SECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549
FORM 10-Q
For the quarterly period ended
OR
For the transition period from
Commission File Number 1-9712
(Exact name of registrant as specified in its charter)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes ý No ¨
Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.
UNITED STATES CELLULAR CORPORATION
1ST QUARTER REPORT ON FORM 10-Q
INDEX
PART I. FINANCIAL INFORMATIONITEM I. FINANCIAL STATEMENTSUNITED STATES CELLULAR CORPORATION AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONS
Unaudited
The accompanying notes to consolidated financial statements are an integral part of these statements.
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UNITED STATES CELLULAR CORPORATION AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS
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UNITED STATES CELLULAR CORPORATION AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETSASSETS
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UNITED STATES CELLULAR CORPORATION AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETSLIABILITIES AND SHAREHOLDERS' EQUITY
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UNITED STATES CELLULAR CORPORATION AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF RESULTSOF OPERATIONS AND FINANCIAL CONDITION
UNITED STATES CELLULAR CORPORATION AND SUBSIDIARIES
United States Cellular Corporation (“U.S. Cellular” — AMEX symbol: USM) owns, operates and invests in wireless markets throughout the United States. U.S. Cellular is an 82.1%-owned subsidiary of Telephone and Data Systems, Inc. (“TDS”).
The following discussion and analysis should be read in conjunction with U.S. Cellular’s interim consolidated financial statements and footnotes included herein, and with its audited consolidated financial statements and footnotes and Management’s Discussion and Analysis of Results of Operations and Financial Condition included in its Annual Report on Form 10-K for the year ended December 31, 2003, as amended.
Investment in Licenses and Goodwill Restatements
On April 19, 2004, U.S. Cellular filed a Form 8-K with the Securities and Exchange Commission (“SEC”) announcing that it would restate its 2003 and 2002 financial statements relating to the implementation of Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets,” which was adopted on January 1, 2002. Prior to January 1, 2002, U.S. Cellular allocated the excess of purchase price over tangible assets and liabilities acquired to investment in licenses and goodwill. At this time, the accounting treatment for U.S. Cellular’s wireless licenses and goodwill was the same for book purposes, with both asset classes amortized over an expected life of 40 years. However, no deferred taxes were provided on the amounts allocated to goodwill.
Based on a subsequent review of goodwill, U.S. Cellular has restated the allocation of $138.9 million of purchase price recorded as goodwill to investment in licenses as of January 1, 2002, the date of the adoption of SFAS No. 142. In connection with this restatement, an additional deferred tax liability of $90.7 million was recorded as of January 1, 2002. The additional deferred tax liability recorded in conjunction with this restatement increased the carrying value of U.S. Cellular’s investment in licenses by a corresponding $90.7 million. Following these adjustments, U.S. Cellular reperformed the impairment tests for its investment in licenses as of January 1, 2002, and recorded an impairment loss of $12.7 million ($20.9 million before an income tax benefit of $8.2 million). This impairment has been recorded as a cumulative effect of an accounting change at January 1, 2002, the date of the adoption of SFAS 142.
In the first quarter of 2003, U.S. Cellular had recorded a loss on assets held for sale related to the pending disposition of certain wireless properties. The investment in licenses upon which the impairment was recorded in the first quarter of 2002 included the investment in licenses of these properties. As a result, a portion of the originally recognized loss on assets held for sale in the first quarter of 2003 was recognized in the first quarter of 2002. Consequently, loss on assets held for sale in 2003 has been reduced by $1.9 million, before income taxes of $0.8 million. In the third quarter of 2003, U.S. Cellular had originally recorded an income tax expense upon the closing of the disposition of such wireless properties. This tax expense has been reduced due to the reversal of additional deferred tax liabilities that were recorded with respect to the wireless properties exchanged in conjunction with the restatement of goodwill to investment in licenses. Consequently, income tax expense in 2003 has been reduced by $10.7 million.
In addition, as a result of the restatement discussed above, U.S. Cellular also reperformed the annual impairment test for its investment in licenses for 2003, which was originally performed during the second quarter of 2003. This resulted in the recognition of an additional impairment loss of $49.6 million, before an income tax benefit of $19.6 million. This additional loss has been recorded in the second quarter of 2003.
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Retention Reclassifications
Certain amounts reported in prior years have been reclassified to conform to the current period presentation. Prior to the fourth quarter of 2003, U.S. Cellular separately disclosed marketing and selling expenses and general and administrative expenses in its statements of operations. In the fourth quarter of 2003, U.S. Cellular combined the marketing and selling expense and general administrative expense captions into one caption designated as selling, general and administrative expense. Previously, costs for equipment sold to retain current customers were included in selling, general and administrative expense. Prior to the fourth quarter of 2003, these costs were partially offset by equipment sales revenues received from these customers. In the fourth quarter of 2003, U.S. Cellular changed its policy for classifying retention costs and has reclassified the equipment sales revenue and cost of equipment sold related to the retention of current customers out of selling, general and administrative expenses and into equipment sales revenues and cost of equipment sold, respectively, for each period presented. These reclassifications have been reflected in the first quarter of 2003. These reclassifications increased first quarter 2003 equipment sales revenues by $7.9 million, and increased cost of equipment sold by $23.9 million from the amounts originally reported. Selling, general and administrative expenses were reduced by $16.0 million from the amounts originally reported to reflect the amounts reclassified to equipment sales revenues and cost of equipment sold. These reclassifications did not have any impact on income from operations, net income, earnings per share, financial position or cash flows of U.S. Cellular for the first quarter of 2003.
U.S. Cellular owned, or had the right to acquire pursuant to certain agreements, either majority or minority interests in 159 cellular markets and 70 personal communications service basic trading area markets at March 31, 2004.
A summary of the number of markets U.S. Cellular owns or has acquirable and their respective population equivalents follows.
The following is a summary of certain selected information from the complete management discussion that follows the overview and does not contain all of the information that may be important. You should carefully read this entire management discussion and analysis and not rely solely on the overview.
Results of Operations
U.S. Cellular positions itself as a regional operator, focusing its efforts on providing wireless service to customers in the geographic areas where it has licenses to provide such service. U.S. Cellular differentiates itself from its competitors through a customer satisfaction strategy, reflecting broad product distribution, a customer service focus and a high-quality wireless network.
U.S. Cellular’s business development strategy is to operate controlling interests in wireless licenses in areas adjacent to or in proximity to its other wireless licenses, thereby building contiguous operating market areas. U.S. Cellular’s operating strategy is to strengthen the geographic areas where it can continue to build long-term operating synergies and to exit those areas where it does not have opportunities to build such synergies. In addition to the recent transactions disclosed in U.S. Cellular’s Annual Report on Form 10-K for the year ended December 31, 2003, as amended, on February 18, 2004, U.S. Cellular completed the sale of certain of its wireless properties in southern Texas to AT&T Wireless Services, Inc. for $96.9 million in cash, including a working capital adjustment.
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U.S. Cellular’s operating income in the first quarter of 2004 increased $32.6 million to $28.3 million from an operating loss of $4.3 million in 2003. The operating income (loss) margins (as a percent of service revenues) were 4.6% in 2004 and (0.8)% in 2003. U.S. Cellular’s operating income (loss) and operating income (loss) margins were significantly affected by the loss on assets held for sale in 2003. U.S. Cellular expects continued pressure on operating income and margins in the next few years related to the following factors:
The effects of these factors are expected to be mitigated by the following factors:
See “Results of Operations.”
Financing Initiatives
U.S. Cellular has recently received or will receive licenses that will be in a development phase for several years. U.S. Cellular anticipates that it may require financing over the next few years for capital expenditures, for the development of these new markets and to further its growth in the Chicago market and its other recently launched markets.
U.S. Cellular had cash and cash equivalents totaling $35.0 million and $614.8 million of availability under its revolving credit facilities as of March 31, 2004. U.S. Cellular is also generating substantial cash flows from operations. Cash flows from operating activities totaled $86.4 million during the first quarter of 2004. In addition, U.S. Cellular has access to public and private capital markets to help meet its long-term financing needs. Management believes that cash on hand, expected future cash flows from operations and existing sources of external financing provide substantial financial flexibility and are sufficient to permit U.S. Cellular to finance its contractual obligations and anticipated capital expenditures.
U.S. Cellular is committed to maintaining a strong balance sheet and its investment grade rating. U.S. Cellular did not enter into any financing transactions during the first quarter of 2004. U.S. Cellular used borrowings under its revolving credit facility to fund the repayment of its $105 million loan from TDS (the “Intercompany Note”) in February 2004.
See “Financial Resources and Liquidity.”
Following is a table of summarized operating data for U.S. Cellular’s consolidated operations.
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On August 1, 2003, U.S. Cellular completed the transfer of wireless assets and customers in ten 25 megahertz markets in Florida and Georgia to AT&T Wireless. In exchange, U.S. Cellular received the following: a) rights to acquire controlling interests in 36 personal communication service licenses; b) approximately $34.0 million in cash; and c) minority interests in six markets in which it previously owned a controlling interest. In accordance with the agreement, U.S. Cellular has deferred the assignment and development of 21 licenses for a period of up to five years from the closing date. U.S. Cellular will take possession of the licenses in staggered closings over that five-year period to comply with service requirements of the Federal Communications Commission (“FCC”). The value of these licenses is recorded as License rights on the balance sheet.
An estimated loss of $21.6 million was recorded in the first quarter of 2003 as a loss on assets held for sale (included in operating expenses), representing the difference between the carrying value of the markets transferred to AT&T Wireless and the fair value of the consideration received or to be received in the transaction. The Florida and Georgia markets that were transferred to AT&T Wireless are included in consolidated operations for the first quarter of 2003.
On February 18, 2004, U.S. Cellular completed the sale of certain of its wireless properties in southern Texas to AT&T Wireless for $96.9 million in cash, including a working capital adjustment. The U.S. Cellular markets sold to AT&T Wireless included wireless assets and customers in six 25 megahertz cellular markets.
An aggregate loss of $21.9 million (including a $22.0 million estimate of the loss on assets held for sale in the fourth quarter of 2003 and a $143,000 reduction of the loss in the first quarter of 2004) was recorded as a loss on assets held for sale (included in operating expenses), representing the difference between the carrying value of the markets sold to AT&T Wireless and the cash received in the transaction. The southern Texas markets sold to AT&T Wireless are included in consolidated operations from January 1, 2004 through February 17, 2004.
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Operating revenues increased $53.9 million, or 9%, to $657.7 million in 2004 from $603.8 million in 2003.
Service revenues increased $54.8 million, or 10%, to $619.4 in 2004 from $564.6 million in 2003. Service revenues primarily consist of: (i) charges for access, airtime, roaming and value-added services provided to U.S. Cellular’s retail customers (“retail service”); (ii) charges to other wireless carriers whose customers use U.S. Cellular’s wireless systems when roaming (“inbound roaming”); and (iii) charges for long-distance calls made on U.S. Cellular’s systems. The increase was primarily due to the growing number of retail customers. Monthly service revenue per customer averaged $46.16 in the first quarter of 2004, a 2% increase in from an average of $45.05 in the first quarter of 2003.
Retail service revenuesincreased $67.9 million, or 14%, to $540.2 million in 2004 from $472.3 million in 2003. Growth in U.S. Cellular’s customer base and an increase in average monthly retail service revenue per customer were the primary reasons for the increase in retail service revenue. The number of customers increased 7% to 4,547,000 at March 31, 2004, from 4,240,000 at March 31, 2003, primarily due to customer additions from its marketing channels, and average monthly retail service revenue per customer increased 7% to $40.26 in 2004 from $37.68 in 2003.
Management anticipates that growth in the customer base in U.S. Cellular’s wireless markets will be slower in the future, primarily as a result of the increased competition in its markets and continued penetration of the consumer market. However, as U.S. Cellular expands its operations in Chicago and into its other recently acquired markets in future years, it anticipates adding customers and revenues in those markets.
Monthly local retail minutes of use per customer averaged 491 in 2004 and 377 in 2003. The increase in monthly local retail minutes of use was driven by U.S. Cellular’s focus on designing sales incentive programs and customer billing rate plans to stimulate overall usage. The impact on retail service revenue of this increase was partially offset by a decrease in average revenue per minute of use in 2004. The decrease in average revenue per minute of use reflects the effects of increasing competition, which has led to the inclusion of an increasing number of minutes in package pricing plans. Management anticipates that U.S. Cellular’s average revenue per minute of use will continue to decline in the future, reflecting increased competition and penetration of the consumer market.
Inbound roaming revenuesdecreased $12.1 million, or 22%, to $42.5 million in 2004 from $54.6 million in 2003. The decrease in revenue related to the transfer of the Florida and Georgia markets to AT&T Wireless in August 2003 and the sale of the southern Texas markets to AT&T Wireless in February 2004; these markets had historically provided substantial amounts of inbound roaming revenue. Also contributing to the decrease in 2004 was the decrease in revenue per roaming minute of use, partially offset by an increase in roaming minutes used. In 2004, the increase in inbound roaming minutes of use was primarily driven by the overall growth in the number of customers throughout the wireless industry, partially offset by the loss of minutes of use from the markets transferred and sold to AT&T Wireless. The decline in revenue per minute of use is primarily due to the general downward trend in negotiated rates.
Management anticipates that the rate of growth in inbound roaming minutes of use will continue to slow down due to these factors:
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Management also anticipates that average inbound roaming revenue per minute of use will continue to decline, reflecting the continued general downward trend in negotiated rates.
Long-distance and other revenue decreased $1.0 million, or 3%, to $36.7 million in 2004 from $37.7 million in 2003, primarily related to a decrease in the volume of long-distance calls billed by U.S. Cellular from inbound roamers using its systems to make long-distance calls. This decrease is caused by the loss of roaming minutes of use in 2004 from the markets transferred and sold to AT&T Wireless; a substantial portion of such minutes generated associated long-distance revenue. In U.S. Cellular’s other markets, the volume of long-distance calls increased from 2003 to 2004, partially offsetting the decrease in long-distance and other revenue. The effect of the increase in long-distance call volume in other markets was partially mitigated by price reductions primarily related to long-distance charges on roaming minutes of use as well as U.S. Cellular’s increasing use of pricing plans for its retail customers which include long-distance calling at no additional charge.
Equipment sales revenuesdecreased $905,000, or 2%, to $38.3 million in 2004 from $39.2 million in 2003. U.S. Cellular includes in its equipment sales revenues any handsets and related accessories sold to its customers, whether the customers are new signups or current customers who are changing handsets. U.S. Cellular also sells handsets to its agents at a price approximately equal to U.S. Cellular’s cost before applying any rebates. Selling handsets to agents enables U.S. Cellular to provide better control over handset quality, set roaming preferences and pass along quantity discounts. Management anticipates that it will continue to sell handsets to agents in the future, and that it will continue to provide rebates to agents who provide handsets to new and current customers.
Equipment sales revenue from handset sales to agents is recognized upon delivery of the related products to the agents, net of any anticipated agent rebates. In most cases, the agents receive a rebate from U.S. Cellular at the time these agents provide handsets to sign up new customers or retain current customers.
Handset sales to agents included in equipment sales revenues, net of all rebates, decreased $1.1 million, or 6%, in 2004. Equipment sales to customers through U.S. Cellular’s non-agent channels increased $148,000, or less than 1%, to $21.6 million in 2004 from $21.5 million in 2003. Customers added to U.S. Cellular’s customer base through its marketing distribution channels (“gross customer activations”), the primary driver of equipment sales revenues, increased 6% in 2004. Gross customer activations from agent channels increased 18% in 2004 while those from non-agent channels decreased 4%.
The decrease in gross customer activations from non-agent channels was driven by a change in the mix of activations coming from U.S. Cellular’s agent and non-agent channels, as the agent channel produced a higher percentage of activations in 2004 than in 2003. The decrease in equipment sales revenues from U.S. Cellular’s non-agent channels was primarily attributable to lower revenue per handset, reflecting the reduction in sales prices to end users as a result of increased competition. Also, U.S. Cellular continued to focus on retaining customers by offering existing customers handset pricing similar to that offered to new customers, particularly as these customers near the expiration date of their service contracts.
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Operating expenses increased $21.3 million, or 3%, to $629.4 million in 2004 from $608.1 million in 2003.
System operations expenses (excluding depreciation) decreased $442,000, or less than 1%, to $137.5 million in 2004 from $138.0 million in 2003. System operations expenses include charges from landline telecommunications service providers for U.S. Cellular’s customers’ use of their facilities, costs related to local interconnection to the landline network, charges for maintenance of U.S. Cellular’s network, long-distance charges and outbound roaming expenses. The decrease in system operations expenses in 2004 was due to the following factors:
The effects of the above factors were partially offset by the following factors:
As a result of the above factors, the components of system operations expenses were affected as follows:
In 2004, roaming charges paid by U.S. Cellular to third parties when its customers roamed in the Chicago market declined compared to 2003. Continued integration of the Chicago market into U.S. Cellular’s operations resulted in increased use of U.S. Cellular’s system by U.S. Cellular’s customers and a corresponding decrease in roaming by its customers on other systems in the Midwest.
In total, management expects system operations expenses to increase over the next few years, driven by the following factors:
These factors are expected to be partially offset by anticipated decreases in the per-minute cost of usage both on U.S. Cellular’s systems and on other carriers’ networks. As the Chicago area has historically been U.S. Cellular’s customers’ most popular roaming destination, management anticipates that the continued integration of the Chicago market and other recently launched markets into its operations will result in a further increase in minutes of use by U.S. Cellular’s customers on its systems and a corresponding
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decrease in minutes of use by its customers on other systems, resulting in a lower overall increase in minutes of use by U.S. Cellular’s customers on other systems. Such a shift in minutes of use should reduce U.S. Cellular’s per-minute cost of usage in the future, to the extent that its customers use its systems rather than other carriers’ networks. Additionally, U.S. Cellular’s acquisition and subsequent buildout of licensed areas received in the AT&T Wireless exchange transaction may shift more minutes of use to U.S. Cellular’s systems, as many of these licensed areas are major roaming destinations for U.S. Cellular’s current customers.
Cost of equipment soldincreased $31.3 million, or 35%, to $119.9 million in 2004 from $88.6 million in 2003. The increase was due to the $16.4 million, or 30% increase in cost of equipment sold from non-agent channels and the $14.9 million, or 45%, increase in handset costs related to the sale of handsets to agents. The increase in cost of equipment sold from non-agent channels primarily reflects the increase in handsets sold to customers for retention purposes, partially offset by a 4% decrease in gross customer activations from non-agent channels in 2004. The increase in cost of equipment sold to agents primarily reflects the 18% increase in new customer activations through the agent channel as well as handsets sold by agents to customers for retention purposes.
Retention costs have increased in non-agent and agent channels as U.S. Cellular continued to focus on retaining customers by offering existing customers new handsets similar to those offered to new customers as the expiration dates of customers’ service contracts approached. In addition, the overall cost per handset increased in the first quarter of 2004 as more customers purchased higher priced data-enabled handsets.
Selling, general and administrative expenses increased $7.8 million, or 3%, to $258.2 million in 2004 from $250.4 million in 2003. Selling, general and administrative expenses primarily consist of salaries, commissions and expenses of field sales and retail personnel and offices; agent commissions and related expenses; corporate marketing, merchandise management and telesales department salaries and expenses; advertising; and public relations expenses. Selling, general and administrative expenses also include the costs of operating U.S. Cellular’s customer care centers, the costs of serving customers and the majority of U.S. Cellular’s corporate expenses.
The increase in selling, general and administrative expenses in the first three months of 2004 is primarily due to the following factors:
The increase was also attributable to the rise in salaries and other employee-related expenses associated with acquiring, serving and retaining customers, primarily as a result of the increase in U.S. Cellular’s customer base.
These increases were partially offset by a $9.4 million decrease in billing-related expenses, primarily due to the expenses incurred in 2003 related to the maintenance of the Chicago market’s billing system and the transition to the system used in U.S. Cellular’s other operations in July 2003.
Sales and marketing cost per gross customer activation increased 4% to $371 in 2004 from $358 in 2003, primarily due to increased handset subsidies. Sales and marketing cost per gross customer activation is not calculable using financial information derived directly from the statement of operations. The definition of sales and marketing cost per gross customer activation that U.S. Cellular uses as a measure of the cost to acquire additional customers through its marketing distribution channels may not be comparable to similarly titled measures that are reported by other companies. Below is a summary of sales and marketing cost per gross customer activation for each period:
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Monthly general and administrative expenses per customer, including the net costs related to the renewal or upgrade of service contracts of existing U.S. Cellular customers ("net customer retention costs"), increased 9% to $14.34 in 2004 from $13.19 in 2003. Management uses this measurement to assess the cost of serving and retaining its customers on a per unit basis.
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This measurement is reconciled to total selling, general and administrative expenses as follows:
These components were previously identified in the table which calculates sales and marketing cost per customer activation and related footnotes.
Average customers for the three month periods were previously defined in footnote 4 to the table of summarized operating data.
Depreciation expense increased $6.5 million, or 7%, to $101.4 million in 2004 from $94.9 million in 2003. The increases primarily reflect a change in the useful lives of certain asset categories, which increased depreciation expense $7.4 million in 2004, as well as rising average fixed asset balances, which increased 14% in 2004. Increased fixed asset balances in 2004 resulted from the following factors:
These increases were partially offset by the divestitures of markets in the exchange and sale transactions with AT&T Wireless, which reduced the number of cell sites in U.S. Cellular’s network by 364.
In 2003, $5 million of depreciation expense was recorded related to the writeoff of certain assets.
See “Financial Resources” and “Liquidity and Capital Resources” for further discussions of U.S. Cellular’s capital expenditures.
Amortization and accretion expensedecreased $2.2 million or 15% to $12.5 million in 2004 from $14.7 million in 2003, primarily representing decreased amortization related to the customer list intangible assets acquired in the Chicago market transaction during 2002. These customer list assets are amortized using the declining balance method, based on average customer retention periods of each customer list. Therefore, decreasing amounts of amortization expense will be recorded in each 12-month period following the establishment of each customer list asset. Amortization and accretion expense includes $1.2 million of accretion related to the asset retirement obligation in 2004, and $1.1 million in 2003.
(Gain)Loss on assets held for sale totaled a gain of $143,000 in 2004 and a loss of $21.6 million in 2003.
The gain in 2004 represents the change in carrying value of the assets sold to AT&T Wireless in the southern Texas markets from January 1, 2004 through February 17, 2004, when the sale was completed. An estimated loss of $22.0 million had been recorded subsequent to the announcement of this transaction in November 2003. Subsequent to recording the gain, the carrying value of the assets U.S. Cellular sold to
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AT&T Wireless is equal to the cash U.S. Cellular has received, and expects to receive related to the working capital adjustment, from AT&T Wireless. The aggregate loss may require an adjustment at the time the working capital adjustment is completed.
The loss in 2003 represented the difference between the fair value, as determined by an independent valuation, of the assets U.S. Cellular expected to receive in the AT&T Wireless exchange transaction which was completed in August 2003, and the recorded value of the assets it expected to transfer to AT&T Wireless.
Operating income (loss)totaled income of $28.3 million in 2004 and a loss of $4.3 million in 2003. The operating income (loss) margins (as a percent of service revenues) were 4.6% in 2004 and (0.8%) in 2003. The increase in operating income and operating income margin in 2004 reflects the following:
These factors were partially offset by the following:
U.S. Cellular expects most of the above factors, except for those related to the loss on assets held for sale, to continue to have an effect on operating income and operating margins for the next several quarters. Any changes in the above factors, as well as the effects of other drivers of U.S. Cellular’s operating results, may cause operating income and operating margins to fluctuate over the next several quarters.
U.S. Cellular plans to incur additional expenses during the remainder of 2004 as it competes in the Chicago market and in other recently launched markets. Additionally, U.S. Cellular plans to build out its network into other as yet unserved portions of its licensed areas, and will begin sales and marketing operations in those areas in the next few years. U.S. Cellular launched its brand of data-related wireless services in many of its markets in the second half of 2003, and expects to incur expenses related to its continued marketing of data-related wireless services in the next few years.
As a result, depending on the timing and effectiveness of these initiatives, U.S. Cellular’s operating income may range from $160 million to $210 million for the full year of 2004, compared to $167 million in 2003.
U.S. Cellular anticipates that service revenues will total approximately $2.55 billion for the full year of 2004, compared to service revenues of $2.4 billion in 2003. The anticipated service revenue growth in 2004 reflects the effects of the sale of properties to AT&T Wireless in February 2004, the markets transferred to AT&T Wireless in the exchange transaction completed in August 2003, the continued growth in U.S. Cellular’s customer base and the continued marketing of data-related wireless services in its markets.
Depending on the timing and effectiveness of its marketing efforts, U.S. Cellular anticipates that net customer activations from its marketing channels will total 475,000 to 500,000 for the full year of 2004, increasing its customer base accordingly. However, management anticipates that average monthly service revenue per customer will decrease slightly, as retail service revenue per minute of use and inbound roaming revenue per minute of use decline.
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U.S. Cellular anticipates that its net costs associated with customer growth, service and retention, initiation of new services, launches in new markets and fixed asset additions will continue to grow. U.S. Cellular anticipates that its net customer retention costs will increase in the future as competitive pressures continue and as per unit handset costs increase. In addition, U.S. Cellular will continue to migrate its customer base to a single digital technology platform and certain customers will require new handsets, further increasing net customer retention costs in the future.
Management believes there exists a seasonality in both service revenues, which tend to increase more slowly in the first and fourth quarters, and operating expenses, which tend to be higher in the fourth quarter due to increased marketing activities and customer growth, which may cause operating income to vary from quarter to quarter. Management anticipates that the impact of such seasonality will decrease in the future, particularly as it relates to operating expenses, as the proportion of full year customer activations derived from fourth quarter holiday sales is expected to decline to reflect ongoing, rather than seasonal, promotions of U.S. Cellular’s products.
Effects of Competition on Operating Income
U.S. Cellular competes directly with several wireless communications services providers, including enhanced specialized mobile radio service providers, in each of its markets. In general, there are between five and seven competitors in each wireless market in which U.S. Cellular provides service. U.S. Cellular generally competes against each of the six near-nationwide wireless companies: Verizon Wireless, Sprint PCS (and affiliates), Cingular Wireless, AT&T Wireless, T-Mobile and Nextel. However, not all six competitors operate in each market where U.S. Cellular does business. U.S. Cellular believes that these competitors have substantially greater financial, technical, marketing, sales, purchasing and distribution resources than it does. In addition, Cingular Wireless has agreed to acquire AT&T Wireless, which will increase this competitor’s financial, technical, marketing, sales, purchasing and distribution resources.
The use of national advertising and promotional programs by such national wireless operators may be a source of additional competitive and pricing pressures in all U.S. Cellular markets, even if those operators may not provide service in a particular market. U.S. Cellular provides wireless services comparable to the national competitors, but the other wireless companies operate in a wider geographic area and are able to offer no- or low-cost roaming and long-distance calling packages over a wider area on their own networks than U.S. Cellular can offer on its network. If U.S. Cellular offers the same calling area as one of these competitors, it will incur roaming charges for calls made in portions of the calling area that are not part of its network.
In the Midwest, U.S. Cellular’s largest contiguous service area, it can offer larger regional service packages without incurring significant roaming charges than it is able to offer in other parts of its network. U.S. Cellular also employs a customer satisfaction strategy throughout its markets which it believes has contributed to a relatively low customer churn rate.
Some of U.S. Cellular’s competitors bundle other services, such as landline telephone service and internet access, with their wireless communications services, which U.S. Cellular either does not have the ability to offer or has chosen not to offer.
In addition, U.S. Cellular competes against both larger and smaller regional wireless companies in certain areas, including ALLTEL, Western Wireless and Rural Cellular Corporation, and against resellers of wireless services. Since each of these competitors operates on systems using spectrum licensed by the FCC and has comparable technology and facilities, competition for customers among these systems in each market is principally on the basis of quality of service, price, size of area covered, services offered and responsiveness of customer service.
Since U.S. Cellular’s competitors do not disclose their subscriber counts in specific regional service areas, market share for the competitors in each regional market cannot be accurately determined.
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Effects of Wireless Number Portability on Operating Income
The FCC has adopted wireless number portability rules requiring wireless carriers to allow a customer to retain, subject to certain geographical limitations, their existing telephone number when switching from one telecommunications carrier to another. These rules became effective on November 24, 2003 for wireless providers in the largest 100 metropolitan statistical areas in the United States. On May 24, 2004, wireless providers in all areas outside such 100 areas that receive a request to allow an end user to port their number must be capable of doing so by such date or within six months of receiving the request, whichever is later.
U.S. Cellular has been successful in facilitating number portability requests in a timely manner in its markets that became subject to the rules on November 24, 2003 and is preparing to facilitate number portability requests in a timely manner in its markets that will become subject to the rules on May 24, 2004. The implementation of wireless number portability has not had a material effect on U.S. Cellular’s results of operations to date. However, U.S. Cellular is unable to predict the impact that the implementation of number portability will have in the future. The implementation of wireless number portability may increase churn rates for U.S. Cellular and other wireless companies, as the ability of customers to retain their wireless telephone numbers removes a significant barrier for customers who wish to change wireless carriers. U.S. Cellular believes that it may be able to obtain additional new customers who wish to change their service from other wireless carriers as a result of wireless number portability. The future volume of any porting requests, and the processing costs related thereto, may increase U.S. Cellular’s operating costs in the future. Any of the above factors could have an adverse effect on U.S. Cellular’s competitive position, costs of obtaining new subscribers, liquidity, financial position and results of operations.
Investment and other income (expense) totaled expense of ($5.3) million in 2004 and ($6.3) million in 2003.
Investment income increased $1.9 million, to $14.3 million in 2004 from $12.4 million in 2003. Investment income primarily represents U.S. Cellular’s share of net income from the markets managed by others that are accounted for by the equity method. The aggregate net income of these investment markets increased significantly in 2004, resulting in a corresponding increase in investment income.
Interest expense increased $4.8 million, or 31%, to $20.3 million in 2004 from $15.5 million in 2003. Interest expense in 2004 is primarily related to Liquid Yield Option Notes ($2.5 million); U.S. Cellular’s 7.25% Notes ($4.6 million); its 8.75% Notes ($2.9 million); its 6.70% Notes ($7.5 million); its revolving credit facilities with a series of banks ($0.8 million); its Vodafone forward contracts ($0.7 million); and its Intercompany Note with TDS (the “Intercompany Note”) ($0.9 million). Interest expense in 2003 is primarily related to Liquid Yield Option Notes ($2.3 million); U.S. Cellular’s 7.25% Notes ($4.7 million); its 8.75% Notes ($2.8 million); its revolving credit facilities with a series of banks ($2.3 million); its Vodafone forward contracts ($0.8 million); and the Intercompany Note ($2.1 million). The Intercompany Note was repaid in full on February 9, 2004 using U.S. Cellular’s $700 million revolving credit facility.
The overall increase in interest expense in the first quarter of 2004 is due to the effect of the issuance of the 6.70% Notes and subsequent repayment of lower interest rate revolving credit facility borrowings in December 2003.
The zero coupon convertible debentures, also known as Liquid Yield Option Notes, accrete interest at 6% annually, but do not require current cash payments of interest. All accreted interest is added to the outstanding principal balance on June 15 and December 15 of each year for purposes of calculating interest expense.
U.S. Cellular’s $250 million principal amount of 7.25% Notes are unsecured and become due in August 2007. Interest on such notes is payable semi-annually on February 15 and August 15 of each year.
U.S. Cellular’s $130 million principal amount of 8.75% Notes are unsecured and become due in November 2032. Interest on such notes is payable quarterly on February 1, May 1, August 1 and November 1 of each year.
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U.S. Cellular’s $444 million principal amount of 6.70% Notes are unsecured, were issued in December 2003 and become due in December 2033. U.S. Cellular issued the 6.70% Notes in order to reduce the use of its revolving credit facility and the related interest rate risk. Interest on such notes is payable semi-annually on June 15 and December 15 of each year.
For information regarding U.S. Cellular’s Revolving Credit Facilities, see “Liquidity and Capital Resources – Revolving Credit Facilities.” For information regarding the Intercompany Note from TDS, see “Certain Relationships and Related Transactions.”
Loss on investments totaled $3.5 million in 2003. A license impairment loss was recorded related to U.S. Cellular’s investment in a non-operational market in Florida that remained with U.S. Cellular after the exchange with AT&T Wireless was completed in August 2003.
Income tax expense (benefit)totaled expense of $11.7 million in 2004 and a benefit of $388,000 in 2003. The overall effective tax rates were 50.7% in 2004 and 3.6% in 2003. The effective tax rates in 2004 and 2003 were impacted by the gains and losses on assets held for sale and the loss on investments, which have different tax rates than U.S. Cellular’s overall operations. For further discussion of U.S. Cellular’s effective tax rates in 2004 and 2003, see Note 4 – Income Taxes.
TDS and U.S. Cellular are parties to a Tax Allocation Agreement, pursuant to which U.S. Cellular is included in a consolidated federal income tax return with other members of the TDS consolidated group.
For financial reporting purposes, U.S. Cellular computes federal income taxes as if it was filing a separate return as its own affiliated group and was not included in the TDS group.
Effective January 1, 2003, U.S. Cellular adopted SFAS No.143 “Accounting for Asset Retirement Obligations” and recorded the initial liability for legal obligations associated with an asset retirement. The cumulative effect of the implementation of this accounting standard on periods prior to 2003 was recorded in the first quarter of 2003, decreasing net income by $14.3 million, net of tax and minority interest, or $0.17 per basic and diluted share.
Net income (loss) totaled income of $9.2 million in 2004 and a loss of $27.8 million in 2003. Diluted earnings (loss) per share was $0.11 in 2004 and ($0.32) in 2003.
Mandatorily Redeemable Noncontrolling Interests
Under SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity,” certain minority interests in consolidated entities with finite lives may meet the standard’s definition of a mandatorily redeemable financial instrument and thus require reclassification as liabilities and remeasurement at the estimated amount of cash that would be due and payable to settle such minority interests under the applicable entity’s organization agreement assuming an orderly liquidation of the finite-lived entity, net of estimated liquidation costs (the “settlement value”). U.S. Cellular’s consolidated financial statements include such minority interests that meet the standard’s definition of mandatorily redeemable financial instruments. These mandatorily redeemable minority interests represent interests held by third parties in consolidated partnerships and limited liability companies (“LLCs”), where the terms of the underlying partnership or LLC agreement provide for a defined termination date at which time the assets of the subsidiary are to be sold, the liabilities are to be extinguished and the remaining net proceeds are to be distributed to the minority interest holders and U.S. Cellular in accordance with the respective partnership and LLC agreements. The termination dates of U.S. Cellular’s mandatorily redeemable minority interests range from 2042 to 2100.
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On November 7, 2003, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position (“FSP”) No. FAS 150-3, “Effective Date, Disclosures, and Transition for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests under FASB Statement No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity.” The FSP indefinitely deferred the classification and measurement provisions of SFAS No. 150 related to the mandatorily redeemable minority interests associated with finite-lived subsidiaries, but retained the related disclosure provisions. The settlement value of U.S. Cellular’s mandatorily redeemable minority interests is estimated to be $106.5 million at March 31, 2004. This represents the estimated amount of cash that would be due and payable to settle minority interests assuming an orderly liquidation of the finite-lived consolidated partnerships and LLCs on March 31, 2004, net of estimated liquidation costs. This amount is being disclosed pursuant to the requirements of FSP FAS 150-3; U.S. Cellular has no current plans or intentions to liquidate any of the related partnerships or LLCs prior to their scheduled termination dates. The corresponding carrying value of the minority interests in finite-lived consolidated partnerships and LLCs at March 31, 2004 is $34.8 million, and is included in the balance sheet caption Minority Interest in Subsidiaries. The excess of the aggregate settlement value over the aggregate carrying value of the mandatorily redeemable minority interests of $71.7 million is primarily due to the unrecognized appreciation of the minority interest holders’ share of the underlying net assets in the consolidated partnerships and LLCs. Neither the minority interest holders’ share, nor U.S. Cellular’s share, of the appreciation of the underlying net assets of these subsidiaries is reflected in the consolidated financial statements. The estimate of settlement value was based on certain factors and assumptions. Change in those factors and assumptions could result in a materially larger or smaller settlement amount.
The FASB plans to reconsider certain implementation issues and perhaps the classification or measurement guidance for mandatorily redeemable minority interests during the deferral period. The outcome of their deliberations cannot be determined at this point. Accordingly, it is possible that the FASB could require the recognition and measurement of mandatorily redeemable minority interests at their settlement value at a later date.
Earnings Per Share
In March 2004, Emerging Issues Task Force (“EITF”) reached a consensus on EITF Issue No. 03-6, “Participating Securities and the Two-Class Method under FASB Statement No. 128, Earnings per Share.” EITF 03-6 clarifies what constitutes a participating security and provides further guidance in applying the two-class method of calculating earnings per share. The consensuses reached by the Task Force in this Issue were ratified by the FASB on March 31, 2004, and are effective for reporting periods beginning after March 31, 2004. U.S. Cellular is currently assessing the provisions of EITF 03-6 and the impact on its calculation of earnings per share.
U.S. Cellular operates a capital- and marketing-intensive business. In recent years, U.S. Cellular has generated cash from its operations, received cash proceeds from divestitures, used its short-term credit facilities and used long-term debt financing to fund its network construction costs and operating expenses. U.S. Cellular anticipates further increases in wireless customers, revenues, operating expenses, cash flows from operating activities and fixed asset additions in the future. Cash flows may fluctuate from quarter to quarter depending on the seasonality of each of these growth factors. Following is a summary of cash flows activities.
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Cash flows from operating activities provided $86.4 million in 2004 and $101.9 million in 2003. Income excluding adjustments to reconcile income (loss) to net cash provided by operating activities, excluding changes in assets and liabilities from operations (“noncash” items) totaled $125.6 million in 2004 and $114.0 million in 2003. Changes in assets and liabilities from operations required $39.2 million in 2004 and $12.1 million in 2003, reflecting timing differences in the payment of accounts payable and accrued taxes and the receipt of accounts receivable. Income taxes and interest paid totaled $15.8 million in 2004 and $6.1 million in 2003.
The following table is a summary of the components of cash flows from operating activities.
Cash flows from investing activities required $41.1 million in 2004 and $130.1 million in 2003. Cash required for property, plant and equipment and system development expenditures totaled $100.5 million in 2004 and $140.9 million in 2003. In both periods, these expenditures were financed primarily with internally generated cash and borrowings from U.S. Cellular’s revolving credit facilities. These expenditures primarily represent the construction of 71 and 73 cell sites in 2004 and 2003, respectively, as well as other plant additions and costs related to the development of U.S. Cellular’s office systems. In 2004 and 2003, these plant additions included approximately $10 million and $15 million, respectively, for the migration to a single digital equipment platform. In both periods, other plant additions included significant amounts related to the replacement of retired assets. In 2003, significant amounts were added to plant under construction as certain markets prepared to migrate to a single digital equipment platform. In 2004, net cash received from the sale of wireless properties in southern Texas to AT&T Wireless totaled $96.9 million. Cash paid for the acquisition of certain minority wireless interests in several wireless markets in which U.S. Cellular already owned a controlling interest totaled $40.4 million in 2004. There were no acquisitions or divestitures completed during the first quarter of 2003. Cash distributions from cellular entities in which U.S. Cellular has an interest provided $3.5 million in 2004 and $13.6 million in 2003.
Cash flows from financing activities required $20.2 million in 2004 and provided $31.2 million in 2003. In 2004, U.S. Cellular repaid the $105.0 million Intercompany Note to TDS, which was financed using its revolving credit facility. In 2003, U.S. Cellular repaid the remaining principal amount outstanding on its 9% Series A Notes due 2032 (the “9% Series A Notes”) with $40.7 million in cash, which was financed using U.S. Cellular’s revolving credit facilities. The 9% Series A Notes were issued to PrimeCo in a private placement on August 2002 and are now retired. In 2004 and 2003, U.S. Cellular borrowed $230.0 million and $120.0 million, respectively, and repaid $145.0 million and $48.0 million, respectively, under its revolving credit facilities.
Management believes that internal cash flow, existing cash and cash equivalents, and funds available from line of credit arrangements provide substantial financial flexibility for U.S. Cellular to meet both its short- and long-term needs. U.S. Cellular also may have access to public and private capital markets to help meet its long-term financing needs. U.S. Cellular anticipates issuing debt and equity securities only when capital requirements (including acquisitions), financial market conditions and other factors warrant.
However, the availability of financial resources is dependent on economic events, business developments, technological changes, financial conditions or other factors, many of which are not in U.S. Cellular’s control. If at any time financing is not available on terms acceptable to U.S. Cellular, it might be required to reduce its business development and capital expenditure plans, which could have a materially adverse effect on its business and financial condition. U.S. Cellular does not believe that any circumstances that could
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materially adversely affect U.S. Cellular’s liquidity or capital resources are currently reasonably likely to occur, but it cannot provide assurances that such circumstances will not occur or that they will not occur rapidly. Economic downturns, changes in financial markets or other factors could rapidly change the availability of U.S. Cellular’s liquidity and capital resources. Uncertainty of access to capital for telecommunications companies, deterioration in the capital markets, other changes in market conditions or other factors could limit or restrict the availability of financing on terms and prices acceptable to U.S. Cellular, which could require U.S. Cellular to reduce its construction, development and acquisition programs.
U.S. Cellular is generating substantial cash from its operations and anticipates financing all of its 2004 obligations with internally generated cash and with short- and long-term debt as the timing of such expenditures warrants. U.S. Cellular had $35.0 million of cash and cash equivalents at March 31, 2004.
U.S. Cellular has a $700 million revolving credit facility available for general corporate purposes. At March 31, 2004, this line of credit had $614.8 million available for use, net of borrowings of $85.0 million and outstanding letters of credit of $0.2 million. This credit facility expires in June 2007. Borrowings bear interest at the LIBOR rate plus a margin percentage, based on U.S. Cellular’s credit rating, which was 55 basis points as of March 31, 2004 (for a rate of 1.64% based on the one month LIBOR rate at March 31, 2004).
The continued availability of this revolving line of credit requires U.S. Cellular to comply with certain negative and affirmative covenants, maintain certain financial ratios and to represent certain matters at the time of each borrowing. On April 19, 2004, U.S. Cellular filed a Form 8-K with the SEC announcing that it expected to restate financial statements for the years ended December 31, 2003 and 2002 and for the interim periods for such years. The restatements resulted in a default under the revolving credit agreement between U.S. Cellular and certain lenders. U.S. Cellular did not fail to make any scheduled payment of principal or interest under such revolving credit agreement. U.S. Cellular received waivers from the lenders under which the lenders agreed to waive any defaults that may have occurred as a result of the restatements. U.S. Cellular’s interest cost on its line of credit would increase if its credit rating goes down, which would increase its cost of financing, but the line of credit would not cease to be available solely as a result of a decline in its credit rating. Certain of U.S. Cellular’s credit facilities would accelerate in the event of a change in control.
The U.S. Cellular Board of Directors has approved a filing with the SEC of a shelf registration statement on Form S-3 to register the issuance from time to time of up to $500 million of senior debt securities. As of the filing date of this Form 10-Q, U.S. Cellular had not filed any registration statement pursuant to its Board of Directors’ approval.
Any sale of debt securities offered under the proposed S-3 Prospectus may be used by U.S. Cellular for general corporate purposes, including, subject to market conditions, the redemption of long-term debt such as the 7.25% notes and 6% zero coupon convertible debentures; in connection with our acquisition, construction and development programs; the reduction of short-term debt; for working capital; or to provide additional investments in U.S. Cellular subsidiaries. Until the proceeds are used for these purposes, U.S. Cellular may deposit them in interest-bearing accounts or invest them in short-term investment securities.
As of the date of filing of this Form 10-Q, U.S. Cellular is in compliance with all covenants and other requirements set forth in its revolving credit agreement and long-term debt indentures. U.S. Cellular does not have any rating downgrade triggers that would accelerate the maturity dates of its debt. However, a downgrade in U.S. Cellular’s credit rating could adversely affect its ability to renew existing, or obtain access to new, credit facilities in the future.
U.S. Cellular and its subsidiaries hold a substantial amount of marketable equity securities that are publicly traded and can have volatile share prices. U.S. Cellular and its subsidiaries do not make direct investments in publicly traded companies and all of these interests were acquired as a result of sales, trades or reorganizations of other assets. The investment in Vodafone resulted from certain sales or trades of non-strategic cellular investments to or settlements with AirTouch Communications in exchange for
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stock of AirTouch, which was then acquired by Vodafone for American Depositary Receipts representing Vodafone stock. The investment in Rural Cellular Corporation is the result of a consolidation of several cellular partnerships in which U.S. Cellular subsidiaries held interests into Rural Cellular Corporation, and the distribution of Rural Cellular Corporation stock in exchange for these interests. U.S. Cellular has not disposed of the investments because their low tax cost basis would trigger a substantial taxable gain upon disposition.
A subsidiary of U.S. Cellular has entered into a number of variable prepaid forward contracts (“forward contracts”) with counterparties related to the marketable equity securities that it holds. The forward contracts mature in May 2007 and, at U.S. Cellular’s option, may be settled in shares of the respective security or cash. U.S. Cellular has provided guarantees to the lenders which provide assurance to the lenders that all principal and interest amounts will be paid upon settlement of the contracts by its subsidiary. If shares are delivered in the settlement of the forward contract, U.S. Cellular would incur a current tax liability at the time of delivery based on the difference between the tax basis of the marketable equity securities delivered and the net amount realized through maturity. Deferred taxes have been provided for the difference between the financial reporting basis and the income tax basis of the marketable equity securities and are included in deferred tax liabilities on the balance sheet. As of March 31, 2004, such deferred tax liabilities totaled $79.1 million.
U.S. Cellular is required to comply with certain covenants under the forward contracts. On April 19, 2004, U.S. Cellular filed a Form 8-K with the SEC announcing that it expected to restate financial statements for the years ended December 31, 2003 and 2002 and for the interim periods for such years. The restatements resulted in defaults under certain of the forward contracts. U.S. Cellular did not fail to make any scheduled payments under any of the forward contracts. U.S. Cellular received waivers from the counterparty to such forward contracts, as required, under which the counterparty agreed to waive any defaults that may have occurred as a result of the restatements.
As of the date of filing of this Form 10-Q, U.S. Cellular is in compliance with all covenants and other requirements set forth in the forward contracts.
Anticipated capital expenditures for 2004 primarily reflect U.S. Cellular’s plans for construction, system expansion, the buildout of certain of its licensed areas and additional expenditures related to its plans to migrate to a single digital equipment platform. U.S. Cellular plans to finance its construction program using internally generated cash and short-term and long-term financing. U.S. Cellular’s estimated capital spending for 2004 is $610 million to $630 million. U.S. Cellular’s capital expenditures for the three months ended March 31, 2004 totaled $100.5 million.
U.S. Cellular’s 2004 capital expenditures will primarily address the following needs:
U.S. Cellular’s overlay of existing technologies with CDMA is largely completed, and when the project is fully completed in 2004 it anticipates total expenditures related to the project to be no more than $300 million. U.S. Cellular will utilize CDMA technology in building out the licenses it has acquired and expects to acquire in the future from AT&T Wireless.
U.S. Cellular expects capital expenditures related to the buildout of the licensed areas it acquired in 2001 through 2003, including those in the AT&T Wireless exchange transaction, to be substantial. U.S. Cellular plans to build networks to serve these licensed areas and launch commercial service in these areas over the next several years. Approximately $100 million of the estimated capital spending for 2004 is allocated to
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the buildout of certain of these licenses, and U.S. Cellular expects a significant portion of its capital spending over the next few years to be related to the buildout of its wireless licensed areas.
U.S. Cellular has no current plans to repurchase a significant number of its Common Shares, and it did not repurchase any Common Shares in the first quarter of 2004 or 2003. U.S. Cellular’s primary repurchase program expired in December 2003. However, U.S. Cellular has an ongoing authorization to repurchase a limited amount of additional Common Shares on a quarterly basis, primarily for use in employee benefit plans.
U.S. Cellular’s Board of Directors has authorized management to opportunistically repurchase its 6% zero coupon convertible debentures, or Liquid Yield Option Notes, in private transactions. U.S. Cellular may also purchase a limited amount of such Notes in open-market transactions from time to time. U.S. Cellular’s Liquid Yield Option Notes are convertible, at the option of their holders, at any time prior to maturity, redemption or purchase, into Common Shares at a conversion rate of 9.475 Common Shares per $1,000 of Notes. Upon conversion, U.S. Cellular has the option to deliver to holders either Common Shares or cash equal to the market value of the Common Shares into which the Liquid Yield Option Notes are convertible. U.S. Cellular may redeem the Liquid Yield Option Notes for cash at the issue price plus accrued original issue discount through the date of redemption.
There has been no material change in the resources required for scheduled repayment of contractual obligations from the table of Contractual Obligations included in Management’s Discussion and Analysis of Results of Operations and Financial Condition included in U.S. Cellular’s Annual Report on Form 10-K for the year ended December 31, 2003, as amended.
U.S. Cellular has no transactions, agreements or contractual arrangements with unconsolidated entities involving “off-balance sheet arrangements,” as defined by SEC rules, that have or are reasonably likely to have a material current or future effect on financial condition, changes in financial condition, results of operations, liquidity, capital expenditures, capital resources, revenues or expenses.
U.S. Cellular has certain variable interests in investments in unconsolidated entities where U.S. Cellular holds a minority interest. The investments in unconsolidated entities total $174.3 million as of March 31, 2004 and are accounted for using either the equity or cost method. U.S. Cellular’s maximum loss exposure for these variable interests is limited to the aggregate carrying amount of the investments.
U.S. Cellular enters into agreements in the normal course of business that provide for indemnification of counterparties. These include certain asset sales and financings with other parties. The term of the indemnification varies by agreement. The events or circumstances that would require U.S. Cellular to perform under these indemnities are transaction specific; however these agreements may require U.S. Cellular to indemnify the counterparty for costs and losses incurred from litigation or claims arising from the underlying transaction. U.S. Cellular is unable to estimate the maximum potential liability for these types of indemnifications as the amounts are dependent on the outcome of future events, the nature and likelihood of which cannot be determined at this time. Historically, U.S. Cellular has not made any significant indemnification payments under such agreements.
U.S. Cellular assesses its wireless holdings on an ongoing basis in order to maximize the benefits derived from its operating markets. U.S. Cellular also reviews attractive opportunities for the acquisition of additional wireless spectrum.
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2004 Activity
On February 18, 2004, U.S. Cellular completed the sale of certain of its wireless properties in southern Texas to AT&T Wireless for $96.9 million in cash, including a working capital adjustment. The U.S. Cellular markets sold to AT&T Wireless included wireless assets and customers in six 25 megahertz cellular markets. An aggregate loss of $21.9 million (including a $22.0 million estimate of the loss on assets held for sale in the fourth quarter of 2003 and a $143,000 reduction of the loss in the first quarter of 2004) was recorded as a loss on assets held for sale (included in operating expenses), representing the difference between the carrying value of the markets sold to AT&T Wireless and the cash received in the transaction.
In addition, in the first quarter of 2004, U.S. Cellular purchased certain minority interests in several wireless markets in which it already owned a controlling interest for $40.4 million in cash. These acquisitions increased investment in licenses, goodwill and customer lists by $2.7 million, $3.6 million and $12.9 million, respectively.
2003 Activity
On March 10, 2003, U.S. Cellular announced that it had entered into a definitive agreement with AT&T Wireless to exchange wireless properties. Pursuant to the exchange, U.S. Cellular has received or will receive the following: a) wireless licenses in 13 states contiguous to and that overlap existing U.S. Cellular properties in the Midwest and the Northeast; b) approximately $34.0 million in cash; and c) minority interests in six markets in which it previously owned a controlling interest.
The acquisition of the licenses in the exchange was accounted for as a purchase by U.S. Cellular and the transfer of the properties by U.S. Cellular to AT&T Wireless was accounted for as a sale. An estimated loss of $21.6 million was recorded in the first quarter of 2003 as a loss on assets held for sale (included in operating expenses), representing the difference between the carrying value of the markets transferred to AT&T Wireless and the fair value of the consideration received or to be received in the transaction.
U.S. Cellular prepares its consolidated financial statements in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”). U.S. Cellular’s significant accounting policies are discussed in detail in Note 1 to the consolidated financial statements included in its Annual Report on Form 10-K for the year ended December 31, 2003, as amended.
The preparation of financial statements in accordance with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Management bases its estimates on historical experience and on various other assumptions and information that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from estimates under different assumptions or conditions.
Management believes the following critical accounting estimates reflect its more significant judgments and estimates used in the preparation of its consolidated financial statements. U.S. Cellular’s senior management has discussed the development and selection of each of the following accounting estimates and the following disclosures with the audit committee of U.S. Cellular’s board of directors.
U.S. Cellular reported $1,192.3 million and $1,189.3 million of investment in licenses and $433.3 million and $430.3 million of goodwill, at March 31, 2004 and December 31, 2003, respectively, as a result of the acquisitions of wireless licenses and markets. In addition, at the end of both periods, U.S. Cellular reported $42.0 million of License Rights related to the licenses that will be received when the AT&T Wireless exchange transaction is fully completed.
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Investments in licenses and goodwill must be reviewed for impairment annually, or more frequently if events or changes in circumstances indicate that the asset might be impaired. U.S. Cellular performs the annual impairment review on licenses and goodwill during the second quarter. There can be no assurance that, upon review at a later date, material impairment charges will not be required.
The intangible asset impairment test consists of comparing the fair value of the intangible asset to the carrying amount of the intangible asset. If the carrying amount exceeds the fair value, an impairment loss is recognized for the difference. The goodwill impairment test is a two-step process. The first step compares the fair value of the reporting unit, as identified in accordance with SFAS No. 142, to its carrying value. If the carrying amount exceeds the fair value, the second step of the test is performed to measure the amount of impairment loss, if any. The second step compares the implied fair value of reporting unit goodwill with the carrying amount of that goodwill. To calculate the implied fair value of goodwill, an enterprise allocates the fair value of the reporting unit to all of the assets and liabilities of that reporting unit (including any unrecognized intangible assets) as if the reporting unit had been acquired in a business combination and the fair value was the price paid to acquire the reporting unit. The excess of the fair value of the reporting unit over the amounts assigned to the assets and liabilities of the reporting unit is the implied fair value of goodwill. If the carrying amount exceeds the implied fair value, an impairment loss is recognized for that difference.
The fair value of an intangible asset and reporting unit goodwill is the amount at which that asset or reporting unit could be bought or sold in a current transaction between willing parties. Therefore, quoted market prices in active markets are the best evidence of fair value and should be used when available. If quoted market prices are not available, the estimate of fair value is based on the best information available, including prices for similar assets and the use of other valuation techniques. Other valuation techniques include present value analysis, multiples of earnings or revenue or a similar performance measure. The use of these techniques involve assumptions by management about factors that are highly uncertain including future cash flows, the appropriate discount rate and other inputs. Different assumptions for these inputs or different valuation methods could create materially different results.
U.S. Cellular tests goodwill for impairment at the level of reporting referred to as a reporting unit. Following the divestiture of its southern Texas markets, which in the aggregate represented an entire reporting unit, in February 2004, U.S. Cellular has identified six reporting units pursuant to paragraph 30 of SFAS No. 142. The six reporting units represent six geographic groupings of FCC licenses, constituting six markets or service areas. U.S. Cellular combines its FCC licenses into six units of accounting for purposes of testing the licenses for impairment pursuant to Emerging Issues Task Force Statement 02-7, “Units of Accounting for Testing Impairment of Indefinite-Lived Assets” (“EITF 02-7”) and SFAS No. 142, using the same geographic groupings as its reporting units.
In 2003, U.S. Cellular retained a third-party valuation firm to prepare valuations of each of the then existing reporting units for purposes of goodwill impairment testing. A discounted cash flow approach was used to value each of the reporting units, using value drivers and risks specific to each individual geographic region. The cash flow estimates incorporate assumptions that market participants would use in their estimates of fair value. Key assumptions made in this process were the selection of a discount rate, estimated future cash flow levels, projected capital expenditures, and selection of terminal values.
U.S. Cellular also retained a third-party valuation firm to prepare valuations of similar groupings of FCC licenses (units of accounting pursuant to EITF 02-7). The valuations were prepared using an excess earnings methodology, through the use of a discounted cash flow approach. This excess earnings methodology estimates the fair value of the intangible assets (FCC license units of accounting) by measuring the future cash flows of the license groups, reduced by charges for contributory assets such as working capital, trademarks, existing subscribers, fixed assets, assembled workforce and goodwill.
In the first quarter of 2003, a license impairment loss was recorded related to U.S. Cellular’s investment in a non-operational market in Florida remaining after the exchange with AT&T Wireless was completed. In the second quarter of 2003, U.S. Cellular recorded an impairment loss on its investment in licenses totaling $49.6 million in 2003 related to the impairment of two reporting units. No impairment losses have been recorded for 2004.
The changes in the carrying amounts of licenses and license rights and goodwill for the quarter ended March 31, 2004 were as follows:
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SFAS No. 143, “Accounting for Asset Retirement Obligations,” was issued in June 2001, and became effective for U.S. Cellular beginning January 1, 2003. SFAS No. 143 requires entities to record the fair value of a liability for legal obligations associated with an asset retirement in the period in which the obligations are incurred. When the liability is initially recorded, the entity capitalizes the cost of the asset retirement obligation by increasing the carrying amount of the related long-lived asset. Over time, the liability is accreted to its present value each period, and the capitalized cost is depreciated over the useful life of the related asset. Upon settlement of the obligation, any difference between the cost to retire the asset and the liability recorded is recognized in the statement of operations as a gain or loss.
The calculation of the asset retirement obligation for U.S. Cellular is a critical accounting estimate because changing the factors used in calculating the obligation could result in larger or smaller estimated obligation that could have a significant impact on its results of operations and financial condition. Such factors may include probabilities or likelihood of remediation, cost estimates, lease renewals and salvage values. Actual results may differ materially from estimates under different assumptions or conditions.
U.S. Cellular is subject to asset retirement obligations associated primarily with its cell sites, retail sites and office locations. Asset retirement obligations include costs to remediate leased land on which U.S. Cellular’s cell sites and switching offices are located. U.S. Cellular is also required to return lease retail store premises and office space to their pre-existing conditions.
U.S. Cellular determined that it had an obligation to remove long-lived assets in its cell sites, retail sites and office locations as described by SFAS 143. The change in asset retirement obligation during 2004 was as follows:
The accounting for income taxes, the amounts of income tax assets and liabilities and the related income tax provision are critical accounting estimates because such amounts are significant to U.S. Cellular’s financial condition, changes in financial condition and results of operations.
The preparation of the consolidated financial statements requires U.S. Cellular to calculate its provision for income taxes. This process involves estimating the actual current income tax liability together with assessing temporary differences resulting from the different treatment of items, such as depreciation expense, for tax and accounting purposes. These temporary differences result in deferred tax assets and liabilities, which are included in U.S. Cellular’s consolidated balance sheet. U.S. Cellular must then assess the likelihood that deferred tax assets will be recovered from future taxable income, and, to the extent management believes that recovery is not likely, establish a valuation allowance. Management’s judgment is required in determining the provision for income taxes, deferred tax assets and liabilities and any valuation allowance recorded against deferred tax assets. U.S. Cellular’s current net deferred tax asset was $17.2 million as of March 31, 2004, representing primarily the deferred tax effects of the allowance for doubtful accounts on accounts receivable, and is included in Other current assets on the balance sheet.
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The temporary differences that gave rise to the noncurrent deferred tax assets and liabilities as of March 31, 2004 are as follows:
The valuation allowance relates to state net operating loss carryforwards and the federal net operating loss carryforwards for those subsidiaries not included in the consolidated federal income tax return since it is more than likely that a portion will expire before such carryforwards can be utilized.
The deferred income tax liability relating to marketable equity securities of $79.1 million at March 31, 2004 represents deferred income taxes calculated on the difference between the book basis and the tax basis of the marketable securities. Income taxes will be payable when U.S. Cellular disposes of the marketable equity securities.
U.S. Cellular is routinely subject to examination of its income tax returns by the Internal Revenue Service (“IRS”) and other tax authorities. U.S. Cellular periodically assesses the likelihood of adjustments to its tax liabilities resulting from these examinations to determine the adequacy of its provision for income taxes, including related interest. Management judgment is required in assessing the eventual outcome of these examinations. Changes to such assessments affect the calculation of U.S. Cellular’s income tax expense. The IRS has completed audits of U.S. Cellular’s federal income tax returns (through its parent company – TDS) for tax years through 1996.
In the event of an increase in the value of tax assets or a decrease in the value of tax liabilities, U.S. Cellular would decrease the income tax expense or increase the income tax benefit by an equivalent amount. In the event of a decrease in the value of tax assets or an increase in the value of tax liabilities, U.S. Cellular would increase the income tax expense or decrease the income tax benefit by an equivalent amount.
U.S. Cellular provides for depreciation on its property, plant and equipment using the straight-line method over the estimated useful lives of the assets. On an annual basis, U.S. Cellular reviews its property, plant and equipment to assess whether the estimated useful lives are appropriate. Factors used in determining useful lives include technology changes, regulatory requirements, obsolescence and type of use.
In the first quarter of 2004, U.S. Cellular adjusted the useful lives of TDMA radio equipment, switch software and antenna equipment. TDMA radio equipment lives were adjusted to be fully depreciated by the end of 2008, which is the latest date the wireless industry will need to support analog service. U.S. Cellular currently uses TDMA radio equipment to support analog service, and expects to have its digital radio network fully migrated to CDMA 1XRTT by that time. The useful lives for certain switch software was reduced to one year from three years and antenna equipment lives were reduced from eight years to seven years in order to better align the useful lives with the actual length of time the assets are in use. These changes increased depreciation by $7.4 million in the first quarter of 2004 and is estimated to increase depreciation by $14.9 million for the full year 2004. The change in useful lives reduced net income by $4.5 million, or $0.05 per share in the three months ended March 31, 2004.
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In August 2002, U.S. Cellular entered into a loan agreement with TDS under which it borrowed $105 million, which was used for the Chicago market purchase. The loan bore interest at an annual rate of 8.1%, payable quarterly, and was due in August 2008, with prepayments optional. The terms of the loan did not contain covenants that are more restrictive than those included in U.S. Cellular’s senior debt, except that, until December 19, 2003, the loan agreement provided that U.S. Cellular may not incur senior debt in an aggregate principal amount in excess of $325 million unless it obtained the consent of TDS as lender. U.S. Cellular’s Board of Directors, including independent directors, approved the terms of this loan and determined that such terms were fair to U.S. Cellular and all of its shareholders. On February 9, 2004, U.S. Cellular repaid this note in full.
U.S. Cellular is billed for all services it receives from TDS, pursuant to the terms of various agreements between it and TDS. The majority of these billings are included in U.S. Cellular’s general and administrative expenses. Some of these agreements were established at a time prior to U.S. Cellular’s initial public offering when TDS owned more than 90% of U.S. Cellular’s outstanding capital stock and may not reflect terms that would be obtainable from an unrelated third party through arms-length negotiations. The principal arrangements that affect U.S. Cellular’s operations are described in Item 13 of its Annual Report on Form 10-K for the year ended December 31, 2003, as amended. Management believes the method TDS uses to allocate common expenses is reasonable and that all expenses and costs applicable to U.S. Cellular are reflected in its financial statements on a basis which is representative of what they would have been if it operated on a stand-alone basis.
The following persons are partners of Sidley Austin Brown & Wood LLP, the principal law firm of U.S. Cellular and its subsidiaries: Walter C. D. Carlson, a director of U.S. Cellular, a director and non-executive Chairman of the Board of Directors of TDS and a trustee and beneficiary of a voting trust that controls TDS; William S. DeCarlo, the General Counsel of TDS and an Assistant Secretary of TDS and certain subsidiaries of TDS; and Stephen P. Fitzell, the General Counsel and an Assistant Secretary of U.S. Cellular and the General Counsel and/or Assistant Secretary of certain other subsidiaries of TDS. Walter C. D. Carlson does not provide legal services to TDS, U.S. Cellular or their subsidiaries.
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PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995SAFE HARBOR CAUTIONARY STATEMENT
This Management’s Discussion and Analysis of Results of Operations and Financial Condition and other sections of this Annual Report to Shareholders contain statements that are not based on historical fact, including the words “believes”, “anticipates”, “intends”, “expects”, and similar words. These statements constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause actual results, events or developments to be significantly different from any future results, events or developments expressed or implied by such forward-looking statements. Such factors include, but are not limited to, the following risks:
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
MARKET RISK
Long-Term Debt
U.S. Cellular is subject to market rate risks due to fluctuations in interest rates and equity markets. U.S. Cellular currently has both fixed-rate and variable-rate long-term debt instruments, with original maturities ranging from five to 30 years. Accordingly, fluctuations in interest rates can lead to significant fluctuations in the fair value of such instruments. As of March 31, 2004, U.S. Cellular has not entered into financial derivatives to reduce its exposure to interest rate risks.
Reference is made to the disclosure under Market Risk - Long Term Debt in U.S. Cellular's Annual Report on Form 10-K for the year ended December 31, 2003, as amended, for additional information about the annual requirements of principal payments, the average interest rates, and the estimated fair values of long-term debt.
Marketable Equity Securities and Derivatives
U.S. Cellular maintains a portfolio of available-for-sale marketable equity securities, the majority of which are the result of sales or trades of non-strategic assets. The market value of these investments aggregated $248.4 million at March 31, 2004. As of March 31, 2004, the net unrealized holding gain, net of tax included in accumulated other comprehensive income totaled $53.4 million.
A subsidiary of U.S. Cellular has entered into a number of forward contracts related to the Vodafone marketable equity securities that it holds. U.S. Cellular has provided guarantees to the lenders which provide assurance to the lenders that all principal and interest amounts are paid upon settlement of the contracts by such subsidiary. The risk management objective of the forward contracts is to hedge the value of the marketable equity securities from losses due to decreases in the market prices of the securities ("downside limit") while retaining a share of gains from increases in the market prices of such securities ("upside potential"). The downside limit of the Vodafone securities is hedged at a range of $15.07 to $16.07 per share, which is at or above the cost basis, thereby eliminating the other than temporary risk on these contracted securities. The upside potential is a range of $21.31 to $22.93 per share.
Under the terms of the forward contracts, U.S. Cellular continues to own the contracted shares and will receive dividends paid on such contracted shares, if any. The forward contracts mature in May 2007 and, at U.S. Cellular's option, may be settled in shares of the security or in cash, pursuant to formulas that "collar" the price of the shares. The collars effectively limit U.S. Cellular's downside risk and upside potential on the contracted shares. The collars are typically adjusted for any changes in dividends on the contracted shares. If U.S. Cellular elects to settle in shares, it will be required to deliver the number of shares of the contracted security determined pursuant to the formula. If shares are delivered in the settlement of the forward contract, U.S. Cellular would incur a current tax liability at the time of delivery based on the difference between the tax basis of the marketable equity securities delivered and the net amount realized though maturity. If U.S. Cellular elects to settle in cash, it will be required to pay an amount in cash equal to the fair market value of the number of shares determined pursuant to the formula.
Deferred taxes have been provided for the difference between the financial reporting basis and the income tax basis of the marketable equity securities and are included in deferred tax liabilities on the balance sheet. Such deferred tax liabilities totaled $79.1 million at March 31, 2004.
The following table summarizes certain facts relating to the contracted securities as of March 31, 2004.
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The following analysis presents the hypothetical change in the fair value of U.S. Cellular's marketable equity securities and derivative instruments at March 31, 2004, using the Black-Scholes model, assuming the same hypothetical price fluctuations of plus and minus 10%, 20% and 30%. The table presents hypothetical information as required by Securities and Exchange Commission rules. Such information should not be inferred to suggest that U.S. Cellular has any intention of selling any marketable equity securities or canceling any derivative instruments.
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ITEM 4. CONTROLS AND PROCEDURES
(a) Evaluation of Disclosure Controls and Procedures. Based on the evaluation required by Rule 13a-15(b) under the Securities Exchange Act of 1934, the principal executive officer and principal financial officer of U.S. Cellular have concluded that U.S. Cellular's disclosure controls and procedures (as defined in Rules 13a-15(e)), as of the end of the period covered by the report, are effective to ensure that the information required to be disclosed by U.S. Cellular in reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms.
(b) Changes in internal controls over financial reporting. There was no change in U.S. Cellular's internal control over financial reporting that occurred during the last fiscal quarter that has materially affected, or is reasonably likely to materially affect, U.S. Cellular's internal control over financial reporting.
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PART II. OTHER INFORMATION
Item 1. Legal Proceedings.
U.S. Cellular is involved in a number of legal proceedings before the FCC and various state and federal courts. In some cases, the litigation involves disputes regarding rights to certain wireless telephone systems and other interests. U.S. Cellular does not believe that any of these proceedings should have a material adverse impact on U.S. Cellular.
Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities.
U.S. Cellular Repurchases of Common Shares
Neither U.S. Cellular, nor any "affiliated purchaser" (as defined by the SEC) of U.S. Cellular, has made any purchases of U.S. Cellular Common Shares under U.S. Cellular's publicly announced repurchase program or otherwise during the quarter covered by this Form 10-Q.
The following is additional information with respect to U.S. Cellular's publicly announced Common Share repurchase program:
U.S. Cellular Repurchases of Liquid Yield Option Notes
Neither U.S. Cellular, nor any "affiliated purchaser" (as defined by the SEC) of U.S. Cellular, has made any purchases of U.S. Cellular's Liquid Yield Option Notes ("LYONs") under U.S. Cellular's publicly announced repurchase program or otherwise during the quarter covered by this Form 10-Q. For these purposes, purchases do not include LYONs canceled upon conversion, regardless of whether U.S. Cellular delivered cash or Common Shares in exchange therefor. Also, purchases do not include any LYONs that may be redeemed pursuant to the terms of the LYONs. U.S. Cellular may redeem the LYONs in whole or in part from time to time at accreted value.
The following is additional information with respect to U.S. Cellular's publicly announced LYONs repurchase programs:
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Item 6. Exhibits and Reports on Form 8-K.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
UNITED STATES CELLULAR CORPORATION(Registrant)
Signature page for the U.S. Cellular 2004 First Quarter Form 10-Q