanced communications and technology provider. As a result of these
strategic activities, our revenue mix has shifted significantly toward our
growth areas.
BUSINESS TRENDS
The following discussion highlights key trends affecting our business.
Business communications services: Demand for advanced communications services is
expected to drive growth in revenues from business customers. To meet this
demand, we continue to expand our capabilities in integrated voice and data
services, which deliver voice and broadband services over a single Internet
connection. We also offer multi-site networking services which provide a fast
and private connection between business locations as well as a variety of other
data services. We view this as a strategic growth area, but we are subject to
competition from other carriers and cable television companies, which could
suppress growth. See "Competition" in Item 1 of Part I of our Annual Report on
Form 10-K for the year ended December 31, 2011, filed with the SEC on
February 22, 2012, for more details.
Data center services: Many businesses are moving towards cloud computing and
managed services as an alternative to a traditional information technology
infrastructure. Our data centers are capable of delivering those services, and
we are actively investing in data center expansion in order to meet the growing
demand for these types of services. In addition to cloud computing and managed
services, our data centers offer colocation services, in which we provide a
safe, secure environment for storage of servers and networking equipment.
Wireless backhaul: As wireless data usage grows, wireless carriers need
additional bandwidth on the wireline network to accommodate the additional
wireless traffic. We have made significant success-based capital investments to
provide backhaul services to wireless carriers. These investments include
building out fiber to new wireless towers and replacing copper facilities with
fiber facilities to wireless towers we already serve. During the three and nine
month periods ended September 30, 2012, we spent approximately $76.2 million and
$206.2 million, respectively, in fiber-to-the-tower investments and we expect to
continue to make significant success-based capital investments during 2012 to
offer additional wireless backhaul services to wireless carriers.
Consumer high-speed Internet: As a result of our already high penetration of 70
percent of primary residential lines, we gained approximately 6,000 consumer
high-speed Internet customers during the third quarter of 2012. We expect the
pace of high-speed Internet customer growth to continue to slow as the number of
households without high-speed Internet service shrinks and our penetration
continues to increase. However, we believe growing customer demand for faster
speeds and value-added services, such as online security and back-up, will drive
growth in consumer high-speed Internet revenues. As of September 30, 2012, we
could deliver speeds of 3 Megabits per second ("Mbps") to approximately 97
percent of our addressable lines, and speeds of 6 Mbps, 12 Mbps and 24 Mbps are
available to approximately 73 percent, 47 percent and 13 percent of our
addressable lines, respectively.
Consumer access line losses: Voice and switched access revenues will continue to
be adversely impacted by future declines in access lines due to competition from
cable television companies, wireless carriers and providers using other emerging
technologies. To combat competitive pressures, we continue to emphasize our
bundled products and services. Our consumers can bundle voice, high-speed
Internet and video services, providing one convenient billing solution and
bundle discounts. We believe that product bundles positively impact customer
retention, and the associated discounts provide our customers the best value for
their communications and entertainment needs. As of September 30, 2012, all of
our access lines had wireless competition and approximately 69 percent of our
access lines had fixed-line voice competition. Consumer lines decreased 87,000,
or 4.4 percent during the twelve month period ended September 30, 2012,
primarily due to the effects of competition.
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Synergies and operational efficiencies: We continually strive to identify
opportunities for operational efficiencies, in the context of both our acquired
businesses and legacy operations. During the three and nine month periods ended
September 30, 2012, we recognized approximately $45.0 million and $123.0 million
in synergies from our acquisitions completed since the beginning of 2010,
respectively, primarily related to workforce and network efficiencies. In
addition to acquisition-related synergies, we also evaluate our legacy
operations for operational efficiency. On May 31, 2012, we announced the review
of our management structure to increase the efficiency of decision-making, to
ensure our management structure is as simple and as responsive to customers as
possible and position ourselves for continued success. We eliminated
approximately 350 management positions as part of the restructuring, which was
completed in the third quarter of 2012 and resulted in severance related costs
of $22.4 million. The changes are expected to result in annualized savings of
approximately $40.0 million.
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ORGANIZATION AND RESULTS OF OPERATIONS
We provide a wide range of telecom services, from advanced data solutions for
businesses to basic consumer voice services. We deliver these services over
owned or leased network facilities. Our sales, marketing and customer support
teams are structured based upon the type of customer they serve. Our corporate
support teams, such as finance and accounting, human resources and legal,
support our operations as a whole. See below a detailed discussion and analysis
of revenues and sales in our discussion of consolidated operating results.
The following table reflects our consolidated operating results as of September
30:
Three Months Ended Nine Months Ended
September 30, September 30,
(Millions) (a) (b) (c) 2012 2011 2012 2011
Revenues and sales:
Service revenues:
Business $ 906.4 $ 491.8 $ 2,694.8 $ 1,468.0
Consumer 335.4 344.9 1,010.0 1,038.7
Wholesale 219.8 147.6 658.9 452.8
Other 26.1 10.3 82.4 33.3
Total service revenues 1,487.7 994.6 4,446.1 2,992.8
Product sales 64.7 28.6 189.3 83.1
Total revenues and sales 1,552.4 1,023.2 4,635.4 3,075.9
Costs and expenses:
Cost of services (exclusive of depreciation
and amortization included below) 671.3 366.3 1,987.3 1,101.5
Cost of products sold 56.8 24.5 159.3 68.6
Selling, general, and administrative 225.4 130.9 713.4 397.8
Depreciation and amortization 326.4 203.8 958.5 605.8
Merger and integration costs 12.7 19.9 54.4 33.9
Restructuring charges 12.1 0.5 23.3 0.7
Total costs and expenses 1,304.7 745.9 3,896.2 2,208.3
Operating income 247.7 277.3 739.2 867.6
Other (expense) income, net (5.3 ) (1.5 ) 4.6 (2.1 )
(Loss) gain on early extinguishment of debt - (20.5 ) 1.9 (124.4 )
Interest expense (155.4 ) (134.2 ) (465.4 ) (417.1 )
Income from continuing operations before
income taxes 87.0 121.1 280.3 324.0
Income taxes 33.3 43.0 107.1 119.8
Income from continuing operations 53.7 78.1 173.2 204.2
Discontinued operations, net of tax - - (0.7 ) -
Net income $ 53.7 $ 78.1 $ 172.5 $ 204.2
Operating Metrics: (Thousands)
Business Operating Metrics:
Customers
Enterprise 174.8 65.8
Small business 471.9 397.0
Total customers (d) 646.7 462.8
Carrier special access circuits 112.7 106.4
Consumer Operating Metrics:
Voice lines 1,865.2 1,951.7
High-speed Internet 1,216.2 1,199.5
Digital television customers 442.7 444.8
Total consumer connections 3,524.1 3,596.0
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(a) Results from operations include post-acquisition results from the former
PAETEC operations. In the discussion and analysis provided below regarding
changes in consolidated revenues and expenses in 2012, the impact of this
acquisition on these changes is considered to be the revenues and expenses
recognized during the period of each year for which results from the
acquired operations are not included in the comparative period of the
prior year.
(b) Effective during the fourth quarter of 2011, we changed our method of
recognizing actuarial gains and losses for pension benefits. We have retrospectively adjusted financial information for prior periods presented
to reflect our voluntary change in accounting principle for pension
benefits. We elected to revise historical results for certain previously
unrecorded immaterial errors. We concluded that the effects, individually
and in the aggregate, are immaterial to the unaudited quarterly financial
information. See Notes 2 and 8 to the consolidated financial statements in
our Annual Report on Form 10-K for the year ended December 31, 2011.
(c) Certain prior year amounts have been reclassified to conform to the current year financial statement presentation. These reclassifications did
not impact net or comprehensive income.
(d) Total customers include each individual business customer location to which we provide service and exclude carrier special access circuits.
Business Service Revenues
Business service revenues include revenues from integrated voice and data
services, advanced data and traditional voice and long-distance services to
enterprise and small-business customers. Revenues from other carriers for
special access circuits and fiber connections are also included. We expect
business service revenues to be favorably impacted by increasing demand for data
services such as integrated data and voice services, multi-site networking and
data center services. As wireless data usage grows and fourth generation ("4G")
networks are expanded, we expect to win additional opportunities to provide
fiber and special access services to support the capacity needs of wireless
carriers.
We experience competition in the business channel primarily from other carriers,
including traditional telephone companies and alternative providers. Cable
television companies are also a source of competition, primarily for small
business customers and wireless backhaul contracts but have communicated their
intention to compete for larger customers by expanding their product and sales
capabilities.
For the twelve months ended September 30, 2012, business customers increased by
approximately 183,900, or 39.7 percent, primarily due to the acquisition of
PAETEC. Excluding PAETEC, business customers decreased by approximately 11,700,
or 2.5 percent percent during the same period. During the third quarter of 2012,
our business customers decreased by 4,600. Our growth in enterprise customers is
slightly outpaced by losses in small business customers, typically due to
competition from cable companies. However, our enterprise customers are driving
growth in overall revenue through purchases of integrated voice and data
services, data center and managed services, and advanced data services such as
multi-site networking.
Despite the opportunities for growth from business services, competition and
weakness in the economy may have the effect of suppressing revenue growth. In
addition, traditional business voice and long-distance service revenues continue
to decline due to competition and migration to more advanced integrated voice
and data services.
The following table reflects the primary drivers of year-over-year changes in
business service revenues:
Three Months Ended Nine Months Ended
September 30, 2012 September 30, 2012
Increase Increase
(Millions) (Decrease) % (Decrease) %
Due to acquisition of PAETEC $ 396.5 $ 1,180.3
Due to increases in data and integrated
services revenues (a) 10.5 28.8
Due to increases in carrier revenues (b) 3.6 14.8
Due to increases in data center and managed
services revenues (c) 3.3 10.3
Due to increases in high-speed Internet
revenues 0.8 3.7
Due to decreases in traditional voice, long
distance and miscellaneous revenues (d) (0.1 ) (11.1 )
Total increases in business revenues $ 414.6 84 % $ 1,226.8 84 %
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(a) Increases in data and integrated services revenues were primarily due to
demand for advanced data services and customer migration to our integrated
voice and data services, previously discussed.
(b) Increases in carrier revenues, which primarily represent monthly recurring
charges for dedicated circuits, were attributable to demand from wireless
and other carriers, previously discussed.
(c) Increases in data center and managed services revenues, which primarily
represent data center and colocation revenues, were due to increased demand
and incremental sales.
(d) Decreases in traditional voice service revenues were primarily attributable
to competition and migration of existing customers to integrated services
and bundled offerings. These declines were partially offset by $4.1 million
due to the implementation of the access recovery charge ("ARC"), which is a
monthly charge established by the FCC designed to mitigate revenue
reductions resulting from intercarrier compensation reform implemented in
the third quarter of 2012.
Consumer Service Revenues
Consumer service revenues are generated from the provision of high-speed
Internet, voice and video services to consumers.
We expect the trend of consumer voice line loss to continue as a result of
competition from wireless carriers, cable television companies and other
providers using emerging technologies. For the twelve months ended September 30,
2012, consumer voice lines decreased by approximately 87,000, or 4.4 percent.
Increasing revenues from high-speed Internet and related services help to offset
some of the losses in consumer voice revenues. Demand for faster broadband
speeds and Internet-related services, such as virus protection and online data
backup services, are expected to favorably impact consumer high-speed Internet
revenues, offsetting some of the decline in consumer voice revenues.
For the twelve months ended September 30, 2012, consumer high-speed Internet
customers increased by approximately 17,000, or 1.4 percent. During the third
quarter of 2012, our consumer high-speed Internet customers increased by
approximately 6,000. As of September 30, 2012, we provided high-speed Internet
service to approximately 41 percent of total access lines in service and
approximately 70 percent of primary residential lines in service. As of
September 30, 2012, approximately 76 percent of our total access lines had
high-speed Internet competition, primarily from cable service providers. We do
not expect significant additional cable expansions into our service areas during
2012, but we could experience some increased competition from high-speed
Internet offerings of wireless competitors. We expect the pace of high-speed
Internet customer growth to continue to slow as the number of households without
high-speed Internet service shrinks and our penetration continues to increase.
To combat competitive pressures in our markets, we continue to emphasize our
bundle service strategy and enhance our network to offer faster Internet speeds.
Service bundles provide discounts and other incentives for customers to bundle
their voice, long distance, high-speed Internet and video services and have
positively impacted our operating trends.
The following table reflects the primary drivers of year-over-year changes in
consumer service revenues:
Three Months Ended Nine Months Ended
September 30, 2012 September 30, 2012
Increase Increase
(Millions) (Decrease) % (Decrease) %
Due to increases in high-speed Internet
revenues (a) 4.3 14.8
Due to decreases in voice, long distance and
miscellaneous revenues (b) (13.8 ) (43.5 )
Total decreases in consumer revenues $ (9.5 ) (3 )% $ (28.7 ) (3 )%
(a) Increases in high-speed Internet revenues were primarily due to the increase
in high-speed Internet customers, continued migration to higher speeds and
increased sales of value added services, as previously discussed.
(b) Decreases in voice service revenues were primarily attributable to declines
in voice lines.
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Wholesale Service Revenues
Wholesale service revenues include switched access revenues, Universal Service
Fund ("USF") revenues and voice and data services sold on a wholesale basis.
Switched access revenues include usage sensitive revenues from long distance
companies and other carriers for access to our network in connection with the
completion of long distance calls, as well as reciprocal compensation received
from wireless and other local connecting carriers for the use of our facilities.
USF revenues are government subsidies, collected from our customers, designed to
partially offset the cost of providing wireline services in high-cost areas. In
addition, we offer our voice and data services on a wholesale basis to other
carriers.
Revenues from these services are expected to decline due to access line losses
and reductions in switched access rates.
The following table reflects the primary drivers of year-over-year changes in
wholesale service revenues:
Three Months Ended Nine Months Ended
September 30, 2012 September 30, 2012
Increase Increase
(Millions) (Decrease) % (Decrease) %
Due to acquisition of PAETEC (a) $ 92.5 $ 252.0
Due to increases in federal USF revenues (b) 12.3 14.7
Due to decreases in voice and other revenues (0.4 ) (1.6 )
Due to decreases in state USF revenues (1.0 ) (2.1 )
Due to decreases in switched access revenues (c) (31.2 )
(56.9 )
Total increases in wholesale revenues $ 72.2 49 % $ 206.1 46 %
(a) During the first quarter of 2012, we suspended and modified certain PAETEC
wholesale products, which represented approximately $16.0 million in
revenue recognized during the nine months ended September 30, 2012.
(b) Increases in federal USF revenues were primarily due to the implementation
of the access recovery mechanism ("ARM") during the third quarter of
2012. The ARM is additional federal universal service support available to
help mitigate revenue losses from intercarrier compensation reform not
covered by the ARC, previously discussed. In addition, Federal USF
revenues increased due to a change in the contribution factor from 14.4 percent to 15.7 percent, resulting in a proportionate change in federal
USF expense included in cost of services below.
(c) Decreases in switched access revenues were primarily due to the impact of
intercarrier compensation reform and continued declines in voice lines.
The ARC and ARM, discussed previously, are designed to help mitigate the
revenue losses resulting from intercarrier compensation reform.
Other Service Revenues
Other service revenues include revenues from certain consumer markets where we
lease the connection to the customer premise, software and other miscellaneous
services. In the consumer markets where we lease the connection to the customer
premise, we are no longer offering new service. As a result of this decision, we
expect other service revenues to decline as current customers disconnect.
The following table reflects the primary drivers of year-over-year changes in
other service revenues:
Three Months Ended Nine Months Ended
September 30, 2012 September 30, 2012
Increase Increase
(Millions) (Decrease) % (Decrease) %
Due to acquisition of PAETEC $ 17.5 $ 55.9
Due to decreases in other (1.7 ) (6.8 )Total increases in other revenues $ 15.8 153 % $ 49.1
147 %
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Product Sales
Product sales include data and communications equipment sold to businesses and
high-speed Internet modems, home networking equipment, computers and other
equipment sold to consumers. In addition, we sell network equipment to
contractors on a wholesale basis.
The following table reflects the primary drivers of year-over-year changes in
product sales:
Three Months Ended Nine Months Ended
September 30, 2012 September 30, 2012
Increase Increase
(Millions) (Decrease) % (Decrease) %
Due to acquisition of PAETEC $ 33.3 $ 89.1
Due to increases in contractor sales (a) 3.3 16.2
Due to increases in consumer product sales (b) 0.2 1.4
Due to decreases in business product sales (0.7 ) (0.5 )
Total increases in product sales $ 36.1 126 % $ 106.2 128 %
(a) Increases in contractor sales were primarily due to increased sales of
outside plant materials.
(b) Increases of consumer product sales were driven by increased sales for
home networking and customer premise equipment.
Cost of Services
Cost of services expenses primarily consist of network operations costs,
including salaries and wages, employee benefits, materials, contract services
and information technology costs to support the network. Cost of services
expenses also include interconnection expense, which are costs incurred to
access the public switched network and transport traffic to the Internet, bad
debt expense and business taxes. Interconnection expenses include charges to
lease network components required for service delivery in markets where we do
not own the primary network infrastructure.
The following table reflects the primary drivers of year-over-year changes in
cost of services:
Three Months Ended Nine Months Ended
September 30, 2012 September 30, 2012
Increase Increase
(Millions) (Decrease) % (Decrease) %
Due to acquisition of PAETEC $ 287.5 $ 856.9
Due to increases in third-party costs for
ancillary voice and data services (a) 3.4 12.5
Due to increases in interconnection expense
(b) 0.6 11.4
Due to increases in federal USF expenses (c) 0.2 3.4
Due to increases in network operations and
other (d) 2.4 3.0
Due to changes in postretirement and pension
expense (e) 10.9 (1.4 )
Total increases in cost of services $ 305.0 83 % $ 885.8 80 %
(a) Increases in third-party costs were due to increases in charges incurred
to provide third-party services to customers and charges incurred to
provide voice features and value added data services to customers.
(b) Increases in interconnection expense were attributable to increased
purchases of circuits, including circuits to service the growth in data
customers, as well as higher capacity circuits to service existing customers and increase the transport capacity of our network, partially
offset by the favorable impact of network efficiency projects and rate
reductions.
(c) Increases in federal USF contributions were driven by an increase in the
USF contribution factors from 14.4 percent and 15.7 percent for the nine
month periods ended September 30, 2011 and 2012, respectively. A
proportionate increase is seen in federal USF surcharge revenues.
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(d) Increases in network operations and other expenses were due to higher
leased network facilities costs, offset by incremental internal labor
charged to capital projects as a result of increased capital spend and
activity.
(e) Increases in postretirement and pension expense for the three months ended
September 30, 2012, are primarily driven by a curtailment gain recognized
during the third quarter of 2011 as a result of the elimination of basic
retiree life insurance coverage for certain current and future retirees.
For the nine months ended September 30, 2012, this was offset by a
curtailment gain recognized during the second quarter of 2012 related to
the elimination of all benefits for certain current and future retirees.
Cost of Products Sold
Cost of products sold represents the cost of equipment sales to customers.
The following table reflects the primary drivers of year-over-year changes in
cost of products sold:
Three Months Ended Nine Months Ended
September 30, 2012 September 30, 2012
Increase Increase
(Millions) (Decrease) % (Decrease) %
Due to acquisition of PAETEC $ 29.6 $ 74.4
Due to increases in costs of contractor sales
(a) 3.5 16.5
Due to changes in equipment sales to business
customers (0.4 ) 0.2
Due to decreases in consumer costs of product
sold (b) (0.4 ) (0.4 )
Total increases in cost of products sold $ 32.3 132 % $ 90.7 132 %
(a) Increases in contractor cost of products sold were consistent with the
changes in contractor sales.
(b) Decreases in consumer costs of products sold were driven by the decrease
in sales, driven by lower customer broadband additions as compared to the
same period in the prior year.
Selling, General and Administrative ("SG&A")
SG&A expenses result from sales and marketing efforts, advertising, information
technology support systems, costs associated with corporate and other support
functions and professional fees. These expenses also include salaries and wages
and employee benefits not directly associated with the provision of services.
The following table reflects the primary drivers of year-over-year changes in
SG&A expenses:
Three Months Ended Nine Months Ended
September 30, 2012 September 30, 2012
Increase Increase
(Millions) (Decrease) % (Decrease) %
Due to acquisition of PAETEC $ 106.4 $ 329.3
Due to increases in medical insurance
expenses (a) 4.6 14.8
Due to changes in pension and postretirement
expenses (b) 3.3 (0.4 )
Due to decreases in other costs (c) (11.5 ) (6.4 )
Due to decreases in sales and marketing
expenses (d) (8.3 ) (21.7 )
Total increases in SG&A and other expenses $ 94.5 72 % $ 315.6 79 %
(a) Increases in medical insurance expenses were primarily due to increases in
medical claims and related costs.
(b) Increases in postretirement and pension expense for the three months ended September 30, 2012, are primarily driven by a curtailment gain recognized
during the third quarter of 2011 as a result of the elimination of basic
retiree life insurance coverage for certain current and future retirees.
For the nine months ended September 30, 2012, this was offset by a
curtailment gain recognized during the second quarter of 2012 related to
the elimination of all benefits for certain current and future retirees.
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(c) Decreases in other costs were primarily due to losses related to
litigation activity recorded in 2011 and various other costs in 2012.
(d) Decreases in sales and marketing expenses were due to lower compensation
costs for the business channel and decreased advertising expenses.
Depreciation and Amortization Expense
Depreciation and amortization expense includes the depreciation of our plant
assets and the amortization of our intangible assets.
The following table reflects the primary drivers of year-over-year changes in
depreciation and amortization expense:
Three Months Ended Nine Months Ended
September 30, 2012 September 30, 2012
Increase Increase
(Millions) (Decrease) % (Decrease) %
Due to depreciation of PAETEC's plant assets $ 53.5 $ 143.9
Due to amortization of intangible assets
acquired from PAETEC 41.0 122.3
Due to increases in depreciation expense (a) 33.9 106.4
Due to decreases in amortization expense (b) (5.8 ) (19.9 )
Total increases in depreciation and
amortization expense $ 122.6 60 % $ 352.7 58 %
(a) Increases in depreciation expense were primarily due to additions in
property, plant and equipment. Additionally, we implemented new
depreciation rates beginning in 2012 for certain subsidiaries, which
resulted in a net increase to depreciation expense of $44.7 million for
the nine month period ended September 30, 2012. See Note 2 to the
consolidated financial statements.
(b) Decreases in amortization expense were due to the use of accelerated
amortization methods.
Merger, Integration and Restructuring Costs
We incur a significant amount of costs to complete a merger or acquisition and
integrate its operations into our business. These costs are presented as merger
and integration expense in our results of operations and include transaction
costs such as banker and legal fees, employee-related costs such as severance,
system conversion and rebranding costs. Our recent acquisitions of PAETEC, NuVox
Inc., Iowa Telecom, Q-Comm and Hosted Solutions drive merger and integration
costs for the periods presented.
Restructuring charges are sometimes incurred as a result of evaluations of our
operating structure. Among other things, these evaluations explore opportunities
for task automation, network efficiency and the balancing of our workforce based
on the current needs of our customers. Severance, lease exit costs and other
related charges are included in restructuring charges.
On May 31, 2012, we announced the review of our management structure to increase
the efficiency of decision-making, to ensure our management structure is as
simple and as responsive to customers as possible and position ourselves for
continued success. We eliminated approximately 350 management positions as part
of the restructuring, which was completed in the third quarter of 2012 and
resulted in severance related costs of $22.4 million. The changes are expected
to result in annualized savings of approximately $40.0 million. Severance, lease
exit costs and other related charges are included in restructuring charges.
Merger, integration and restructuring costs are unpredictable by nature but
should not necessarily be viewed as non-recurring.
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Set forth below is a summary of merger, integration and restructuring costs for
the three and nine month periods ended September 30:
Three Months Ended Nine Months Ended
(Millions) 2012 2011 2012 2011
Merger and integration costs:
Transaction costs associated with acquisitions (a) $ - $ 17.8 $ 7.1 $ 21.1
Employee related transition costs (b) 3.1 1.0 17.4 7.9
Computer system and conversion costs 1.9 0.9 5.3 4.3
Signage, rebranding and other costs (c) 7.7 0.2 24.6 0.6
Total merger and integration costs 12.7 19.9 54.4 33.9
Restructuring charges (d) 12.1 0.5 23.3 0.7
Total merger, integration and restructuring charges $ 24.8 $ 20.4 $ 77.7 $ 34.6
(a) Transaction costs incurred during the three and nine months ended
September 30, 2012, primarily relate to accounting, legal, broker fees and
other miscellaneous costs associated with the acquisition of PAETEC. These
costs are considered indirect or general and are expensed when incurred.
During the three and nine months ended September 30, 2011, we incurred
acquisition-related costs for accounting, legal, broker fees and other
miscellaneous costs associated with the acquisitions of NuVox, Iowa
Telecom, Q-Comm, Hosted Solutions and PAETEC. These costs are considered
indirect or general and are expensed when incurred.
(b) Employee related transition costs during 2012 primarily consists of
severance related to the integration of PAETEC.
(c) Signage, rebranding and other costs includes signage, rebranding, lease
termination, consulting fees associated with integration activities and
other integration related expenses.
(d) Restructuring charges primarily related to the restructuring announcement
made on May 31, 2012. See previous discussion.
Summary of Liability Activity Related to Both Merger and Integration Costs and
Restructuring Charges
As of September 30, 2012, we had unpaid merger, integration and restructuring
liabilities totaling $22.2 million, which consisted of $4.8 million of accrued
severance costs primarily associated with the integration of PAETEC, $6.7
million primarily associated with the restructuring announcement made on May 31,
2012, and $10.7 million related to other integration activities. Severance and
related employee costs are included in other current liabilities in the the
accompanying unaudited interim consolidated balance sheet and will be paid as
positions are eliminated, excluding salary continuation payments. These payments
will be funded through operating cash flows (see Note 9).
Operating Income
Operating income decreased $29.6 million, or 10.7 percent and $128.4 million, or
14.8 percent, during the three and nine month periods ended September 30, 2012,
respectively, as compared to the same period in 2011. The decrease for the three
month period ended September 30, 2012, as compared to the same period in 2011,
was primarily due to an increase in depreciation and amortization expense,
driven by changes in depreciable lives and increased capital expenditures, as
previously discussed.
The decrease for the nine month period ended September 30, 2012, as compared to
the same period in 2011 was primarily due to an increase in depreciation and
amortization expense, driven primarily by changes in depreciable lives and
increased capital expenditures as previously discussed. Also contributing to the
decrease in operating income were increases in merger, integration and
restructuring expense as a result of the integration of PAETEC and our
management reorganization previously discussed. These increases in expense were
partially offset by operating income generated from PAETEC of $19.3 million and
expense management initiatives.
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Operating Income before Depreciation and Amortization ("OIBDA")
OIBDA increased $93.0 million, or 19.3 percent and $224.3 million, or 15.2
percent, for the three and nine month periods ended September 30, 2012,
respectively, as compared to the same period in 2011 (see "Reconciliation of
non-GAAP Financial Measures"). The increases for the three and nine month
periods ended September 30, 2012, were primarily due to OIBDA from PAETEC of
$86.7 million and $285.5 million, respectively. The increase in OIBDA from
PAETEC for the nine month period ended September 30, 2012, was partially offset
by an increase in merger, integration and restructuring charges, discussed
above.
Other (Expense) Income, Net
Set forth below is a summary of other income, net for the three and nine month
periods ended September 30:
Three Months Ended Nine Months Ended
(Millions) 2012 2011 2012 2011
Interest income $ - $ - $ 1.0 $ 1.5
(Loss) gain on sale of investments (a) (0.2 ) - 7.2 0.9
Other income, net (0.2 ) - 3.9 0.5
Ineffectiveness of interest rate swaps (4.9 ) (1.5 ) (7.5 ) (5.0 )
Other (expense) income, net $ (5.3 ) $ (1.5 ) $ 4.6 $ (2.1 )
(a) This increase for the nine month period ended September 30, 2012, was
primarily due to the sale of wireless assets associated with Iowa Telecom
and D&E Communications, Inc. ("D&E"). See Note 2 to the consolidated
financial statements.
Loss (Gain) on Extinguishment of Debt
During the first quarter of 2012, we retired all $300.0 million of the
outstanding 9.500 percent notes due July 15, 2015 ("PAETEC 2015 Notes"). The
PAETEC 2015 Notes were purchased using borrowings on our revolving line of
credit. The retirements were accounted for under the extinguishment method, and
as a result we recognized a gain on extinguishment of debt of $1.9 million
during the nine month period ended September 30, 2012.
During the nine month period ended September 30, 2011, we repurchased $1,544.5
million of our 2016 8.625 percent Senior Notes ("2016 Notes") and all $400.0
million of our 7.750 percent Valor Notes ("Valor Notes"). We financed these
transactions with proceeds from various debt offerings and borrowings from our
revolving line of credit. These transactions allowed us to extend our existing
debt maturities and lower our interest rates. The retirements were accounted for
under the extinguishment method, and as a result we recognized a loss on
extinguishment of debt of $124.4 million during the first quarter of 2011.
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The loss (gain) on extinguishment of debt is shown as follows for the three and
nine month periods ended September 30:
Three Months Ended Nine Months Ended
(Millions) 2012 2011 2012 2011
2015 PAETEC Notes:
Premium on early redemption $ - $ - $ 14.3 $ -
Unamortized premium on original issuance - - (16.2 ) -
Gain on early extinguishment for 2015 PAETEC Notes - - (1.9 ) -
2016 Notes:
Premium on early redemption - 15.2 - 92.7
Unamortized discount on original issuance - 5.1 - 23.7
Third-party fees for early redemption - - - 2.7
Unamortized debt issuance costs on original issuance - 0.2 - 1.1
Loss on early extinguishment for 2016 Notes - 20.5 - 120.2
Valor Notes:
Premium on early redemption - - - 10.3
Third-party fees for early redemption - - - 0.4
Unamortized premium on original issuance - - - (6.5 )
Loss on early extinguishment for Valor Notes - - - 4.2
Total loss (gain) on early extinguishment of debt $ - $ 20.5 $ (1.9 ) $ 124.4
Interest Expense
Set forth below is a summary of interest expense for the three and nine month
periods ended September 30:
Three Months Ended Nine Months Ended
(Millions) 2012 2011 2012 2011
Senior secured credit facility, Tranche A $ 4.1 $ 1.3 $ 9.0 $ 4.8
Senior secured credit facility, Tranche B 14.2 10.1 35.2 30.0
Senior secured credit facility, revolving line
of credit 3.7 5.2 15.8 13.1
Senior unsecured notes 100.2 101.6 300.5 314.4
Notes issued by subsidiaries 22.7 2.2 69.2 10.1
Impacts of interest rate swaps 13.3 16.2 41.1 49.5
Interest on capital leases and other 0.7 - 2.5 0.2
Less capitalized interest expense (3.5 ) (2.4 ) (7.9 ) (5.0 )
Total interest expense $ 155.4 $ 134.2 $ 465.4 $ 417.1
Interest expense increased $21.2 million, or 15.8 percent and $48.3 million, or
11.6 percent for the three and nine month periods ended September 30, 2012, as
compared to the same period of 2011, respectively. The increase in 2012 was
primarily due to interest incurred on notes issued by subsidiaries, specifically
PAETEC.
Income Taxes
Income tax expense decreased $9.7 million, or 22.6 percent and $12.7 million, or
10.6 percent for the three and nine month periods ended September 30, 2012, as
compared to the same periods in 2011, respectively. The decrease in income tax
expense in 2012 is primarily due to the decrease in income before taxes. Our
effective tax rate increased to 38.3 percent and 38.2 percent for the three and
nine month periods ended September 30, 2012, as compared to 35.5 percent and
37.0 percent in the corresponding periods in 2011.
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For 2012, our annualized effective income tax rate is expected to range between
38.0 percent and 39.0 percent, excluding one-time discrete items. Changes in our
relative profitability, as well as recent and proposed changes to federal and
state tax laws may cause the rate to change from historical rates. In
determining our quarterly provision for income taxes, we use an estimated annual
effective tax rate, which is based on our expected annual income, statutory
rates and tax planning opportunities. Significant or unusual items are
separately recognized in the quarter in which they occur.
Discontinued Operations, Net of Tax
On November 30, 2011, we completed the acquisition of PAETEC. The operating
results of the energy business acquired as part of PAETEC, which sells
electricity to business and residential customers, primarily in certain
geographic regions in New York state, as a competitive supplier, have been
separately presented as discontinued operations in the accompanying consolidated
statements of income. On June 15, 2012, we completed the sale of the energy
business. See Note 14 for additional information.
Pension Expense
In accordance with our accounting policy for pension benefits, we recognize
actuarial gains and losses in our operating results in the year in which the
gains or losses occur. We will remeasure our pension assets and liabilities
based on updated actuarial assumptions at December 31, 2012, including the
actual return on plan assets during the year and the current discount rate. We
expect to take a significant charge during the fourth quarter of 2012, primarily
due to a decline in the discount rate.
As of June 30, 2012, a decline in the discount rate of 25 basis points would
have resulted in an increase in pension expense of $37.4 million. As of
September 30, 2012, our discount rate had declined approximately 90 basis points
as compared to the prior plan measurement. We have also experienced year to date
gains in our pension plan assets through September 30, 2012, of 11.6 percent, as
compared to projected gains of 8.0 percent. Each increase (decrease) of 50 basis
points as compared to the projected gains would result in a gain (loss) of $4.6
million upon remeasurement.
Our discount rate and return on plan assets are primarily driven by changes in
interest rates and the performance of the financial markets, both of which could
change significantly prior to the plan remeasurement. As such, we are not able
to determine or project the actual amount of the expected charge that we may
record in the fourth quarter at this time.
Regulatory Matters
We are subject to regulatory oversight by the Federal Communications Commission
("FCC") for particular interstate matters and state public utility commissions
("PUCs") for certain intrastate matters. We are also subject to various federal
and state statutes that direct such regulations. We actively monitor and
participate in proceedings at the FCC and PUCs and engage federal and state
legislatures on matters of importance to us.
Federal Regulation and Legislation
Intercarrier Compensation and USF Reform
On November 18, 2011, the FCC released an order ("the Order") which established
a framework for reform of the intercarrier compensation system and the federal
Universal Service Fund ("USF"). The Order had two major provisions:
• the elimination of terminating switched access rates and other per-minute
terminating charges between service providers by 2018, through annual
reductions in the rates, and
• the provision of USF support for voice and broadband services.
In reforming the USF, the Order established the Connect America Fund, which
included a short-term ("CAF Phase 1") and a longer-term ("CAF Phase 2")
framework. CAF Phase 1 provides for continued legacy USF funding frozen at 2011
levels as well as the opportunity for incremental broadband funding to a number
of unserved locations, limited to $775 per unserved location. As a result of our
aggressive broadband deployment to date, we have very few unserved locations
remaining in our service areas for which $775 in incremental support would make
broadband deployment economical. On July 24, 2012, we elected to accept
approximately $0.7 million of the $60.4 million in incremental support allocated
to us for 2012. In addition, we filed a waiver request seeking to modify certain
CAF Phase 1 requirements, which would enable us to accept the remaining $59.7
million to expand our broadband footprint. The waiver request is still pending.
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The FCC is working to establish rules for CAF Phase 2 funding based on a
forward-looking cost model to further extend broadband to high-cost areas. The
development of this model is ongoing and is not expected to be completed by the
end of 2012 as originally scheduled by the FCC. Until the implementation of CAF
Phase 2 is complete, our annual USF funding will continue to be frozen at 2011
levels, but we will be required to use one-third of the frozen legacy support to
operate and build broadband networks beginning in 2013. In 2014, this condition
will apply to two-thirds of the frozen legacy support, and in 2015 it will
increase to 100 percent. Based on current expenditures, we expect to comply with
these additional funding conditions for all periods. In addition, if the FCC
does not implement CAF Phase 2 by the end of 2012, the FCC may continue to
provide CAF Phase 1 incremental support in 2013.
As part of the Order's reform of intercarrier compensation, the FCC established
two recovery mechanisms that mitigate the revenue reductions resulting from the
reductions and ultimate elimination of terminating access rates. First, the FCC
established the access recovery charge ("ARC"), a fee which may be assessed to
our retail customers. Second, the access recovery mechanism ("ARM") is a form of
additional federal universal service support designed to allow carriers to
recover revenue reductions not recovered from the assessment of the ARC.
On April 25, 2012, the FCC decided that originating access rates for intrastate
long distance traffic exchanged between an Internet-protocol network and the
traditional telecommunications network should be subject to default rates equal
to interstate originating access rates beginning on July 1, 2014. The FCC
refused at that time to adopt a mechanism that would allow companies to recover
the loss of originating access revenues resulting from the change. On July 27,
2012, we filed a petition for review with the U.S. Court of Appeals of the
District of Columbia seeking relief from the April 2012 ruling on the grounds
that it is arbitrary, capricious, in excess of the FCC's statutory authority and
otherwise not in accordance with law. That petition for review was transferred
to the U.S. Court of Appeals for the 10th Circuit on August 28, 2012, and on
October 1, 2012, our appeal was consolidated with 30 appeals on the Order. Our
initial brief is due on December 10, 2012, and briefing is expected to be
completed in the second quarter of 2013. We continue to assess the impacts of
the FCC's intercarrier compensation reform on our wholesale business activities.
Additional implications of the Order will likely result in future additional
rulemaking and require significant interpretation, management judgment and
collaboration with other telecommunications carriers. As a result of these
factors, we expect numerous disputes with other carriers with respect to the
proper amount of intercarrier compensation that is payable between such parties,
and these disputes can sometimes become significant. Our policy is to establish
reserves on wholesale revenues and accounts receivable balances when
collectability is not reasonably assured. We do not believe that ultimate
resolution of uncertainties, including asserted and unasserted disputes and
claims from other telecommunications carriers, relate to wholesale services
provided to date will have a material impact on the future consolidated results
of operations, cash flows or our financial condition.
We believe the steps we have taken to diversify our revenue streams and focus on
growth opportunities will help us navigate through this transition without
significant adverse effects. Given the ongoing transformation of our business
towards business and enterprise, coupled with the positive impact of the ARC and
the additional universal service support available from the ARM, we do not
believe the Order's reform of intercarrier compensation will have a material
impact on our results of operation, cash flows or our financial condition.
Set forth below is a summary of intercarrier compensation revenue, reciprocal
compensation expense and federal universal service support for the three and
nine month periods ended September 30:
Three Months Ended Nine Months Ended
(Millions) 2012 2011 2012 2011
Intercarrier compensation revenue $ 84.0 $ 72.2 $ 267.1 $ 220.6
Reciprocal compensation expense $ 36.6 $ 29.6 $ 135.5 $ 58.2
Federal universal service support $ 36.3 $ 24.5 $ 86.5 $ 74.8
Broadband Stimulus
As part of the American Recovery and Reinvestment Act of 2009 ("ARRA"),
approximately $7.2 billion was allocated for the purpose of expanding broadband
services to unserved and underserved areas. The Rural Utilities Service ("RUS"),
part of the United States Department of Agriculture, approved eighteen of our
applications for these funds for projects totaling $241.7 million. The RUS will
fund 75 percent of these approved grants, or $181.3 million, and we will fund 25
percent, or $60.4 million.
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Selected information related to the broadband stimulus expenditures and receipts
is as follows for the three and nine month periods ended September 30:
Three Months Ended Nine Months Ended Inception to
(Millions) 2012 2011 2012 2011 Date
Stimulus capital expenditures funded by
RUS $ 31.0 $ 7.2 $ 68.8 $ 9.2 $ 91.5
Stimulus capital expenditures funded by
Windstream (a) 15.8 2.4 28.4 3.1 36.4
Total stimulus capital expenditures $ 46.8 $ 9.6 $ 97.2 $ 12.3 $ 127.9
Funds received from RUS $ 6.9 $ 0.5 $ 26.5 $ 0.5 $ 30.5
(a) Stimulus capital expenditures funded by Windstream are included in our
capital expenditure totals for each period presented in the statements of
cash flows. This figure includes certain non-reimburseable charges for which
we are responsible for the full amount of the cost.
State Regulation and Legislation
State Universal Service
We recognize revenue from the receipt of state universal service funding in a
limited number of states in which we operate. For the nine month period ended
September 30, 2012, we recognized $94.9 million in state USF revenue, which
included approximately $66.7 million from the Texas USF. These payments are
intended to provide additional support, beyond the federal USF receipts, for the
high cost of operating in certain rural markets.
Several states, including Texas and Pennsylvania, are currently conducting
reviews of their universal service funds and intercarrier compensation systems.
The Texas PUC recently adopted an order which we expect to reduce our Texas USF
support by approximately $4.3 million each year over the next four years. The
Texas PUC is considering further needs-based and rate rebalancing reforms which
could adversely impact our support in the future. We are not yet able to
determine the financial impact of additional Texas USF reform or reform in other
states. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations" in Item 7 of Part II of our Annual Report on Form 10-K
for the year ended December 31, 2011, filed with the SEC on February 22, 2012,
for more information regarding our state regulatory matters.
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FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES
Liquidity and Capital Resources
We rely largely on operating cash flows and long-term debt to provide for our
liquidity requirements. We expect cash flows from operations will be sufficient
to fund ongoing working capital requirements, planned capital expenditures,
scheduled debt principal and interest payments and dividend payments through
2012. Additionally, we have access to capital markets and available borrowing
capacity under our revolving credit agreements.
Our cash position decreased by $112.2 million to $114.8 million at September 30,
2012, from $227.0 million at December 31, 2011, as compared to an increase of
$8.0 million during the same period in 2011. Cash outflows were primarily driven
by repayments of debt and payment of interest, capital expenditures and
dividends. These outflows were partially offset by cash inflows from operations
of $1,243.6 million and proceeds from debt issuances of $1,775.0 million.
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