Item 1.
Business.
General
Valor Communications Group, Inc. (NYSE: VCG) is one of the largest providers of telecommunications services in rural communities in the southwestern United States and, based on the number of telephone lines we have in service, the seventh largest independent local telephone company in the country. We operate approximately 518,000 telephone access lines in primarily rural areas of Texas, Oklahoma, New Mexico and Arkansas. We operate our business through telephone company subsidiaries that qualify as rural local exchange carriers under the Telecommunications Act of 1996.
We offer a wide range of telecommunications services to residential, business and government customers. Our services include: local exchange telephone services, which covers basic dial-tone service as well as enhanced services, such as caller identification, voicemail and call waiting; long distance services; and data services, such as providing digital subscriber lines. We also provide access services that enable inter-exchange carriers to complete interstate and intrastate long distance calls. In addition to the services we provide, we receive revenues from Universal Service Fund (“USF”) payments from the State of Texas and the federal government to support the high cost of providing local telephone service in rural areas.
We formed our company in 2000 in connection with the acquisition of select telephone assets from GTE Southwest Corporation (“GTE”), which is now part of Verizon. In January 2002, we acquired the local telephone company serving Kerrville, Texas. The rural telephone businesses that we own have been operating in the markets we serve for over 75 years. We completed our initial public offering on February 9, 2005 and our shares began trading on the NYSE under the symbol “VCG.”
As previously announced on December 9, 2005, the board of directors of Valor Communications Group, Inc. (“Valor”) unanimously approved a strategic merger that will combine Valor and the wireline telecommunications business of Alltel Corporation (“Alltel”). Pursuant to the Agreement and Plan of Merger Valor entered into on December 8, 2005 with Alltel and Alltel Holding Corp. (which we refer to as “Spinco”), Spinco will merge with and into Valor and Valor will survive as a stand-alone company and will hold and conduct the combined business operations of Valor and Spinco. The merger will take place immediately after Alltel contributes the assets making up its wireline telecommunications business to Spinco and distributes the common stock of Spinco to its stockholders. In the merger, each share of Spinco common stock will be converted into the right to receive approximately 1.04 shares of Valor common stock. Existing shares of Valor common stock will remain outstanding. Following completion of the merger, the separate existence of Spinco will cease. Valor expects to issue approximately 403 million shares of common stock to Alltel stockholders in the merger. However, this amount is subject to change as a result of compensatory equity grants and other issuances of Valor common stock. Valor also expects to assume approximately $4 billion in outstanding debt in the merger. Immediately following the merger, Valor expects to change its name and that its common stock will be quoted on the New York Stock Exchange under that new name and with a new ticker symbol, each of which has yet to be determined. When the merger is completed, Alltel stockholders will together own approximately 85%, and Valor’s stockholders will own approximately 15%, of the shares of common stock in that entity on a fully diluted basis. The composition of the senior management and board of directors of the combined business will be largely determined by Alltel. While we are the legal acquirer and the surviving entity in this transaction, Alltel’s wireline business will be deemed to be the accounting acquirer in a transaction treated for accounting purposes as a reverse acquisition. The historical financial statements of Valor after the close of the merger will be those of Alltel’s wireline business. The merger is subject to both regulatory and shareholder approval and is expected to close in mid-2006.
Initial Public Offering and Reorganization
On February 9, 2005, we completed our initial public offering (the “Offering”) registering 29,375,000 shares of common stock at an offering price of $15 per share. In conjunction with the Offering, we issued $400 million aggregate principal senior notes. In August 2005, we exchanged all of the senior notes
with substantially identical senior notes that were registered under the Securities Act of 1933. The proceeds from the Offering and the issuance of the senior notes were used to repay the second lien loan of $265 million, senior subordinated loan of $135 million, and a portion of the existing credit facility of $373.4 million and associated fees and expenses of $66.3. Immediately following the Offering, we amended our senior credit facility. The amended senior credit facility resulted in the reduction of the commitment amount, excluding the senior secured revolving facility, to $805.6 million. In connection with the Offering, certain of our stockholders granted an option to the underwriters to purchase up to 4,406,250 additional shares at the Offering price less the underwriting discount. On March 16, 2005, the underwriters exercised their over-allotment option in full. We received no proceeds from the over-allotment exercise.
Immediately prior to and in connection with the Offering, we consummated a reorganization pursuant to which our existing equity holders contributed all their equity interests in Valor Telecommunications, LLC, (“VTC”) and Valor Telecommunications Southwest, LLC, (“VTS”) to Valor in exchange for 39,537,574 shares of common stock in the aggregate. Following the reorganization, Valor exists as a holding company with no direct operations and each of VTC, VTS and Valor Telecommunications Southwest II, LLC, (“VTS II”) is either a direct or an indirect wholly-owned subsidiary of Valor. Valor’s principal assets consist of the direct and indirect equity interests of its subsidiaries.
Industry Overview
The U.S. local telephone industry is comprised of a few large, well-known companies, including the regional Bell operating companies and numerous small and mid-sized independent rural telephone companies that typically operate in sparsely populated rural areas where competition has been limited due to the generally unfavorable economics of constructing and operating competitive systems. To ensure that affordable universal telephone service is available in these remote areas, rural telephone companies may receive various support mechanisms provided by both state and federal government regulation.
Federal and state laws and regulations promoting the widespread availability of telephone service have allowed rural telephone companies to invest in their networks while keeping prices affordable for customers. This policy commitment was reaffirmed and expanded by the universal service provisions of the Telecommunications Act of 1996. In light of the high cost per access line of installing lines and switches and providing telephone service in sparsely populated areas, a system of cost recovery mechanisms has been established to, among other things, keep customer telephone charges at a reasonable level and yet allow owners of such telephone companies to earn a fair return on their investment. These cost recovery mechanisms, which are less available to larger telephone companies, have resulted in robust telecommunications networks in many rural areas.
The passage of the Telecommunications Act of 1996 substantially changed the regulatory structure applicable to the telecommunications industry, with a stated goal of stimulating competition for telecommunications services, including local telephone service, long distance service and enhanced services. In recent years, the telecommunications industry has undergone significant structural change. Many of the largest service providers have achieved growth through acquisitions and mergers while an increasing number of competitive providers have restructured or entered bankruptcy to obtain protection from their creditors. Since 2001, capital in the form of public financing has been generally difficult to obtain for new entrants and competitive providers. Capital constraints have caused a number of competitive providers to change their business plans, resulting in industry consolidation. Despite these changes, the demand for all types of telecommunications services, particularly data services, has not diminished, and companies increasingly bundle services and provide integrated offerings for end-user customers.
The most common measure of the relative size of a local telephone company is the number of access lines it operates. An “access line” is the telephone line connecting a person’s home or business to the public switched telephone network. A local telephone company can acquire access lines either through normal growth or through a transaction with another local telephone company. The net increase or decrease in access lines realized by a local telephone company on an annual basis is a relevant measure because the access line is the foundation for a large majority of local telephone company revenues and it is also an indicator of customer
growth or contraction. A local telephone company experiences normal growth when it sells additional access lines in a particular market due to increased demand for telephone service by current customers or from new customers, such as from the construction of new residential or commercial buildings. Growth in access lines through transactions with other local telephone companies occurs less frequently. Typically, one local telephone company purchases access lines from another local telephone company. Such purchases usually provide the acquiring local telephone company with the opportunity to expand the geographic areas it serves, rather than increasing its access lines in markets that it already serves.
Services
We locally manage our service offerings to serve effectively and efficiently the needs of each community. We are committed to a high standard of service and have dedicated sales and customer service representatives with local market knowledge positioned in each of the states in which we operate. Based on our understanding of our local customers’ needs, we offer bundled services that are designed to simplify the customer’s selection and use of our services. Offering bundled services allows us to capitalize on our network infrastructure by offering a full suite of integrated communications services in voice, high-speed data, Internet access and long distance services, as well as enhanced services, such as voicemail and caller identification, all on one bill.
We also generate revenue through the provision of network access to long distance carriers for origination and termination of interstate and intrastate long distance phone calls, the receipt of government-sponsored USF support, and from the sale of other services, such as customer premises equipment and directory advertising.
The following summarizes each component of our revenue sources (percentages are based on revenues for the year ended December 31):
You should refer to the section “Management’s Discussion and Analysis of Financial Condition and Results of Operation” for more information.
Local Services. Local calling services include basic local lines and private lines, as well as enhanced services such as voicemail and caller identification. We provide local calling services to residential, business and government customers, generally for a fixed monthly charge. In the markets we serve, the amount that we can charge a customer for local service is generally determined by the appropriate state regulatory authorities pursuant to the laws and regulations of the particular state. We also generate revenue from non-recurring services, such as service activation and reconnection of service.
Data Services. We provide high-speed Internet access with our DSL products for a monthly fee. We also provide Internet access services to dial-up Internet subscribers. Our dial-up Internet service provides customers, primarily residential customers, with a local dial-up number they can use to establish a connection to the Internet over their existing phone lines for a flat, monthly fee. Our Internet access services also enable customers to establish an email account and to send and receive email.
Long Distance Services. We generate revenue from the provision of long distance calling services either based on usage or pursuant to flat-rate calling plans. These services include traditional switched and dedicated long distance, toll free calling, international, calling card and operator services.
Access Services. Long distance carriers pay us network access charges when our local customers make or receive long distance telephone calls. Since these calls are generally billed to the customer originating the call, a mechanism is required to compensate each rural telephone company, regional Bell operating company or long distance carrier providing services relating to the call. Access services include switched access, charges that depend on call volume, and special access, involving dedicated circuits for which long distance telephone companies pay a flat fee. We bill access charges to long distance companies and other customers for the use of our facilities to access the customer, as described below. In addition, per Federal Communications Commission (“FCC”) rule, end users are charged a monthly flat-rate fee assessed on access lines.
Intrastate Access. We generate intrastate access revenue when an intrastate long distance call involving a long distance carrier is originated by or terminated with a customer in our exchange to or from a customer in another exchange in the same state. The long distance carrier pays us an intrastate access payment for either terminating or originating the call. We record the details of the call through our carrier access billing system and receive the access payment from the long distance carrier. When one of our customers originates the call, we sometimes provide billing and collection for the long distance carrier through a billing and collection agreement. The access charge for our intrastate service is regulated and approved by the state regulatory authority.
Interstate Access. We generate interstate access revenue when an interstate long distance call is originated by or terminated with a customer in our exchange to or from a customer in another state. We bill interstate access charges in the same manner as we bill intrastate access charges; however, the interstate access charge is regulated and approved by the FCC instead of the state regulatory authority.
Universal Service Fund
Texas USF. The Texas USF supports eligible telecommunications carriers that serve high cost markets. See further discussion of Texas USF within this Item under the caption “State Regulation.”
Federal USF. The federal USF supplements the amount of local service revenue that we receive to ensure that basic local service rates for customers in high cost rural areas are comparable to rates charged in lower cost urban and suburban areas. The federal USF, which is funded by monthly fees paid by long distance carriers and local telephone companies, distributes funds to us on a monthly basis based upon our embedded costs for providing local service. This mostly reflects the changes in the universal service support as a result of the Coalition for Affordable Local and Long Distance Service (“CALLS”) plan that moved the implicit support from access charges and made it explicit.
Other Services. Our other services consist primarily of the sale of customer premises equipment, directory advertising, wholesale services such as unbundled network elements, billing and collection fees, and other ancillary services.
Sales and Marketing
Our marketing approach emphasizes customer-oriented sales, marketing and service with a local presence. We market our products primarily through our customer service representatives, direct sales representatives, local retail stores and outsourced telemarketing supported by direct mail, bill inserts, newspaper advertising, website promotions, public relations activities and sponsorship of community events. We have established relationships with local government officials and business leaders. In our largest operating areas, we maintain retail business offices that allow our customers the opportunity to pay their bills directly or meet personally with our customer service and sales representatives to purchase additional services or, in some locations, customer premises equipment. Our customer service and sales representatives earn incentive compensation to promote sales of services that meet the unique needs of our customers.
Our sales force makes direct calls to prospective and existing business customers and conducts analyses of business customers’ usage histories and service needs, and demonstrates how our service package may improve a customer’s communications capabilities and costs. Our network engineers work closely with our various sales groups to design service products and applications, such as high-speed data and wholesale
transport services, for our customers. Our technicians survey customer premises to assess building entry, power and space requirements and coordinate delivery, installation and testing of equipment.
To foster long-term relationships with our subscribers, we have undertaken many initiatives to provide superior customer service. We operate three call centers located in the rural areas that we serve with customer service representatives who are knowledgeable about the local market. In addition, we have automated many of our customer service functions so our customers can receive answers to many frequently asked questions regarding their telecommunications services 24 hours a day without speaking to a customer service representative.
Network Architecture and Technology
Our network consists of central office hosts and remote sites with advanced digital switches, primarily manufactured by Nortel, Lucent and Siemens, generally operating with the most current software. The outside plant consists of transport and distribution delivery networks connecting our host central office with remote central offices and ultimately with our customers. We own fiber optic cable, which has been deployed throughout our current network and is the primary transport technology between our host and remote central offices and interconnection points with other incumbent carriers. We also lease fiber optic capacity from other major carriers.
In our markets, DSL-enabled integrated access technology is being deployed to provide significant broadband capabilities to our customers. We continue to remove any network impediments so we can offer DSL service to more customers. Based on current technical limitations and the cost characteristics in certain of our rural markets, DSL is available to many, but not to all, of our customers.
Rapid and significant changes in technology are expected in the communications industry. Our future success will depend, in part, on our ability to anticipate and adapt to technological changes. We believe that our network architecture enables us to respond efficiently to these technological changes.
We offer facilities-based services in each of our markets. Our fully integrated telecommunications network is comprised primarily of asynchronous transport mode (“ATM”) core switches, capable of handling both voice and data, and time digital multiplex (“TDM”) digital central office switches in our four divisions of operation. We currently own or lease all of our network facilities and have not booked any revenues from swaps of indefeasible rights to use (“IRUs”).
Our SS7 network consists of six Signal Transfer Points (“STP”) and two Signal Control Points (“SCP”) nodes which provide 800 Number Routing, Caller Name delivery, CLASS, and Message Waiting Indicator service for all of our class 5 TDM digital central office switches. Our Voice Mail network consists of 11 voice mail servers which leverage the ATM Core transport network to reach 100% of our customer base.
Our network operations center located in Texarkana, Texas monitors all our networks, transport and ATM elements, digital switching systems and Internet services infrastructure devices 24 hours a day, seven days a week.
Competition
We experience competition from wireless service providers in many of our markets. We also experience competition from wireline local carriers and cable companies in a limited number of our markets. In addition, future technological changes could negatively impact our competitive position. For example, as Voice over Internet Protocol (“VoIP”) emerges, some wholesale customers may be able to bypass network access charges. See further discussion at Item 1A.
Item 1A - “Risk Factors,” Item 3 - “Legal Proceedings,” Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operation” and Item 7A - “Quantitative and Qualitative Disclosures About Market Risk,” are forward-looking statements that represent management’s beliefs and assumptions based on currently available information. Forward-looking statements can be identified by the use of words such as “believes,” “intends,” “may,” “should,” “anticipates,” “expects” or comparable terminology or by discussions of strategies or trends. Although we believe that the expectations reflected in such forward-looking statements are reasonable, we cannot give any assurances that these expectations will prove to be correct. Such statements by their nature involve substantial risks and uncertainties that could significantly impact expected results, and actual future results could differ materially from those described in such forward-looking statements. Among the factors that could cause actual future results to differ materially are the risks and uncertainties discussed in this Annual Report and those described from time to time in materials filed with our other filings with the SEC.
While it is not possible to identify all factors, we continue to face many risks and uncertainties including, but not limited to, the following:
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our high degree of leverage and significant debt service obligations;
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our ability to refinance our existing indebtedness on terms acceptable to us, or at all;
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any adverse changes in law or government regulation, including possible changes to cash funding requirements for our defined benefit pension plan;
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the risk that we may not be able to retain existing customers or obtain new customers;
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the risk of technological innovations outpacing our ability to adapt or replace our equipment to offer comparable services;
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the possibility of labor disruptions;
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the risk of increased competition in the markets we serve;
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the impact of pricing decisions;
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the risk of weaker economic conditions within the United States;
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uncertainties associated with new product development;
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environmental matters;
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potential outcome of income tax audits;
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possible future litigation or regulatory proceedings;
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changes in accounting policies or practices adopted voluntarily or as required by accounting principles generally accepted in the United States;
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changes in laws or regulations governing telecommunications providers or the provision of telecommunications services; and
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other risks and uncertainties.
Should one or more of these risks materialize (or the consequences of such a development worsen) or should the underlying assumptions prove incorrect, actual results could differ materially from those forecasted or expected. We disclaim any intention or obligation to update publicly or revise such statements whether as a result of new information, future events or otherwise.
Executive Officers of the Registrant
The following table sets forth information with respect to our executive officers.
John J. Mueller has served as our Chief Executive Officer and President since April 2004 and was previously our President and Chief Operating Officer since November 2002. Mr. Mueller was appointed to our board of directors following the consummation of our Offering. Mr. Mueller joined us in April 2002 as Executive Vice President and Chief Operating Officer. Prior to joining our company, Mr. Mueller spent 23 years at Cincinnati Bell Inc. including serving as General Manager - Consumer Markets from February
1999 to May 1999, President - Business Units from May 1999 to November 1999 and President of the Cincinnati Bell Telephone Company from November 1999 to October 2001.
Jerry E. Vaughn has served as Senior Vice President - Chief Financial Officer since October 2005. Most recently, from June 1999 until August 2005, Mr. Vaughn was Chief Financial Officer for Louisiana-based U.S. Unwired, Inc. where he led the company’s finance and accounting activities. Mr. Vaughn has more than 25 years of diversified financial management experience.
William M. Ojile, Jr. has served as our Senior Vice President, Chief Legal Officer and Secretary since November 2000. Before joining our company, Mr. Ojile worked at US WEST, Inc. for approximately 12 years, serving as Regional Executive Director - Public Policy from January 1998 to July 2000 and, after the merger between US WEST and Qwest Communications International in July 2000, as Corporate Counsel for Qwest Communications International from July 2000 to November 2000.
W. Grant Raney has served as our Chief Operating Officer since September 2005 and Senior Vice President - Operations, Sales and Marketing since August 2004. Prior to then, Mr. Raney had served as our Senior Vice President - Operations and Engineering since January 2001. In February 2000, Mr. Raney joined our company as Vice President - Operations. Prior to joining our company, from March 1999 to February 2000, Mr. Raney was Division Vice President at Spectra Communications Group, a partnership of CenturyTel, Inc. Starting in March 1979 at CenturyTel, Mr. Raney has 26 years of experience in the telecommunications industry in a variety of roles of increasing responsibility.
Cynthia B. Nash has served as our Senior Vice President and Chief Information Officer since January 2004. In April 2002, Ms. Nash joined our company as our Vice President and Chief Technology Officer. Before joining our company, Ms. Nash held various positions of increasing responsibility with CenturyTel, Inc., including Vice President of Information Technology from January 2001 to April 2002, Director of the Program Management Office and Customer Care from September 2000 to January 2001, Director of Applications Development from December 1999 to September 2000 and Director of Telco Applications from September 1997 to December 1999. Ms. Nash has over 17 years of experience in the telecommunications industry.
Item 1A.
Risk Factors.
Risks Relating to Our Business
We provide services to our customers over access lines and if we lose access lines our revenues, earnings and cash flow from operations may decrease.
Our business generates revenue by delivering voice and data services over access lines. We have experienced net access line losses since 2002, and during the year ended December 31, 2005, the number of access lines we serve declined by 4.0% due to the competitive landscape and changes in customer preferences for communications services in the markets we serve. We may continue to experience net access line losses in our markets for an unforeseen period of time.
A significant portion of our access line losses have come from markets where we experience cable telephony competition. We have defined active cable telephony markets as those markets where we have processed request(s) by the cable competitor to port customer telephone numbers to the cable provider. “Porting” is an industry term used to describe the process that allows a customer to retain its existing phone number when switching its telephone service to a competitor. Beginning in November 2004 in Broken Arrow, Oklahoma, the incumbent local cable television operator, began offering cable telephony. For the year ended December 31, 2005, approximately 12% of our access lines were in active cable telephony markets, consisting essentially of the lines we serve in Broken Arrow, Oklahoma and bordering communities, along with three of our West Texas markets. Our active cable telephony markets contributed more than 65% of our 2005 access line losses. In non-active cable telephony markets, representing approximately 88% of our access lines, our 2005 line losses are approximately 1.5%.
In addition, we experience access line losses due to wireless substitution and competition from subsidiaries of rural local telephony companies that have extended their facilities into some of our adjacent
rural markets. Future technological changes could also negatively impact our competitive position. For example, as VoIP develops, some wholesale customers may be able to bypass network access charges. Our inability to retain access lines could adversely affect our revenues, earnings and cash flow from operations.
Rapid and significant changes in technology in the telecommunications industry could adversely affect our ability to compete effectively in the markets in which we operate.
The rapid introduction and development of enhanced or alternative services that are more cost effective, more efficient or more technologically advanced than the services we offer is a significant source of potential competition in the telecommunications industry. Technological developments may reduce the competitiveness of our networks, make our service offerings less attractive or require expensive and time-consuming capital improvements. If we fail to adapt successfully to technological changes or fail to obtain timely access to important new technologies, we could lose customers and have difficulty attracting new customers or selling new services to our existing customers.
We cannot predict the impact of technological changes on our competitive position, profitability or industry. Wireless and cable technologies that have emerged in recent years provide certain advantages over traditional wireline voice and data services which we provide. The mobility afforded by wireless voice services and its competitive pricing appeal to many customers. The ability of cable television providers to offer voice, video and data services as an integrated package provides an attractive alternative to traditional voice services from local exchange carriers. In addition, as the emerging VoIP services develop, some customers may be able to bypass network access charges. Increased penetration rates for these technologies in our markets could cause our revenues to decline.
The competitive nature of the telecommunications industry could adversely affect our revenues, results of operations and profitability.
The telecommunications industry is very competitive. Increased competition could lead to price reductions, declining sales volumes, loss of market share, higher marketing costs and reduced operating margins. Significant and potentially larger competitors could enter our markets at any time. For example, wireless providers currently compete in most of our rural markets. We expect this competition to continue, and likely become more intense, in the future. We also compete, or may in the future compete, with companies that provide other close substitutes for the traditional telephone services we provide, like cable television, VoIP, high-speed fiber optic networks or satellite telecommunications services and with companies that might provide traditional telephone services over nontraditional network infrastructures, like electric utilities.
Weak economic conditions may decrease demand for our services.
We are sensitive to economic conditions and downturns in the economy. Downturns in the economies in the markets we serve could cause our existing customers to reduce their purchases of our basic and enhanced services and make it difficult for us to obtain new customers.
We depend on a few key vendors and suppliers to conduct our business and any disruption in our relationship with any one or more of them could adversely affect our results of operations.
We rely on vendors and suppliers to support many of our administrative functions and to enable us to provide long distance services. For example, we currently outsource much of our operational support services to Alltel, including our billing and customer care systems. Transitioning these support services to another provider could take a significant period of time and involve substantial costs. In addition, we have a resale agreement with Sprint to provide our long distance transmission services. Replacing this resale agreement could be difficult as there are a limited number of national long distance providers. Any disruptions in our relationship with these third party providers could have an adverse effect on our business and operations.
Disruption in our networks and infrastructure may cause us to lose customers and incur additional expenses.
To be successful, we will need to continue to provide our customers with reliable service over our networks. Some of the risks to our networks and infrastructure include: physical damage to access lines, breaches of security, capacity limitations, power surges or outages, software defects and disruptions beyond our control, such as natural disasters and acts of terrorism.
From time to time in the ordinary course of our business, we experience short disruptions in our service due to factors such as cable damage, inclement weather and service failures of our third party service providers. We cannot assure you that we will not experience more significant disruptions in the future. Disruptions may cause interruptions in service or reduced capacity for customers, either of which could cause us to lose customers and incur expenses, and thereby adversely affect our business, revenue and cash flow.
Recent difficulties in the telecommunications industry could negatively impact our revenues and results of operations.
We originate and terminate long distance phone calls on our networks for other interexchange carriers, some of which are our largest customers in terms of revenues. In the years ended December 31, 2003, 2004 and 2005, we generated 17.5%, 16.3% and 15.7%, respectively, of our total revenues from originating and terminating phone calls for interexchange carriers. Bankruptcies or disruptions in the businesses of these interexchange carriers could have an adverse effect on our financial results and cash flows.
Regulatory Risks
We receive revenues from the Texas and federal Universal Service Funds and any adverse regulatory developments with respect to these funds could curtail our profitability.
We receive Texas and federal USF revenues to support the high cost of providing affordable telecommunications services in rural markets. Such support payments constituted 24.1%, 23.7% and 22.8% of our revenues for the years ended December 31, 2003, 2004 and 2005, respectively. Of these support payments, in the years ended December 31, 2003, 2004 and 2005, 20.7%, 20.1% and 19.8%, respectively, of our revenues were received from the Texas USF. In addition, we are required to make contributions to the Texas USF and federal USF each year. Current state and federal regulations allow us to recover these costs by including a surcharge on our customers’ bills. Furthermore, we incur no incremental costs associated with the support payments we receive or the contributions we are required to make. Thus, if Texas and/or federal regulations changed and we were unable to receive support, such support was reduced, or we are unable to recover the amounts we contribute to the Texas USF and federal USF from our customers, our earnings and cash flow from operations would be directly and adversely affected.
The rules governing USF could be altered or amended as a result of regulatory, legislative or judicial action and impact the amount of USF support that we receive and our ability to recover our USF contributions by assessing surcharges on our customers’ bills. For example, in September 2005, the Texas Legislature adopted significant telecommunications legislation. Part of that legislation directed the TPUC to initiate a study of the Texas Universal Service Fund and to make a report to the Legislature. As a result, either the Texas Legislature or the TPUC could make future changes to the Texas USF that may impact our support from the Texas USF. Similarly, in June 2004, the FCC asked the Federal-State Joint Board on Universal Service to review the federal rules relating to universal service support mechanisms for rural carriers, including addressing the relevant costs and the definition of “rural telephone company.” It is not possible to predict at this time whether state or federal regulators, Congress or state legislatures will order modification to those rules or statutes, or the ultimate impact any such modification might have on us.
In addition, the Texas USF rules provide that the TPUC must open an investigation within 90 days after any changes are made to the federal USF. Therefore, changes to the federal USF may prompt similar or conforming changes to the Texas USF. The outcome of any of these legislative or regulatory changes could
affect the amount of Texas USF support that we receive, and could have an adverse effect on our business, revenue or profitability.
Reductions in the amount of network access revenue that we receive could negatively impact our results of operations.
In the years ended December 31, 2003, 2004 and 2005, we derived $132.0 million, $126.8 million and $120.7 million, respectively, of our revenues from network access charges. Our network access revenue consists of (i) usage sensitive fees we charge to long distance companies for access to our network in connection with the completion of interstate and intrastate long distance calls, (ii) fees charged for use of dedicated circuits and (iii) end user fees, which are monthly flat-rate charges assessed on access lines. Federal and state regulatory commissions set these access charges, and they could change the amount of the charges or the manner in which they are charged at any time. The FCC is currently examining proposals to revise interstate access charges and other intercarrier compensation. The outcome of this proceeding is uncertain and could result in significant changes to the way in which we receive compensation from our customers. Also, as people in our markets decide to use Internet, wireless or cable television providers for their local or long distance calling needs, rather than using our wireline network, the reduction in the number of access lines or minutes of use over our network could reduce the amount of access revenue we collect. As penetration rates for these technologies increase in rural markets, our revenues could decline. In addition, if our customers take advantage of favorable calling plans offered by wireless carriers for their long distance calling needs, it could reduce the number of long distance calls made over our network, thereby decreasing our access revenue. Furthermore, the emerging technology application known as VoIP can be used to carry voice communications services over a broadband Internet connection. The FCC has ruled that some VoIP arrangements are not subject to regulation as telephone services. The FCC has ruled that certain VoIP services are jurisdictionally interstate, and preempted the ability of the states to regulate such VoIP applications or providers. The FCC has pending a proceeding that will address the applicability of various regulatory requirements to VoIP providers, however, we cannot assure you that this proceeding will result in VoIP providers having to pay access charges. Expanded use of VoIP technology could reduce the access revenues received by local exchange carriers like us. We cannot predict whether or when VoIP may be required to pay or be entitled to receive access charges or USF support, or the extent to which users will substitute VoIP calls for traditional wireline communications or the effect of the growth of VoIP on our revenues.
The introduction of new competitors or the better positioning of existing competitors due to regulatory changes could cause us to lose customers and impede our ability to attract new customers.
Changes in regulations that open our markets to more competitors offering substitute services could impact our profitability because of increases in the costs of attracting and retaining customers and decreases in revenues due to lost customers and the need to offer competitive prices. We face competition from current and potential market entrants, including:
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domestic and international long distance providers seeking to enter, reenter or expand entry into the local telecommunications market;
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other domestic and international competitive telecommunications providers, wireless carriers, resellers, cable television companies and electric utilities; and
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providers of broadband and Internet services.
Regulatory requirements designed to facilitate the introduction of competition, the applicability of different regulatory requirements between our competitors and us, or decisions by legislators or regulators to exempt certain providers or technologies from the same level of regulation that we face, could adversely impact our market position and our ability to offer competitive alternatives.
In November 2003, the FCC ordered us and other local exchange carriers to adopt wireline-to-wireless local number portability. This may help wireless carriers compete against us because if customers switch from traditional local telephone service to wireless service, they can now transfer their local telephone number to
their wireless provider. On remand from the United States Court of Appeals for the District of Columbia Circuit, the FCC is examining the impact of the rules on “small entities,” which by definition includes Valor. Pending completion of this review, the court stayed the impact of the wireline-to-wireless porting rules on small entities. In addition, federal and state regulators and courts are addressing many aspects of our obligations to provide unbundled network elements and discounted wholesale rates to competitors.
New regulations and changes in existing regulations may force us to incur significant expenses.
Our business may also be impacted by legislation and regulation that impose new or greater obligations related to assisting law enforcement, bolstering homeland security, minimizing environmental impacts or addressing other issues that impact our business. For example, existing provisions of CALEA and FCC regulations implementing CALEA require telecommunications carriers to ensure that their equipment, facilities, and services are able to facilitate authorized electronic surveillance. On August 4, 2004, in response to a joint petition filed by the Department of Justice, Federal Bureau of Investigation, and the Drug Enforcement Administration, the FCC launched a Notice of Proposed Rulemaking proposing a thorough examination of the appropriate legal and policy framework of CALEA. In this proceeding, the FCC will examine issues relating to the scope of CALEA’s applicability to services such as broadband Internet access, as well as implementation and enforcement issues. We cannot predict the eventual outcome of this proceeding or what compliance with any rules adopted by the FCC may cost. Similarly, we cannot predict whether or when federal or state legislators or regulators might impose new security, environmental or other obligations on our business.
A reduction by a state regulatory body or the FCC of the rates we charge our customers would reduce our revenues, earnings and cash flow from operations.
The prices, terms and conditions of the services that we offer to local telephone customers are subject to state regulatory approval. If a state regulatory body orders us to reduce a price, withdraws their approval allowing us to charge a certain price, changes material terms or conditions of a service we offer or refuses to approve or limits our ability to offer a new or existing service, our revenues, earnings and cash flow from operations may be reduced.
FCC regulations also affect the rates that are charged to customers. The FCC regulates tariffs for interstate access and subscriber line charges, both of which are components of our revenues. The FCC currently is considering proposals to reduce interstate access charges for carriers like us. If the FCC lowers interstate access charges without adopting an adequate revenue replacement mechanism, we may be required to recover more revenue through subscriber line charges and Universal Service Funds or forego this revenue altogether. This could reduce our revenue or impair our competitive position.
Our business is subject to extensive regulation that could change in a manner adverse to us.
We operate in a heavily regulated industry, and most of our revenues come from providing services regulated by the FCC and the state public utility commissions. Federal and state communications laws may be amended in the future, and other laws may affect our business. The FCC and the state public utility commissions may add new rules, amend their rules or change the interpretation of their rules at any time. Laws and regulations applicable to us and our competitors may be, and have been, challenged in the courts, and could be changed at any time. We cannot predict future developments or changes to the regulatory environment, or the impact such developments or changes would have on us.
Risks Relating to Our Common Stock and Senior Debt
Our dividend policy may limit our ability to pursue growth opportunities.
Upon the completion of our Offering in February 2005, our board of directors adopted a dividend policy that reflects an intention to distribute a substantial portion of the cash generated by our business in excess of operating needs, interest and principal payments on our indebtedness and capital expenditures as regular quarterly dividends to our stockholders. As a result, we may not retain a sufficient amount of cash to finance
growth opportunities. In addition, because a significant portion of cash available to pay dividends is distributed to holders of our common stock under our dividend policy, our ability to pursue any material expansion of our business, including through acquisitions, increased capital spending or other increases of our expenditures, depends more than it otherwise would on our ability to obtain third party financing. We cannot assure you that such financing will be available to us on terms acceptable to us or at all.
You may not receive any dividends.
We are not obligated to pay dividends. Dividend payments are not guaranteed and are within the absolute discretion of our board of directors. Future dividends with respect to shares of our common stock, if any, will depend on, among other things, our results of operations, cash requirements, financial condition, contractual restrictions in our loan agreements, business opportunities, anticipated cash needs, provisions of applicable law and other factors that our board of directors may deem relevant. In addition, we have reported a loss from continuing operations in the past.
We might not generate sufficient cash from operations in the future to pay dividends on our common stock in the intended amounts or at all. Our board of directors may decide not to pay dividends at any time and for any reason. Our dividend policy is based upon our directors’ current assessment of our business and the environment in which we operate, and that assessment could change based on competitive or technological developments (which could, for example, increase our need for capital expenditures), new growth opportunities or other factors. If our cash flows from operations for future periods were to fall below our minimum expectations, we would need either to reduce or eliminate dividends or, to the extent permitted under the terms of our senior credit facility, fund a portion of our dividends with borrowings or from other sources. If we were to use working capital or permanent borrowings to fund dividends, we would have less cash and/or borrowing capacity available for future dividends and other purposes, which could negatively affect our financial condition, our results of operations, our liquidity and our ability to maintain or expand our business. Our board of directors is free to depart from or change our dividend policy at any time and could do so, for example, if it were to determine that we had insufficient cash to take advantage of growth opportunities. In addition, our senior credit facility contains, and any agreement we enter into in the future to refinance this indebtedness may contain, limitations on our ability to pay dividends.
Our substantial indebtedness could restrict our ability to pay dividends and impact our financing options and liquidity position.
As of December 31, 2005, we had approximately $1,180.6 million of total debt outstanding. The degree to which we are leveraged on a consolidated basis could have important consequences to the holders of our common stock, including:
•
it may be more difficult to pay dividends on our common stock;
•
our ability to obtain additional financing in the future for working capital, capital expenditures or acquisitions may be limited;
•
a significant portion of our cash flow from operations is likely to be dedicated to the payment of interest on our indebtedness, thereby reducing funds available for other corporate purposes;
•
our substantial indebtedness may make us more vulnerable to economic downturns and limit our ability to withstand competitive pressures; and
•
all principal amounts owed under our existing indebtedness are due in full at maturity. Our debt service in the meantime consists of interest payments. It is highly likely that we will be required to refinance our existing debt obligations at maturity. We may be unable to do so on terms acceptable to us, or at all.
We are subject to restrictive debt covenants that impose operating and financial restrictions on our operations and could limit our ability to grow our business.
Covenants in our senior credit facility impose significant operating and financial restrictions on us. These restrictions prohibit or limit, among other things:
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the incurrence of additional indebtedness and the issuance of preferred stock and certain redeemable capital stock;
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the payment of dividends on, and the repurchase of, capital stock;
•
a number of other restricted payments, including investments and acquisitions;
•
specified sales of assets;
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specified transactions with affiliates;
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the creation of a number of liens;
•
consolidations, mergers and transfers of all or substantially all of our assets; and
•
our ability to change the nature of our business.
These restrictions could limit our ability to obtain future financing, make acquisitions, withstand downturns in our business or take advantage of business opportunities. Furthermore, our senior credit facility requires us to maintain specified total leverage and interest coverage ratios and to satisfy specified financial condition tests, and under certain circumstances requires us to make quarterly mandatory prepayments with a portion of our available cash.
If we fail to comply with the restrictive covenants in our senior credit facility, our senior lenders may accelerate the payment of indebtedness outstanding under our senior credit facility.
The terms of our senior credit facility include several restrictive covenants that prohibit us from prepaying our other indebtedness while indebtedness under the facility is outstanding. Our senior credit facility also requires us to maintain specified financial ratios and satisfy financial condition tests. Our ability to comply with the ratios or tests may be affected by events beyond our control, including prevailing economic, financial and industry conditions.
A breach of any of these covenants, ratios or tests could result in a default under our senior credit facility. Upon the occurrence of an event of default, the lenders could elect to declare all amounts outstanding under our senior credit facility, together with accrued interest, to be immediately due and payable. If we were unable to repay or refinance those amounts, the lenders could proceed against the security granted to them to secure that indebtedness. If the lenders accelerate the payment of the indebtedness, our assets may not be sufficient to repay in full this indebtedness.
We are a holding company with no operations, and unless we receive dividends and other payments or distributions, advances and transfers of funds from our subsidiaries, we will be unable to meet our debt service and other obligations.
We are a holding company and we conduct all of our operations through our subsidiaries. We currently have no significant assets other than equity interests in our subsidiaries. As a result, we will rely on dividends and other payments or distributions from our subsidiaries to meet our debt service obligations and enable us to pay dividends. The ability of our subsidiaries to pay dividends or make other payments or distributions to us will depend on their respective operating results and may be restricted by, among other things, the laws of their jurisdiction of organization (which may limit the amount of funds available for the payment of dividends), agreements of those subsidiaries, the terms of our senior credit facility (under which the equity interests of our subsidiaries will be pledged), and the covenants of any future outstanding indebtedness we or our subsidiaries incur.
Our interest expense may increase significantly and could cause our results of operations and distributable cash to decline significantly.
Our senior credit facility is subject to periodic renewal or must otherwise be refinanced. We may not be able to renew or refinance the credit facility, or if renewed or refinanced, the renewal or refinancing may occur on less favorable terms, including higher interest rates. Borrowings under the facility are made at a floating rate of interest. In the event of an increase in the base reference interest rates, our interest expense will increase and could have a material adverse effect on our ability to make cash dividend payments to our stockholders. Our ability to continue to expand our business will, to a large extent, be dependent upon our ability to borrow funds under our senior credit facility and to obtain other third party financing, including through the sale of common stock or other securities. We cannot assure you that such financing will be available to us on favorable terms or at all.
Limitations on use of our net operating losses may negatively affect our ability to pay dividends to you.
Because certain of our subsidiaries may have had an “ownership change” for purposes of Section 382 of the Internal Revenue Code as a result of our reorganization that occurred immediately prior to the consummation of our Offering, the use of our current net operating losses to offset our taxable income for taxable periods (or portions thereof) beginning after the ownership change will be limited pursuant to Section 382 of the Internal Revenue Code. In addition, we may have another “ownership change” for purposes of Section 382 of the Internal Revenue Code subsequent to the Offering if, under certain circumstances, our existing equity holders were to sell within a three-year period all (or most) of our common stock that they received in our reorganization. If we do experience another ownership change, we may be further limited, pursuant to Section 382 of the Internal Revenue Code, in using our then-current net operating losses to offset taxable income for taxable periods (or portions thereof) beginning after the second ownership change. Consequently, in the future we may be required to pay increased cash income taxes because of the Section 382 limitations on our ability to use our net operating losses. Increased cash taxes would reduce our after-tax cash flow available for payment of dividends on our common stock.
Risks Related to Our Pending Merger with Alltel’s Wireline Business
As a result of our pending merger with Alltel’s wireline business, certain agreements or events could have a significant impact on our stock price, operations and liquidity. We refer to the company that will be created as a result of the merger with Alltel’s wireline business as Newco in the following discussion of risks related to the pending merger.
Failure to complete the merger could adversely impact the market price of Valor’s common stock.
If the merger is not completed for any reason, the price of our common stock may decline to the extent that the market price of our common stock reflects positive market assumptions that the spin-off and the merger will be completed and the related benefits will be realized.
After the close of the transaction, sales of Newco common stock may negatively affect its market price.
The market price of Newco common stock could decline as a result of sales of a large number of shares of Newco common stock in the market after the completion of the merger or the perception that these sales could occur. These sales, or the possibility that these sales may occur, also might make it more difficult for Newco to obtain additional capital by selling equity securities in the future at a time and at a price that Newco deems appropriate.
The merger agreement will create a new management team and new Board of Directors.
If the merger is completed, the composition of Newco’s senior management team and board of directors will be determined almost exclusively by Alltel upon completion of the merger in accordance with the terms of the merger agreement. Most of our present management and board of directors, except for the one
appointment we will make to the board of directors of Newco, will not have significant input on the strategic and operating decisions of the surviving company upon completion of the merger.
Present Valor shareholders will have a reduced ownership and voting interest after the merger and will exercise less influence over management.
After the merger’s completion, Valor stockholders will own a significantly smaller percentage of Newco than they currently own of Valor. Following completion of the merger, Valor’s stockholders will own approximately 15% of Newco on a diluted basis. Consequently, Valor stockholders, as a group, will be able to exercise less influence over the management and policies of Newco than they currently exercise over the management and policies of Valor.
The merger agreement contains provisions that may discourage a third party from submitting a business combination proposal to us that might result in greater value to our stockholders than the merger.
The merger agreement generally prohibits us from soliciting any acquisition proposal. In addition, if the merger agreement is terminated by Valor or Alltel in circumstances that obligate us to pay a termination fee and to reimburse transaction expenses to Alltel, our financial condition may be adversely affected as a result of the payment of the termination fee and transaction expenses, which might deter third parties from proposing alternative business combination proposals.
We may also be subject to additional risks if the merger is not completed.
We expect to incur substantial costs related to the merger, such as legal, accounting, filing, financial advisory and financial printing fees, which must be paid regardless of whether the merger is completed.
Depending on the reasons for termination of the merger agreement, Valor is required to pay Alltel a termination fee of $35 million plus costs incurred by Alltel and Alltel’s wireline business in connection with the transaction.
We may experience potential disruption to our businesses and distraction of our workforce and management team, including our ability to retain and motivate qualified personnel, including executive officers and other key management personnel. A significant number of employees at our corporate headquarters in Irving may be displaced as a result of the merger when headquarters for Newco becomes located in Central Arkansas, and thus those affected employees may choose to end their employment with us sooner. The loss of key management personnel or other key employees or our inability to attract such personnel may adversely affect our ability to manage our overall operations, particularly if the loss of personnel was to occur and the merger is not completed.
Newco may not realize the anticipated benefits from the merger.
The success of the merger will depend, in part, on the ability of Newco to realize the anticipated synergies, cost savings and growth opportunities from integrating the businesses of Valor with those of Alltel’s wireline business. The companies’ success in realizing these synergies, cost savings and growth opportunities, and the timing of this realization, depends on the successful integration of Alltel’s wireline business and Valor’s operations. Even if the companies are able to integrate their business operations successfully, there can be no assurance that this integration will result in the realization of the full benefits of synergies, cost savings and growth opportunities that Newco currently expects from this integration or that these benefits will be achieved within the anticipated time frame. For example, the elimination of duplicative costs may not be possible or may take longer than anticipated, the benefits from the merger may be offset by costs incurred in integrating the companies and regulatory authorities may impose adverse conditions on the combined business in connection with granting approval for the merger.
Item 1B.
Item 1B.
Unresolved Staff Comments.
None.
Item 2.
Item 2.
Properties.
Our corporate headquarters are located in Irving, Texas. We lease over 60,000 square feet of office space for our headquarters in Irving pursuant to a lease that will expire in August 2010. In addition, we lease an aggregate of over 100,000 square feet with respect to three call centers in New Mexico and Texas and retail phone stores located in Texas, New Mexico and Oklahoma pursuant to leases that expire at various times between 2006 and 2010. We own all of the other properties that are material to our business. Our other properties include maintenance facilities, rolling stock, central office and remote switching platforms and transport and distribution network facilities in the states in which we operate our business. Our administrative and maintenance facilities are generally located in or near the rural communities we serve and our central offices are often within the administrative building and outlying customer service centers. Auxiliary battery or other non-utility power sources are at each central office to provide uninterrupted service in the event of an electrical power failure. Mobile generators are located near our central offices in the event of a major power outage that continues for a long period of time. Transport and distribution network facilities include fiber optic backbone, copper wire distribution facilities and some digital loop carriers (“DLC”) which connect customers to remote switch locations or to the central office and to points of presence or interconnection with the incumbent long distance carrier. These facilities are located on land pursuant to permits, easements, rights of way or other agreements.
Item 3.
Item 3.
Legal Proceedings.
On July 13, 2005, four former employees served us with a Demand for Arbitration, claiming that we had breached the terms of the former employees’ VTS stock option agreements in our valuation of those options in the reorganization that preceded the Offering. In this action, the former employees seek to exercise their VTS options to receive, on a one-for-one basis, shares of Valor common stock or, alternatively, the cash value of the Valor common stock they would have received had such exercise been permitted. The American Arbitration Association established arbitration to be held in April 2006. We believe that we have meritorious defenses and we intend to continue to vigorously defend this matter. Even though litigation is inherently uncertain and it is possible that an adverse decision could be rendered, we anticipate resolution of this matter will not have a material effect on our consolidated financial statements.
We are involved, from time to time, in various other claims, legal actions and regulatory proceedings arising in the ordinary course of our business. Currently no material litigation is pending or, to our knowledge, threatened against us that will have a material adverse effect, either individually or in the aggregate, on our consolidated financial condition, results of operations or liquidity.
Item 4.
Item 4.
Submission of Matters to a Vote of Security Holders.
No matters were submitted to a vote of security holders during the quarter ended December 31, 2005.
PART II
Item 5.
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
On February 9, 2005, we completed our Offering, registering 29,375,000 shares of common stock at an offering price of $15 per share. The proceeds from the Offering of $411.3 million, net of underwriting discounts and other expenses, were used to repay existing indebtedness and related transaction costs. In connection with the Offering, certain of our stockholders granted an option to the underwriters to purchase up to 4,406,250 additional shares in the aggregate at the offering price less the underwriting discount. On March 16, 2005, the underwriters exercised their over-allotment option in full. We received no proceeds from the over-allotment exercise.
Immediately prior to and in connection with the Offering, we consummated a reorganization pursuant to which our existing equity holders contributed all their ownership interests in VTC and VTS to Valor in
exchange for 39,537,574 shares of common stock in the aggregate, in a private offering pursuant to Section 4(2) of the Securities Act of 1933, as amended (the “Act”). In addition, in connection with our reorganization, we issued restricted shares of our common stock pursuant to Rule 701 promulgated under the Act. Following the reorganization, Valor exists as a holding company with no direct operations and each of VTC, VTS and VTS II is either a direct or an indirect wholly-owned subsidiary of Valor. Valor’s principal assets consist of the direct and indirect equity interests of its subsidiaries, all of which are pledged to the creditors under our new credit facility.
Beginning on February 9, 2005, our common stock was listed and traded on the New York Stock Exchange (symbol: VCG). Prior to February 9, 2005, there was no established public trading market. As of February 1, 2006, there were approximately 127 holders of record of our common stock. Because many of our shares of existing common stock are held by brokers and other institutions on behalf of stockholders, we are unable to estimate the total number of stockholders represented by these record holders. On February 1, 2006 the closing price per share of our common stock was $11.70.
The following table sets forth the high and low closing sales prices per share of common stock since our Offering according to the New York Stock Exchange, and dividends declared per share during such periods:
(1)
Represents the period from our Offering, February 9, 2005 through March 31, 2005.
(2)
Represents a partial, prorated dividend for the first quarter of 2005.
We intend to continue to pay quarterly dividends at an annual rate of $1.44 per share for the year through the date when the merger with Alltel’s wireline business is consummated. Thereafter, as provided in the merger agreement, the initial dividend policy, subject to applicable law, of the combined business will be to pay quarterly dividends at an annual rate of $1.00 per share, at the discretion of the newly appointed board of directors and subject to covenant restrictions under the new company’s then existing indebtedness. The declaration and payment of future dividends and the amount thereof, if any, will be dependent upon our results of operations, financial condition, cash requirements for our business, contractual requirements, restrictions and other factors deemed relevant by the board of directors and the pending merger with Alltel’s wireline business. Furthermore, covenants in our amended credit facility impose restrictions as to our ability to pay dividends. See further discussion within “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation.”
Item 6.
Item 6. “Selected Financial Data” and the Consolidated Financial Statements and related Notes thereto included elsewhere in this annual report on Form 10-K. This discussion includes forward-looking statements. Please see the “Cautionary Statement” above and Item 1A. “Risk Factors” for a discussion of the uncertainties, risks and assumptions associate with these statements.
Overview
We are one of the largest providers of telecommunications services in rural communities in the southwestern United States and the seventh largest independent telephone company in the country. As of December 31, 2005, we operated approximately 518,000 telephone access lines in primarily rural areas of Texas, Oklahoma, New Mexico and Arkansas. We believe that in many of our markets we are the only service provider that offers customers an integrated package of local and long distance voice, high-speed data and Internet access, as well as a variety of enhanced services such as voicemail and caller identification. We generated revenues of $505.9 million in the year ended December 31, 2005 compared to $507.3 million and $497.3 million in the years ended December 31, 2004 and 2003, respectively. Operating income in the year ended December 31, 2005 was $167.0 million compared to $177.1 million and $182.3 million in the years ended December 31, 2004 and 2003, respectively. Net income for the year ended December 31, 2005 was
$35.3 million compared to a net loss for the year ended December 31, 2004 of $27.8 million and to net income of $58.2 million for the year ended December 31, 2003.
We formed our company in 2000 in connection with the acquisition of select telephone assets from GTE Southwest Corporation, which is now part of Verizon. In January 2002, we acquired the local telephone company serving Kerrville, Texas. The rural telephone businesses that we own have been operating in the markets we serve for over 75 years. Since our inception, we have invested substantial resources to improve and expand our network infrastructure. In the markets we serve, we provide a full range of voice and data services, including integrated packages of local, long distance, high-speed data and Internet access, as well as a variety of enhanced services such as voicemail and caller identification. We provide reliable, personalized customer care through three call centers, and we have automated many of our customer service functions to enable our customers to interact with our company 24 hours a day, 365 days a year.
The competitive landscape and customer preferences for communications services continue to evolve in the telecommunications industry in general, as well as in the markets we serve. We have taken numerous steps to position ourselves to meet the competitive pressures that we face, including: (i) expanding the coverage of our DSL product to provide greater broadband opportunities, including increased DSL speeds, to our customers in rural America; (ii) aggressively pricing and bundling services such as DSL, Internet access, long distance and second lines with our basic service to create more appealing product offerings at more attractive prices to our customers; (iii) offering discounts to customers who make commitments to purchase service from us for a one-year period; and (iv) improving customer service. We added approximately 30,000 DSL subscribers for the year ended December 31, 2005 and we have expanded our DSL footprint to make DSL service available to approximately 71% of our access lines. We have also focused intently on increasing the efficiency of our business by investing in our infrastructure to improve our underlying business processes and increase the quality of our customer service, maintaining tight expense controls and utilizing a disciplined approach to our capital spending.
We experience competition from wireless service providers in many of our markets and wireline local carriers and cable companies in a limited number of our markets. The number of access lines we serve is one of the fundamental drivers of our business, and competition has been a significant factor in the recent decline in our access lines. While the number of access lines we serve has been declining for the last several years, we have been able to increase our revenues in prior years as a result of our strategy to sell additional services to our existing customers to increase our average revenue per line. We lost 21,881 access lines for the year ended December 31, 2005. Revenues for the year ended December 31, 2005 were essentially flat compared to the prior year.
Competition continues in Broken Arrow, Oklahoma, a suburb of Tulsa, Oklahoma. The cable provider serving that market began offering a cable telephony product late in 2004. We have defined active cable telephony markets as those markets where we have processed request(s) by the cable competitor to port customer telephone numbers to the cable provider. “Porting” is an industry term used to describe the process that allows a customer to retain his or her existing phone number when switching his or her telephone service to a competitor. For the year ended December 31, 2005, approximately 12% of our access lines were in active cable telephony markets, consisting essentially of the lines we serve in Broken Arrow and bordering communities along with three of our West Texas markets. Our active cable telephony markets have contributed more than 65% of our year to date access line losses. In non-active cable telephony markets, representing approximately 88% of our access lines, our 2005 line losses are approximately 1.5%.
We are subject to regulation primarily by federal and state government agencies. At the federal level, the FCC has jurisdiction over interstate and international telecommunications services. State telecommunications regulators exercise jurisdiction over intrastate telecommunications services.
Significant transactions
As previously announced on December 9, 2005, the board of directors of Valor unanimously approved a strategic merger that will combine Valor and the wireline telecommunications business of Alltel. Pursuant to the Agreement and Plan of Merger Valor entered into on December 8, 2005 with Alltel and Alltel Holding Corp.
(which we refer to as “Spinco”), Spinco will merge with and into Valor and Valor will survive as a stand-alone company and will hold and conduct the combined business operations of Valor and Spinco. The merger will take place immediately after Alltel contributes the assets making up its wireline telecommunications business to Spinco and distributes the common stock of Spinco to its stockholders. In the merger, each share of Spinco common stock will be converted into the right to receive approximately 1.04 shares of Valor common stock. Existing shares of Valor common stock will remain outstanding. Following completion of the merger, the separate existence of Spinco will cease. Valor expects to issue approximately 403 million shares of common stock to Alltel stockholders in the merger. However, this amount is subject to change as a result of compensatory equity grants and other issuances of Valor common stock. Valor also expects to assume approximately $4 billion in outstanding debt in the merger. Immediately following the merger, Valor expects to change its name and that its common stock will be quoted on the New York Stock Exchange under that new name and with a new ticker symbol, each of which has yet to be determined. When the merger is completed, Alltel stockholders will together own approximately 85%, and Valor’s stockholders will own approximately 15%, of the shares of common stock in that entity on a fully diluted basis. The composition of the senior management and board of directors of the combined business will be largely determined by Alltel. While we are the legal acquirer and the surviving entity in this transaction, Alltel’s wireline business will be deemed to be the accounting acquirer in a transaction treated for accounting purposes as a reverse acquisition. The historical financial statements of Valor Communications Group, Inc. after the close of the merger will be those of Alltel’s wireline business. The merger is subject to both regulatory and shareholder approval and is expected to close in mid-2006.
On February 9, 2005, we completed the Offering, registering 29,375,000 shares of Valor common stock at a price of $15 per share. The net proceeds from the Offering were used to repay certain existing indebtedness. In conjunction with the Offering, we completed a reorganization of our company. In connection with the Offering, certain of the company’s stockholders granted an option to the underwriters to purchase up to 4,406,250 additional shares in the aggregate at the Offering price less the underwriting discount. On March 16, 2005, the underwriters exercised their over-allotment option in full. We received no proceeds from the over-allotment exercise.
Concurrent with the Offering, our subsidiary, Valor Telecommunications Enterprises, LLC, and its direct wholly owned subsidiary, Valor Telecommunications Enterprises Finance Corp., as co-issuers, issued $400 million aggregate principal amount of 73/4% ten-year senior notes in a private offering pursuant to Rule 144A of the Securities Act of 1933. We used the net proceeds from such issuance to repay certain existing indebtedness. In August 2005, we completed the exchange of all outstanding 73/4% senior notes in aggregate principal amount of $400 million due 2015 for substantially identical 73/4% senior notes that have been registered under the Securities Act of 1933. The new notes will mature on February 15, 2015 and will pay interest semi-annually on February 15 and August 15, starting on August 15, 2005. The senior notes contain restrictions on our ability to pay dividends that are no more restrictive than those contained in our credit facility as discussed in Item 7
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk.
We are exposed to market risk from changes in interest rates on our long-term debt obligations. We estimate our market risk using sensitivity analysis. Market risk is defined as the potential change in the fair value of a fixed-rate debt obligation due to a hypothetical adverse change in interest rates and the potential change in interest expense on variable rate long-term debt obligations due to changes in market interest rates. Fair value on long-term debt obligations is determined based on quoted market prices and a discounted cash flow analysis, using the rates and maturities of these obligations compared to terms and rates currently available in the long-term markets. The potential change in interest expense is determined by calculating the effect of the hypothetical rate increase on our variable rate debt for the year and does not assume changes in our financial structure.
The results of the sensitivity analysis used to estimate market risk are presented below, although the actual results may differ from these estimates.
At December 31, 2004, we had total debt of $1,601.0 million, consisting of both fixed and variable debt with weighted average interest rates of 7.3%. Substantially all of our debt balances were scheduled to mature 2011 through 2012. As a result of the debt recapitalization that occurred November 10, 2004, the fair value of our debt approximated its carrying value.
At December 31, 2005, we had total debt of $1,180.6 million, consisting of both fixed and variable debt with weighted interest rates ranging from 5.8% to 7.8%. Approximately $780.6 million of our debt matures in 2012 and $400.0 million matures in 2015. In February 2005, we completed the Offering and issuance of 73/4% senior notes for net proceeds of approximately $801.0 million. We used the proceeds from the Offering and the issuance of senior notes to repay certain indebtedness that was outstanding at December 31, 2004 and related transaction costs. The fair value of our debt based on current prevailing rates and quoted market prices is $1,196.6 million at December 31, 2005.
At December 31, 2005, we had approximately $725.0 million of variable rate debt. If market interest rates increase 100 basis points within the next year over the rates in effect at December 31, 2005, annual interest expense would increase $3.9 million. The increase in interest expense is impacted by our interest rate caps and swaps that are currently in effect or will be in effect over the next year. We are charged interest on our variable rate debt, as defined in our Amended and Restated Credit Agreement, based on LIBOR, plus
1.75%, or an applicable base rate plus 0.75%. The three-month LIBOR rate for the year ended December 31, 2005 ranged from 2.6% to 4.5%.
Pursuant to our credit facility, we are required to reduce the risk of interest rate volatility with at least 50% of our indebtedness. To manage our interest rate risk exposure and fulfill our requirement under our credit facility, we entered into nine agreements, three interest rate caps and six interest rate swaps, with investment grade financial institutions in March and September of 2005 (collectively, the “Agreements”). In connection with entering the interest rate cap agreements, we paid $0.9 million.
The following represents a summary of the Agreements (dollars in thousands):
Our interest rate caps are not treated as hedges as prescribed by the accounting literature; therefore, the fair value of the instruments is recorded each reporting period on the Consolidated Balance Sheets with the change in fair value recorded in the Consolidated Statements of Operations in “Gain (loss) on interest rate hedging arrangements.” The interest rate swaps effectively convert our variable rate debt to fixed rate debt. Our interest rate swap agreements qualify for hedge accounting under SFAS No. 133; therefore, they are carried at fair market value and are included on the Consolidated Balance Sheets with changes in fair value recorded as “Other comprehensive income (loss)” in the accompanying Consolidated Statements of Operations. We do not hold or issue derivative financial instruments for trading or speculative purposes.
Item 8.
Item 8.
Financial Statements and Supplementary Data.
The information called for by this Item is contained in a separate section of this annual report on Form 10-K. See “Index of Financial Statements and Schedule” (page).
Item 9.
Item 9.
Changes In and Disagreements with Accountants on Accounting and Financial Disclosure.
None.
Item 9A.
Item 9A.
Controls and Procedures.
The company, under the supervision and with the participation of its management, including the Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the design and operation of the company’s “disclosure controls and procedures” (as defined in Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act) as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that the company’s disclosure controls and procedures were effective as of December 31, 2005 to ensure that information relating to the Company and the company’s consolidated subsidiaries required to be disclosed in the company’s reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to the company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely discussions regarding required disclosure. It should be noted, however, that the design of any system of controls is limited in its ability to detect errors, and there can be no assurance
that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote. There has been no change in the company’s internal control over financial reporting during the quarter ended December 31, 2005 that has materially affected, or is reasonably likely to materially affect, the company’s internal control over financial reporting.
Item 9B.
Item 9B. Other Information.
None.
PART III
Item 10.
Item 10.
Directors and Executive Officers of the Registrant.
A list of our executive officers and biographical information appears in Part I, Item I of this annual report on Form 10-K.
The Company has adopted a code of business conduct and ethics applicable to the Company’s Directors, officers (including the Company’s principal executive, principal financial officer and principal accounting officer) and employees known as the Code of Business Conduct. The Code of Business Conduct is available on the Company’s website. In the event that we amend or waive any of the provisions of the Code of Business Conduct applicable to our principal executive officer, principal financial officer or principal accounting officer, we intend to disclose the same on the Company’s website at www.valortelecom.com.
The remaining information required by this Item is incorporated by reference to Valor’s definitive Proxy Statement to be filed with the Securities and Exchange Commission pursuant to Regulation 14A within 120 days after the end of the fiscal year covered by this report (the “Valor Proxy Statement”).
Item 11.
Item 11.
Executive Compensation.
The information required by this Item is incorporated by reference to the Valor Proxy Statement.
Item 12.
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
The information required by this Item is incorporated by reference to the Valor Proxy Statement.
Item 13.
Item 13.
Certain Relationships and Related Transactions.
The information required by this Item is incorporated by reference to the Valor Proxy Statement. See also Note 18 to the Consolidated Financial Statements.
Item 14.
Item 14.
Principal Accounting Fees and Services.
The information required by this Item is incorporated by reference to the Valor Proxy Statement.
PART IV
Item 15.
Item 15.
Exhibits, Financial Statement Schedule.
3. Exhibits:

Incorporated by reference to Form 8-K of ALLTEL Corporation filed with the Securities and Exchange Commission on December 9, 2005

Incorporated by reference to the Registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2005
*
Incorporated by reference to the Registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2005
**
Incorporated by reference to the Registrant’s Report on Form 8-K filed on September 19, 2005
***
Incorporated by reference to the Registrant’s Registration Statement on Form S-4, filed on May 13, 2005 (Reg. No. 333-124917)
****
A request for confidential treatment was filed for portions of this document. Confidential portions have been omitted and filed separately with the Securities and Exchange Commission as required by Rule 406.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
VALOR COMMUNICATIONS GROUP, INC.
By:
/s/ John J. Mueller
John J. Mueller
President and Chief Executive Officer
(Principal Executive Officer)
Date: February 27, 2006
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
ANNUAL REPORT ON FORM 10-K
ITEMS 8 AND 15(a)
INDEX OF FINANCIAL STATEMENTS AND SCHEDULE
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
Valor Communications Group, Inc.
Irving, Texas
We have audited the accompanying consolidated balance sheets of Valor Communications Group, Inc. and subsidiaries (the “Company”) as of December 31, 2004 and 2005, and the related consolidated statements of operations and comprehensive income (loss), changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2005. Our audits also included the financial statement schedule listed in the Index at Item 15. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statements and financial statement schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Valor Communications Group, Inc. and subsidiaries at December 31, 2004 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
As discussed in Note 21 to the financial statements, in 2005 the Company changed its method of accounting for conditional asset retirement obligations to conform to Financial Accounting Standards Board Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations, an Interpretation of FASB Statement No. 143.”
/s/ Deloitte & Touche LLP
Dallas, Texas
February 24, 2006
Valor Communications Group, Inc.
Consolidated Balance Sheets
See accompanying notes to consolidated financial statements.
Valor Communications Group, Inc.
Consolidated Statements of Operations and Comprehensive Income (Loss)
See accompanying notes to consolidated financial statements.
Valor Communications Group, Inc.
Consolidated Statements of Cash Flows
See accompanying notes to consolidated financial statements.
Valor Communications Group, Inc.
Consolidated Statements of Changes in Stockholders’ Equity
For the Years Ended December 31, 2003, 2004 and
See accompanying notes to consolidated financial statements.
VALOR COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands except per owner unit and per share amounts)
(1)
Background and Basis of Presentation
The consolidated financial statements include the accounts of Valor Communications Group, Inc., (“Valor”) and its wholly owned subsidiaries (collectively, the “Company”). All significant intercompany transactions have been eliminated. Valor is a holding company and has no direct operations. Valor was formed for the sole purpose of reorganizing our corporate structure and consummation of our initial public offering. Valor’s principle assets are the direct and indirect equity interest of its subsidiaries, Valor Telecommunications, LLC (“VTC”), Valor Telecommunications Southwest, LLC (“VTS”) and Valor Telecommunications Southwest II, LLC (“VTS II”). The historical consolidated financial statements prior to the initial public offering represent those of VTC.
The Company was created in 1999 for the purpose of acquiring three groups of rural local telephone exchange properties clustered in New Mexico, Oklahoma, Arkansas and Texas from GTE Southwest Corporation (“GTE”). The Company purchased all of the GTE access lines in Oklahoma and New Mexico, and approximately 15% of GTE’s access lines in Texas. A portion of the access lines acquired in Texas is physically located in Texarkana, Arkansas. In addition to local exchange services, the Company also offers long distance and Internet access service through other subsidiaries. On January 31, 2002, the Company acquired Kerrville Communications Corporation, Inc. (“KCC”) and has included the operating results of KCC in its consolidated results since the date of acquisition.
As previously announced on December 9, 2005, the board of directors of Valor unanimously approved a strategic merger that will combine Valor and the wireline telecommunications business of Alltel. Pursuant to the Agreement and Plan of Merger Valor entered into on December 8, 2005 with Alltel and Alltel Holding Corp. (which is referred to as “Spinco”), Spinco will merge with and into Valor and Valor will survive as a stand-alone company and will hold and conduct the combined business operations of Valor and Spinco. The merger will take place immediately after Alltel contributes the assets making up its wireline telecommunications business to Spinco and distributes the common stock of Spinco to its stockholders. In the merger, each share of Spinco common stock will be converted into the right to receive approximately 1.04 shares of Valor common stock. Existing shares of Valor common stock will remain outstanding. Following completion of the merger, the separate existence of Spinco will cease. Valor expects to issue approximately 403 million shares of common stock to Alltel stockholders in the merger. However, this amount is subject to change as a result of compensatory equity grants and other issuances of Valor common stock. Valor also expects to assume approximately $4,000,000 in outstanding debt in the merger. Immediately following the merger, Valor expects to change its name and that its common stock will be quoted on the New York Stock Exchange under that new name and with a new ticker symbol, each of which has yet to be determined. When the merger is completed, Alltel stockholders will together own approximately 85%, and Valor’s stockholders will own approximately 15%, of the shares of common stock in that entity on a fully diluted basis. The composition of the senior management and board of directors of the combined business will be largely determined by Alltel. While the Company is the legal acquirer and the surviving entity in this transaction, Alltel’s wireline business will be deemed to be the accounting acquirer in a transaction treated for accounting purposes as a reverse acquisition. The historical financial statements of Valor Communications Group, Inc. after the close of the merger will be those of Alltel’s wireline business. The merger is subject to both regulatory and shareholder approval and is expected to close in mid-2006.
On February 9, 2005, the Company completed its initial public offering (“Offering”) through registering 29,375,000 shares of common stock for net proceeds of $411,257. Concurrent with the Offering, the Company issued $400,000 principal amount of 73/4% senior notes due in 2015 for net proceeds of approximately $389,700. The proceeds from the Offering and the issuance of the senior notes were used to repay the second lien loan, senior subordinated loan, a portion of the existing credit facility and associated fees and expenses.
VALOR COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
In connection with the Offering, certain of the Company’s stockholders granted an option to the underwriters to purchase up to 4,406,250 additional shares in the aggregate at the Offering price less the underwriting discount. On March 16, 2005, the underwriters exercised their over-allotment option in full. The Company received no proceeds from the over-allotment exercise.
Immediately prior to and in connection with the Offering, the Company consummated a reorganization pursuant to which the existing equity holders contributed all their equity interests in VTC and VTS to Valor in exchange for 39,537,574 shares of Valor common stock in the aggregate.
(2)
Summary of Significant Accounting Policies
Use of Estimates - The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Revenue Recognition - Revenue is recognized when evidence of an arrangement exists, the earnings process is complete and collectibility is reasonably assured. The prices for most services are filed in tariffs with the appropriate regulatory bodies that exercise jurisdiction over the various services.
Basic local services, enhanced calling features such as caller ID, special access circuits, long distance flat rate calling plans, and most data services are billed one month in advance. Revenue for these services is recognized in the month services are rendered. The portion of advance-billed revenue associated with services that will be delivered in a subsequent period is deferred and recorded as a current liability under “Advance billings and customer deposits” in the Consolidated Balance Sheets.
Amounts billed to customers for activating service are deferred and recognized over the average life of the customer. The costs associated with activating such services are deferred and recognized as an operating expense over the same period. Costs in excess of revenues are recognized as expense in the period in which activation occurs.
Revenues for providing usage based services, such as per-minute long distance service and access charges billed to long distance companies for originating and terminating long distance calls on the Company’s network, are billed in arrears. Revenues for these services are recognized in the month services are rendered.
Universal Service revenues are government-sponsored support received in association with providing service in mostly rural, high-cost areas. These revenues are typically based on information provided by the Company and are calculated by the government agency responsible for administering the support program. Revenues are recognized in the period the service is provided.
Cash and Cash Equivalents - For purposes of reporting cash flows, the Company considers all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents. Cash equivalents are stated at cost, which approximates fair value.
Allowance for doubtful accounts - In evaluating the collectibility of accounts receivable, the Company assesses a number of factors, including a specific customer’s or carrier’s ability to meet their financial obligations, the length of time the receivable has been past due and historical collection experience. Based on these assessments, the Company recorded both specific and general reserves for uncollectible accounts receivable to the amount the Company ultimately expects to collect from customers and carriers. If circumstances change or economic conditions worsen such that the past collection experience is no longer relevant, the Company’s estimate of the recoverability of accounts receivable could be further reduced from the levels reflected in the Company’s Consolidated Balance Sheets.
VALOR COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Property, Plant and Equipment - Telephone property, plant and equipment are recorded at original cost of acquisition or construction and related costs, including payroll and other direct and indirect costs related to construction activity. Major replacements and improvements are capitalized. Repairs are charged to operating expense as incurred. Depreciation on telephone plant is based on the estimated remaining lives of the various classes of depreciable property and is calculated using straight-line composite rates. This method provides for the recovery of the remaining net investment in telephone plant, less salvage value, over the remaining asset lives. The composite depreciation rates range from 2.5% to 33.3%. Normal retirements are charged to accumulated depreciation, and any gain or loss on dispositions is amortized over the remaining asset lives of the remaining net investment in telephone plant.
Non-telephone property is depreciated on a straight-line basis. When these assets are retired or otherwise disposed of, the related cost and accumulated depreciation are removed and any gains or losses on disposition are recognized.
Property, plant and equipment, as well as other long-lived assets, are evaluated for impairment in accordance with Statement of Financial Accounting Standards (“SFAS”) 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” whenever events or circumstances indicate that the carrying value may not be recoverable.
Self-insurance - The Company is partially self-insured for certain employee health benefits and is self insured for most environmental issues. The Company purchases stop-loss coverage in order to limit its exposure to any significant levels of employee health benefit claims. Self-insured losses are accrued based upon estimates of the aggregate liability for uninsured claims incurred using the Company’s own historical claims experience.
Pension and Postretirement Benefit Obligations - The Company maintains defined benefit pension plans covering the majority of its employees, which provide benefit payments to vested participants upon retirement. The Company also provides certain postretirement healthcare and life insurance benefits to eligible employees. These pension and other postretirement benefit plans are accounted for in accordance with SFAS 87, “Employers’ Accounting for Pensions” (“SFAS 87”) and SFAS 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions,” (“SFAS 106”) which require costs and the related obligations and assets arising from the pension and other postretirement benefit plans to be accounted for based on actuarially determined estimates. The plans use different factors, including age, years of service and eligible compensation, to determine the benefit amount for eligible participants. The Company funds its pension plans in compliance with applicable laws. See Note 9 for further discussion of the Company’s pension and postretirement plans.
Income Taxes - As a result of the Company’s reorganization that occurred in connection with the Company’s Offering in 2005, all of the Company’s operations with Valor and VTC became reportable in a consolidated corporate federal income tax return. Accordingly, since the Offering, the financial statement provision for the Company’s income taxes includes federal income taxes currently payable and those deferred due to temporary differences between the financial statement and tax bases of assets and liabilities and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. These differences result from the use of different accounting methods for financial and tax reporting purposes principally with respect to depreciable assets, materials and supplies, revenue recognition and pension and postretirement costs. The Company periodically evaluates its deferred tax assets in the various taxing jurisdictions in which it operates and records any related valuation allowance based on the estimate of the amount of such deferred tax assets which the Company believes is more likely than not that such assets will not be realized.
VALOR COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Prior to the reorganization in February 2005, only VTS II had elected to be taxed as a corporation for federal income tax purposes. Each legal operating entity owned directly or indirectly by VTS II is legally formed either as a limited liability company, a limited partnership, or a corporation. However, each of these entities was treated for federal income tax purposes either as a corporation or a disregarded entity (a division of a corporation). Operations for all entities directly or indirectly owned by VTS II were included in a consolidated federal income tax return filed by VTS II. Since VTS II had elected to be treated as a corporation for tax purposes, the income tax expense and the deferred tax assets and liabilities reported in the consolidated results of operations are reported under this entity’s name and are computed based upon the consolidated VTS II operations.
Segment Reporting - The Company has two operating segments, rural local exchange carrier (“RLEC”) and Other.
As an RLEC, the Company provides regulated telecommunications services to customers in its service areas. These services include local calling services to residential and business customers, as well as providing interexchange carriers (“IXC”) with call origination and termination services, on both a flat-rate and usage-sensitive basis, allowing them to complete long distance calls for their customers who reside in the Company’s service areas.
In Other, the Company provides unregulated telecommunications services to customers throughout its RLEC service areas. These services include long distance and Internet services. Long distance is provided through resale agreements and national long distance carriers.
The Company has considered the aggregation criteria in SFAS 131, “Disclosures about Segments of an Enterprise and Related Information” and determined that these operating segments are similar in respect to:
•
the nature of the services;
•
their processes;
•
the type or class of customer for these services;
•
the methods used to provide these services; and
•
the nature of the overall regulatory environment.
In addition to the above criteria, the Company believes the economic characteristics of the two operating segments, as well as their expected future performance, to be similar, and accordingly, has aggregated the two operating segments into a single reportable segment.
Equity Method Investments - Investments in companies in which the Company owns 20 percent to 50 percent of the voting common stock or otherwise exercises significant influence over operating and financial policies of the company are accounted for under the equity method. The Company periodically assesses its investments to determine if an other than a temporary decline in the value of the investment has occurred. If such a decline has occurred and the carrying value is less than the fair value, the Company will recognize a loss on the investment. In the 2004 and 2005, the Company recorded impairment charges of $6,678 and $2,339, respectively, for other than temporary declines in its investments.
Earnings per common share - Subsequent to the Offering, basic earnings per share of common stock are based upon the weighted average number of common shares actually outstanding during each period. Diluted earnings per share include the impact of unvested restricted stock to the extent the unvested restricted stock is dilutive.
Stock Compensation - The Company accounts for its employee stock compensation plans in accordance with Accounting Principles Board (“APB”) Opinion 25, “Accounting for Stock Issued to Employees” (“APB 25”) as allowed by SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) As
VALOR COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
permitted by SFAS 123, the Company measures compensation using the intrinsic value based method as prescribed by APB 25, but is required to make proforma disclosures in the footnotes to the financial statements as if the measurement provisions of SFAS 123 and SFAS 148, “Accounting for Stock-Based Compensation-Transition and Disclosure - an Amendment of SFAS 123” had been adopted. Under the intrinsic value method, compensation is measured as the difference between the market value of the stock on the grant date, less the amount required to be paid for the stock. The difference, if any, is charged to expense over the vesting period of the options or the restricted stock. No stock-based employee compensation cost is reflected in net income (loss) for stock options, since options granted under the plan had an exercise price equal to the market value of the underlying common stock on the date of grant. The Company recorded $12,699 of non-cash stock compensation expense for the year ended December 31, 2005 related to the difference between the exercise price and the Company’s common stock price at the measurement date associated with restricted stock grants. See Note 15 for additional information. If compensation cost had been determined in accordance with SFAS 123, the Company’s net income (loss) and per owner unit and common share amounts would have been as follows:
For the year ended December 31, 2003, the following awards were granted under the Southwest Equity Incentive Non-Qualifying Stock Option Plan:
VALOR COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Concurrent with the Offering, the Company completed a reorganization resulting in the cancellation of equity incentive non-qualifying stock options. There were no option grants made in 2004 or 2005.
Members of the Company’s management determined the fair value of the equity instruments issued retrospectively. The Company believes that management possesses the requisite valuation expertise to prepare a reasonable estimate of fair value of the options.
Regulatory Accounting - Certain of the Company’s operating subsidiaries, specifically the telephone operations of VTS II, prepare their financial statements in accordance with the provisions of SFAS No. 71, “Accounting for the Effects of Certain Types of Regulation” (“SFAS 71”) The provisions of SFAS 71 require, among other things, that regulated enterprises reflect rate actions of regulators in their financial statements, when appropriate. These rate actions can provide reasonable assurance of the existence of an asset, reduce or eliminate the value of an asset, or impose a liability on a regulated enterprise. The Company periodically reviews its position as to the applicability of SFAS 71 based on the current regulatory and competitive environment.
Derivative Financial Instruments - SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended, requires that all derivative instruments, such as interest rate swaps, interest rate caps and interest rate collar agreements, be recognized on the balance sheet at fair value, regardless of the purpose or intent of holding them. In addition, SFAS No. 133 provides that for derivative instruments that qualify for hedge accounting, changes in the fair value will either be offset against the change in fair value of the hedged assets, liabilities, or firm commitments through earnings or recognized in stockholders’ equity as a component of accumulated other comprehensive income (loss) until the hedged item is recognized in earnings, depending on whether the derivative is being used to hedge changes in fair value or cash flows. The ineffective portion of a derivative’s change in fair value will be immediately recognized in earnings. Upon termination of an interest rate swap agreement, the cash received or paid that relates to the future value of the swap agreement at the termination date is a deferred gain or loss, which is recognized as a decrease or an increase to interest expense over the remaining life of the original swap agreement.
Goodwill and Intangibles - Goodwill represents the excess of cost over fair value of individual net assets acquired in business combinations accounted for under the purchase method as determined by SFAS No. 141, “Business Combinations.” SFAS No. 142, “Goodwill and Other Intangible Assets” requires that goodwill no longer be amortized to earnings, but instead be reviewed for impairment annually. Such an impairment review may result in future periodic write-downs charged to earnings. Goodwill and other intangible assets are stated net of accumulated amortization. See Note 5 for additional information.
Other intangible assets, consisting of the estimated fair value of certain customer lists acquired, are amortized by the straight-line method over the estimated useful life of the customer, which represents three years.
Asset Retirement Obligations - The Company accounts for asset retirement obligations as determined by SFAS No. 143, “Accounting for Asset Retirement Obligations” and Financial Accounting Standards Board Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations, an interpretation of FASB Statement No. 143” (“FIN 47”). SFAS No. 143 and FIN 47 address financial accounting and reporting for legal obligations associated with the retirement of tangible long-lived assets and the related asset retirement costs. SFAS No. 143 requires that companies recognize the fair value of a liability for an asset retirement obligation (“ARO”) in the period in which it is incurred and capitalize the expected retirement costs as part of the book value of the long-lived asset. The Company’s ARO, as determined by SFAS No. 143 and FIN 47, primarily relate to chemically treated poles and certain other assets. Historically, the Company generally has had no legal obligation to remove assets and, therefore, has not accrued a liability for anticipated removal costs. Removal costs are expensed as they are incurred. Upon adoption of FIN 47, the Company recorded a liability equal to the fair value of the estimated cost to retire the asset for those items in which there is a
VALOR COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
conditional legal obligation associated with the retirement of tangible long-lived assets. The Company also increased the carrying amount of the related long-lived asset by an amount equal to the liability. The ARO is accreted to its present value and the capitalized costs are depreciated over the useful life of the long-lived asset. Removal costs for other long-lived assets continue to be expensed as incurred. See Note 21 for additional information.
The telephone operations of the Company’s subsidiary, VTS II, are subject to SFAS No. 71 and, therefore, have historically included a component for removal costs in excess of the related estimated salvage value even though there is no legal obligation to remove the assets. Notwithstanding SFAS No. 143, SFAS No. 71 requires the Company to continue to reflect this accumulated liability for removal costs in excess of salvage value even though there is no legal obligation to remove the assets.
Other - Advertising costs, expensed as incurred, were $1,587, $1,566 and $1,298 for the years ended December 31, 2003, 2004 and 2005, respectively.
Redeemable Preferred Interests of Subsidiary and Minority Interest - The Company allocated earnings and losses attributable to the redeemable preferred interests of subsidiary and minority interest as determined by the limited liability company agreement. A summary of the allocation terms is as follows:
Earnings
•
Earnings are first allocated to redeemable preferred interests to the extent of their 20% accretion and then to common interests. However, if losses had previously been allocated to the respective capital accounts as noted below, the earnings will first be allocated to the redeemable preferred interests to the extent of allocated losses and then to common interests to the extent of their allocated losses.
Losses
•
Losses are first allocated to common interests to the extent of capital contributed.
•
After losses allocated to the common interests reduce the capital accounts to zero, any additional losses are allocated to the redeemable preferred interests to the extent of their capital contributed.
Before the year ending December 31, 2002, the Company had incurred losses resulting in allocated losses to both common interests and redeemable preferred interests of subsidiary. As of December 31, 2003, all of the redeemable preferred interests of subsidiary’s capital account had been restored to their initial capital contribution. For the years ended December 31, 2003 and 2004, the Company allocated the following amounts to the redeemable preferred interests of subsidiary and minority interest:
In April 2004, the Company repurchased certain interests from a group of individual investors who owned direct equity interest in VTS II (see Note 20). In connection with the Offering, all remaining outstanding preferred interests were exchanged for common stock of Valor.
Recent Accounting Pronouncements - In December 2004, the FASB issued a revision to SFAS 123. This revision will require the Company to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. The cost will be recognized over the period during which an employee is required to provide service in exchange for the award. This revised Statement is effective as of the beginning of the first interim or annual reporting period that begins after December 15, 2005. This revised Statement will apply to all awards granted after the required effective date
VALOR COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
and to awards modified, repurchased or canceled after that date. As of the required effective date, the Company will apply this revised Statement using a modified version of prospective application. Under that transition method, compensation cost is recognized on or after the required effective date for the portion of outstanding awards for which the requisite service has not yet been rendered, based on the grant-date fair value of those awards calculated under SFAS 123 for either recognition or pro forma disclosures adjusted for estimated forfeitures. The Company will adopt the provisions of SFAS 123 revision in the first quarter of 2006. The Company does not expect the adoption will have a material impact on our financial position or results of operation.
In January 2004, FASB Staff Position (“FSP”) No. 106-1, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003” (“FSP 106-1”) was issued. FSP 106-1 permits the deferral of recognizing the effects of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the “Act”) in the accounting for post-retirement health care plan under SFAS 106 and in providing disclosures related to the plan required by SFAS 132 (revised 2003), “Employers’ Disclosures about Pensions and Other Postretirement Benefits.” In May 2004, FSP 106-2, “Accounting and Disclosure Requirement Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003” was issued. FSP 106-2 provides guidance that measures the accumulated post-retirement benefit obligation (“APBO”) and net periodic postretirement benefit cost on or after the date of enactment. FSP 106-2 is effective for the first interim or annual period beginning after June 15, 2004. The Act introduces a prescription drug benefit beginning in 2006 under Medicare (“Medicare Part D”), as well as a federal subsidy to sponsors of retiree health care benefit plans that provide a benefit that is at least actuarially equivalent to Medicare Part D. Due to the levels of benefits provided under the Company’s health care plans, the Company has concluded that its health care plans are at least “actuarially equivalent” to Medicare Part D. The Company has elected not to apply for the federal subsidy, as the benefit to its results of operations would be minimal.
In June 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections - a replacement of APB Opinion No. 20 and FASB Statement No. 3” (“SFAS 154”). SFAS 154 replaces APB Opinion No. 20, “Accounting Changes” (“APB 20”), and SFAS No. 3, “Reporting Accounting Changes in Interim Financial Statements.” SFAS 154 requires retrospective application to prior periods’ financial statements of a voluntary change in accounting principle unless it is impracticable to determine either the period-specific effects or the cumulative effects of the change. APB 20 previously required that most voluntary changes in accounting principles be recognized by including in net income in the period of the change the cumulative effect of changing to the new accounting principle. This standard generally will not apply with respect to the adoption of new accounting standards, as new accounting standards usually include specific transition provisions, and will not override transition provisions contained in new or existing accounting literature. SFAS 154 is effective for fiscal years beginning after December 15, 2005, and early adoption is permitted for accounting changes and error corrections made in years beginning after the date that SFAS 154 was issued. The Company does not expect that SFAS 154 will have a significant effect on its financial condition or results of operations upon its adoption.
Reclassification - The Company reclassified certain prior year amounts to conform to current year presentation.
VALOR COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(3)
Other Current Assets
Other current assets consist of the following:
(4)
Property, Plant and Equipment
Property, plant and equipment consist of the following:
The above table references the weighted average depreciable life of the Company’s property, plant and equipment. For the majority of its property, plant and equipment, the Company calculates depreciation expense based on its estimate of the useful life of the assets. Certain of the Company’s total property, plant and equipment are accounted for under the requirements of SFAS No. 71. SFAS No. 71 allows the Company to depreciate its assets over useful lives as prescribed by regulatory authorities, which can exceed the estimated useful lives of the assets.
Included in the furniture, vehicles and other equipment amount at December 31, 2004 is $7,793, for vehicles under capital leases. The related accumulated depreciation for these leases is $3,993 at December 31, 2004. In the first quarter of 2005, the Company paid all outstanding capital lease obligations in full.
Depreciation expense was $81,638, $86,295 and $89,673 for the years ended December 31, 2003, 2004 and 2005, respectively, and is included in “Depreciation and amortization” in the Company’s Consolidated Statements of Operations. Depreciation expense for 2003 and 2004 includes $1,350 and $1,604 respectively, related to assets acquired under capital lease obligations.
VALOR COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(5)
Investments and Other Assets
Investments and other assets consist of the following:
The Company’s goodwill primarily represents the excess price paid by the Company over the fair value of the tangible and intangible assets and liabilities of the telephone operating properties purchased in Oklahoma, New Mexico, Arkansas and Texas on the date of acquisition net of accumulated amortization of $74,429. In November 2004, the Company acquired certain high-speed and dial-up Internet assets, along with the related customers and revenues. The purchase price consisted of $1,500 in cash and assumption of $400 of liabilities. The Company performed a preliminary purchase price allocation which resulted in goodwill of $1,228. During 2005, the Company finalized their purchase price allocation resulting in an increase of $146 of tangible assets and a corresponding decrease in goodwill.
The Company evaluates the carrying value of its RLEC reporting unit goodwill as of September 30 of each year and at other times during each year when events or changes in circumstances indicate an impairment may exist. Prior to our November 2004 acquisition, the Company only had goodwill at the RLEC reporting unit. As part of the evaluation, the Company compares the reporting unit’s carrying value, including goodwill, with its fair value to determine whether an impairment exists. If the net carrying value, including goodwill, is in excess of the respective fair value, then no impairment is considered to exist. If the fair value of the reporting unit is less then the carrying value, including goodwill, then a goodwill impairment loss would be recognized equal to the excess, if any, of the net carrying value of the reporting unit goodwill over its implied fair value, not to exceed the carrying value of the reporting unit’s goodwill. The implied fair value of the reporting unit’s goodwill would be the amount equal to the excess of the estimated fair value of the reporting unit over the amount that would be allocated to the tangible and intangible net assets of the reporting unit, including unrecognized intangible assets, as if such reporting unit had been acquired in a purchase business combination accounted for in accordance with GAAP as of the date of the impairment testing.
In determining the estimated fair value for each reporting unit, the Company discounts future cash flow projections to determine if the goodwill can be recovered. Cash flow projections, although subject to a degree of uncertainty, are based on trends of historical performance and management’s estimate of future performance, giving consideration to existing and anticipated competitive and economic conditions. Upon completion of its annual assessment for the RLEC reporting unit in the third quarters of 2004 and 2005, the Company determined that no write-down in the carrying value of the goodwill was required. In the fourth quarter of 2005, the Company assessed the recoverability of its goodwill carrying value associated with its Other reporting unit. Based on this analysis, the Company determined the value of the goodwill would not be recoverable and recorded an impairment charge of $1,082.
In accordance with the terms of the Rural Telephone Finance Cooperative (“RTFC”) loans, the Company was required to purchase an equity certificate in RTFC equal to approximately 10% of the total amount borrowed from the RTFC. RTFC provided a loan to finance the purchase of the equity certificate. The funds invested in this equity certificate will be refunded to the Company upon repayment of the outstanding loan balance. The RTFC certificate is not marketable and is carried at cost. As a member of RTFC, the Company
VALOR COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
receives non-cash patronage capital certificates based on RTFC earnings. During the years ended December 31, 2004 and 2005, the Company recorded patronage capital certificates with a present value of $404 and $281, respectively. These non-cash patronage capital certificates will accrue interest on a monthly basis and will be redeemed for approximately $1,304 and $731 in the years 2019 and 2020, respectively. In connection with the debt recapitalization in 2004 (see Note 6) and the Offering in 2005, the Company redeemed $31,111 and $24,445, respectively, of RTFC capital certificates.
As a result of amending the terms of its credit facilities in 2003, 2004 and 2005, the Company expensed $555, $44,827 and $9,869 respectively, of its previously deferred debt issuance costs. In addition, in 2004 and 2005 the Company deferred an additional $23,948 and $17,530, respectively, of new debt issuance costs incurred as a result of the debt recapitalization and the credit facility amendment in connection with the Offering, respectively. Debt issuance costs are amortized utilizing the effective interest rate method over the term of the related debt. Amortization expense is expected to be approximately $3,780 in 2006, $4,009 in 2007, $4,255 in 2008, $4,519 in 2009 and $4,686 in 2010.
Investments in cellular partnerships represent the Company’s 32% ownership in both CGKC&H and CGKC&H #2. The Company accounts for its investments using the equity method of accounting. Income taxes on the Company’s equity in earnings of the partnerships are included in the Company’s provision for federal income taxes. In 2004, a wireless competitor began constructing facilities in areas serviced by the Company’s unconsolidated cellular partnerships. This has resulted in a significant decrease in roaming revenue further decreasing the Company’s earnings from unconsolidated cellular partnerships. In light of the financial results of the cellular partnerships, the Company assessed recoverability of the investments in unconsolidated cellular partnerships, which resulted in an impairment charge of $6,678 in the third quarter of 2004. One of the Company’s cellular partnerships continued to experience a significant decline in roaming revenues in 2005. Due to the financial results of this cellular partnership through September 30, 2005, the Company recorded an impairment charge of $2,339 in its Consolidated Statements of Operations.
(6)
Long Term Debt
Long-term debt outstanding is as follows:
*
weighted average interest rate at December 31, 2005
Debt Recapitalization
On November 10, 2004, the Company completed its debt refinancing and entered into a new $1,300,000 senior credit facility consisting of a $100,000 senior secured revolving facility and a $1,200,000 term loan. The term loan consists of $900,000 of Tranche B, $270,000 of Tranche C and $30,000 of Tranche D.
VALOR COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Concurrently, the Company secured a $265,000 second lien loan and a $135,000 subordinated loan. Proceeds from the credit facility, second lien loan and the subordinated loan were used to (i) repay all amounts owed under the Company’s previous senior credit facilities; (ii) redeem $325,500 of 10% senior subordinated notes due 2010 held primarily by our equity sponsors, including accrued interest thereon; (iii) redeem $134,102 of redeemable preferred interests and $16,458 of Class C interests held by the Company’s existing equity investors, including our equity sponsors, in VTC; (iv) redeem $8,791 of redeemable preferred minority interests our equity investors held in VTS; and (v) pay $30,719 in associated transaction costs.
As a result of the debt refinancing, the Company accounted for the debt issuance costs associated with the existing and new credit facilities based on Emerging Issue Task Force (“EITF”) 96-19, “Debtor’s Accounting for a Modification or Exchange of Debt Instruments” and EITF 98-14, “Debtor’s Accounting for Changes in Line-of-Credit or Revolving-Debt Arrangements.” Based on the terms of the new and old credit facilities and the composition of the respective lending groups, the Company recorded a loss on extinguishment of debt of $62,975 for the year ended December 31, 2004. The loss on extinguishment of debt consisted of prepayment penalty fees of $11,376, write-off of existing deferred financing costs of $44,827 and fees paid to lenders to modify existing credit facilities of $6,772.
Senior Credit Facilities
In connection with the Offering, the Company amended its senior credit facility. The amended senior credit facility resulted in the reduction of the commitment amount of Tranche B Term Loan to $750,000, Tranche C Term Loan to $50,000 and Tranche D Term Loan to $5,556. Under the amended credit facility, the entire principal balances on the Tranches B, C and D are due at maturity, February 2012. Interest on Tranche B bears interest based on LIBOR plus 1.75% and is payable no less frequently than monthly. Interest on the Tranches C and D is fixed at 6.38% through April 2007 and is payable quarterly.
As a result of the repayment of existing indebtedness completed in connection with the Offering, the Company recorded a loss on extinguishment of debt of $29,262 due to prepayment premiums, breakage costs and the write-off of related deferred debt costs.
As a member of RTFC, the Company receives cash distributions based on RTFC earnings. During the year ended December 31, 2003, 2004 and 2005, the Company recorded $3,173, $3,042 and $1,705, respectively, of distributions declared from the RTFC as a reduction of interest expense.
At December 31, 2004 and 2005, the weighted average interest rate of the Senior Credit Facilities was 6.1% and 6.0%, respectively.
The amount of borrowing available to the Company under the Revolving credit facility (“Revolver”) is generally based upon achieving certain levels of operating performance. At December 31, 2005, the Company had an aggregate of $99,840 in available borrowings under the Revolver, for which the Company pays a commitment fee of 0.5% based upon certain financial tests. The Revolver matures February 2011.
The Company may borrow funds under the Revolver for short-term requirements for a period not to exceed seven days. Any amounts outstanding under these terms are classified as “Notes Payable” on the Consolidated Balance Sheets. As of December 31, 2004 and 2005, the Company had no balance outstanding.
Borrowings under the Senior Credit Facilities, as amended, are collateralized by virtually all assets of the Company. These agreements limit, among other things, additional borrowings, transactions with affiliates, capital expenditures and the payment of dividends. The agreements also require maintenance of certain financial ratios, including leverage and interest coverage ratios. As of December 31, 2005, the Company is in compliance with all of the covenants included in the credit facility.
VALOR COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Senior Notes
The senior notes were issued in February 2005 in connection with the Offering. In August 2005, the Company completed an exchange of all outstanding 73/4% senior notes for substantially identical senior notes that had been registered under the Securities Act of 1933. The senior notes are due 2015. They bear interest at an annual fixed rate of 73/4% and pay interest every six months on February 15 and August 15. The senior notes are general unsecured unsubordinated obligations. The senior notes contain covenants similar to those identified in the Senior Credit Facilities. As of December 31, 2005, the Company is in compliance with all of the covenants included in the senior notes.
The senior notes issued are guaranteed jointly and severally by all of Valor’s existing subsidiaries (the “Guarantor Subsidiaries”) and such guarantees are full and unconditional. Existing subsidiaries include VTC, VTS including its operating entities, and VTS II including its operating entities. Valor has no independent assets or operations. Separate financial information has not been presented for the Guarantor Subsidiaries because the Guarantor Subsidiaries will effectively comprise all of Valor’s assets and operations.
Provisions of the senior credit agreement that the Company entered in conjunction with the Offering restrict the ability of all of the Guarantor Subsidiaries to transfer funds to the Company. The senior credit agreement also precludes the guarantor subsidiaries from transferring funds to Valor:
i. to pay dividends on common stock during a dividend suspension period, as defined in the senior credit agreement;
ii. when an event of default has occurred, as defined in the senior credit agreement; or
iii. for the purpose of paying dividends that would exceed available distributable cash, as defined in the senior credit agreement.
Other
The approximate annual debt maturities for the five years subsequent to December 31, 2005 are as follows:
During the years ended December 31, 2003, 2004 and 2005, the Company capitalized $997, $104 and $412, respectively, of interest expense related to construction projects.
Pursuant to the Company’s Senior Credit Agreement, the Company is required to enter into swap contracts or other interest rate protection agreements, reasonably satisfactory to the lender, that would be payable in connection with 50 percent of all consolidated funded indebtedness exclusive of any revolving loans. The Company entered into nine agreements, three interest rate caps and six interest rate swaps, with investment grade financial institutions in 2005. In connection with entering the interest rate cap agreements, the Company paid $854.
The interest rate caps are not treated as hedges as prescribed by the accounting literature; therefore, the fair value of the instruments is recorded each reporting period on the Consolidated Balance Sheets, with the change in fair value recorded in the Consolidated Statements of Operations in “Gain (loss) on interest rate hedging arrangements.” The interest rate swaps effectively convert our variable rate debt to fixed rate debt.
VALOR COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Since the relevant terms of the interest rate swap agreements match the corresponding terms of long-term debt, there is no hedge ineffectiveness. The Company’s interest rate swap agreements qualify for hedge accounting under SFAS No. 133; therefore, they are carried at fair market value and are included on the Consolidated Balance Sheets in “Other assets” or “Deferred credits and other liabilities,” with changes in fair value recorded as “Other comprehensive income (loss)” in the accompanying Consolidated Statements of Operations. The Company does not hold or issue derivative financial instruments for trading or speculative purposes. At December 31, 2005, the Company expects to reclassify $627 of net gains on derivative instruments from accumulated other comprehensive income to earnings during the next twelve months due to the payment of variable interest associated with the floating rate debt.
As a further hedge against rising interest rates, the Company selected fixed rate options available under certain of the Senior Credit Facilities. For the year ended December 31, 2005, the Company fixed Tranches C and D debt through April 2007 at the rate of 6.38%.
(7)
Deferred Credits and Other Liabilities
Deferred credits and other liabilities were composed of the following:
Deferred revenue represents revenues billed to customers for activating services. This revenue is recognized over the average life of the customers along with the costs associated with activating such services (see Note 2).
(8)
Income Taxes
In connection with the Offering, the Company completed a reorganization, which resulted in the operations of all entities within Valor and VTC becoming reportable in a consolidated corporate federal tax return. As a result of the reorganization, the Company’s previous owners contributed approximately $307,000 of federal net operating losses (“NOLs”) that the Company will be able to use, subject to certain limitations, to reduce future taxable income. Furthermore, the Company, as of the Offering date, had cumulative book/tax differences of approximately $499,000 resulting from items such as goodwill amortization and accelerated tax depreciation that the Company has deducted faster for tax purposes under the tax code than for financial reporting purposes. The Company also had other items totaling $818,000, which consist of $725,000 related to unamortized goodwill and $93,000 related to the step-up in tax basis of assets as a result of the reorganization that occurred in connection with the Offering. Unamortized goodwill represents tax deductions through 2015 that will result in a future deferred tax liability for financial reporting purposes due to the book/tax basis difference related to the goodwill. The $93,000 step-up in tax basis of assets, as determined by the applicable tax code, is allocated in part to tangible assets and in part to tax goodwill based upon relative fair market values. The portion allocated to tangible assets will be treated as a temporary difference that will reverse upon the disposition of certain Company assets. The portion attributable to tax goodwill will continue to be treated as a permanent difference in accordance with SFAS No. 109, “Accounting for Income Taxes,” since there is no corresponding book goodwill. The Company recorded the tax effect of the items noted above as a net deferred
VALOR COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
tax liability of approximately $59,000. The net deferred tax liability is an estimate and is subject to change upon finalization of tax valuations, of certain tax calculations and of the partners’ tax returns related to the period prior to the Offering. Any changes to this deferred tax liability will be recorded through additional paid-in capital.
The components of the Company’s net deferred tax liability consist of the following:
At December 31, 2005, the Company has federal net operating loss (“NOL”) carryforwards, which for U.S federal income tax purposes expire in 2020 through 2025, of approximately $320,100. The NOL carryforwards primarily arose from the Company’s reorganization that occurred in conjunction with the Offering. The NOLs that were generated prior the Company’s reorganization are subject to certain limitations pursuant to Section 382 of the Internal Revenue Code. The Company believes that it is more-likely-than-not that all such NOLs for federal income tax purposes will be utilized to reduce future income tax liabilities. Consequently, no valuation allowance has been recorded to offset the deferred tax asset related to these NOLs. However, certain of the Company’s state NOLs have a five-year expiration period beginning in 2005. The Company has considered the likelihood of realizing some portion or all of the deferred tax assets associated with these NOLs and has determined that it is more-likely-than-not that such deferred tax assets will not be realized. Accordingly, the Company has recorded a $4,029 valuation allowance at December 31, 2005.
Income tax expense for the years ended December 31 is as follows:
VALOR COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
There was no income tax expense associated with the discontinued operations.
The differences between the federal income tax statutory rate and the Company’s effective income tax rate is as follows:
Permanent differences relate to the Company’s purchase of minority interests and the impairment charge on investment in cellular partnerships in 2004. The permanent differences in 2005, which offset each other, relate to the step-up in the Company’s tax basis of assets attributable to goodwill that occurred in connection with the Company’s reorganization and an impairment charge on the Company’s investment in cellular partnership.
(9)
Pension and Employee Benefits
The Company sponsors a qualified pension plan and a postretirement benefit plan for the union employees. The pension plan is noncontributory. The Company’s postretirement health care plans are generally contributory and include a limit on the Company’s share of the cost for recent and future retirees. The Company accrues the costs, as determined by an actuary, of the pension and the postretirement benefits over the period from the date of hire until the date the employee becomes fully eligible for benefits.
VALOR COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following tables provide a reconciliation of the changes in the plans’ benefit obligations and fair value of plan assets and a statement of funded status as of December 31:
The accumulated benefit obligation for the pension plan was $39,813, $43,402 and $47,506 as of December 31, 2003, 2004 and 2005, respectively. SFAS 87 requires a company to record a minimum liability that is at least equal to the unfunded accumulated benefit obligation. Changes in the amount of the unfunded accumulated benefit obligation result from factors such as a change in the interest rate used to discount the accumulated benefit obligation to its present settlement amount, contributions to the pension plan and the investment return generated by pension plan assets. As a result, the Company recorded an additional minimum pension liability adjustment of $3,054, $414 and $1,528 in 2003, 2004 and 2005, respectively. The additional minimum pension liability, net of a deferred tax asset, is charged to accumulated other comprehensive loss.
VALOR COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The accrued benefit cost is reflected in “Deferred credits and other liabilities” on the Company’s Consolidated Balance Sheets (see Note 7). The Company’s investment policy is to invest 55-75% of the pension assets in equity funds, with the remainder being invested in fixed income funds and cash equivalents.
The following table shows the asset allocations by asset category at December 31:
The following table provides an estimate of the benefit payments expected to be paid during the years ended December 31:
The Company made cash contributions of $15,647 to its defined benefit pension plan in 2005, consisting of: (i) the required 2004 plan year contribution of $6,465, (ii) the required quarterly contributions for the 2005 plan year of $1,616 and $1,566 in April and July, respectively, and (iii) a $6,000 optional cash contribution in September 2005. The optional cash contribution in September 2005 made the Company’s plan fully funded on a current liability basis, as determined under ERISA funding law, as of January 1, 2005 for the 2005 plan year. Had the Company not made this optional contribution, the Company would have been required to continue making quarterly contributions in October 2005 and in January 2006. Also, as a result of the Company’s optional contribution and the funded status of the plan, the Company does not anticipate that it will be required to make cash contributions in 2006 for the 2005 or 2006 plan years. The Company’s earliest required cash contribution will be in 2007. The Company may, however, elect to make optional contributions prior to that date. The Company expects to contribute $793 to its other postretirement benefits plan in 2006.
The following table provides the components of net periodic benefit cost for the years ended December 31:
VALOR COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The weighted-average assumptions used in measuring the Company’s benefit obligations as of December 31 are as follows:
In determining the appropriate discount rate at year-end, the Company considered the current yields on high quality corporate fixed-income investments with maturities and coupon payments corresponding to the expected benefit payments of the plan. As of December 31, 2005, the Company lowered its discount rate 20 basis points to 5.70%.
In 2005, the Company used an expected long-term rate of return of 8.5%. The projected portfolio mix of the plan assets is developed in consideration of the expected duration of related plan obligations and as such is more heavily weighted toward equity investments, including public and private equity positions. The Company’s investment policy is to invest 55-75% of the pension assets in equity funds with the remainder being invested in fixed income funds and cash equivalents. The expected return on plan assets is determined by applying the expected long-term rate of return to the market-related value of plan assets.
The assumed health care cost trend rate is 9.0% in 2004 and is assumed to decrease gradually to an ultimate rate of 5.0% in the year 2009. In 2005, trend rates are not used since the Company’s costs are assumed to have reached the Company’s cap on benefits. A one percentage point change in the assumed health care cost trend rate would have no effect on the Company’s other postretirement benefits due to the Company’s cap on benefit payouts.
The Company also sponsors an employee savings plan under Section 401(k) of the Internal Revenue Code. The plan covers all employees. Under the plan, the Company provides matching contributions based on qualified employee contributions. Matching contributions charged to expense were $1,840, $1,447 and $1,754 during the years ended December 31, 2003, 2004 and 2005, respectively.
(10)
Commitments and Contingencies
The Company has operating leases covering primarily buildings and land. Total rental expense was $4,578, $4,723 and $5,320 in 2003, 2004 and 2005, respectively. At December 31, 2005, rental commitments under noncancelable leases with initial or remaining terms in excess of one year are as follows:
The Company has various commitments for capital expenditures of $3,580 at December 31, 2005. Capital expenditures were $69,850, $65,525 and $57,385, for the years ended December 31, 2003, 2004 and 2005,
VALOR COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
respectively. Additionally, the Company has unfulfilled contractual commitments for miscellaneous services at December 31, 2005 of $103,967. These commitments primarily relate to administration of our billing and customer care systems provided by Alltel and a long distance resale arrangement with Sprint Nextel Corporation. These commitments extend through 2011.
On July 13, 2005, four former employees served the Company with a Demand for Arbitration, claiming that the Company and its subsidiary, VTS, had breached the terms of the former employees’ VTS stock option agreements in its valuation of those options in the reorganization that preceded the Offering. The American Arbitration Association established arbitration to be held in April 2006. The Company believes that it has meritorious defenses and intends to continue to vigorously defend this matter. Even though litigation is inherently uncertain and it is possible that an adverse decision could be rendered, the Company anticipates resolution of this matter will not have a material effect on its consolidated financial statements.
The Company is involved, from time to time, in various other claims, legal actions and regulatory proceedings arising in the ordinary course of its business. Currently no material litigation is pending or, to the knowledge of the Company, threatened that will have a material adverse effect, either individually or in the aggregate, on the Company’s consolidated financial condition, results of operations or liquidity.
The Company has collective bargaining agreements with Communications Workers of America (“CWA”) and their Local 6171 and Local 7019. One of the Company’s contracts with CWA, covering a majority of the represented employees from Local 6171 and all represented employees of Local 7019, expires on February 28, 2008. The second contract, covering employees of Kerrville Telephone Company, a fully owned subsidiary of the Company, was renegotiated in February 2006, when ratified, and will expire March 1, 2008. There is no material impact to our results of operations or liquidity as a result of the new agreement.
(11)
Redeemable Preferred Interests
At December 31, 2004, the Company had two classes of Redeemable Preferred Interests: Class A and Class B. The carrying amount of the Redeemable Preferred Interests equals approximately the amount of cash that would be paid under the conditions specified in the Partnership Agreement if settlement of the Redeemable Preferred Interests had occurred at December 31, 2004. The Company was required to make an estimate of the fair value of the Redeemable Preferred Interests in order to determine the carrying value of the liability at December 31, 2004. The Redeemable Preferred Interests were not entitled to dividends and had no voting rights. The Redeemable Preferred Interest did, however, include a provision that entitles the holder to a return equal to the sum of (i) the initial contribution per interest, or $1.00 for Class A Preferred interests and $0.00 for Class B Preferred interests, and (ii) and appreciation amount calculated as interest on $1.00 per interest, at a rate of 20% per year, compounded quarterly upon the occurrence of a liquidation event or redemption. The appreciation amount defined in (ii) above is payable only after all holders of Class A common interests have received a return of their initial $1.00 capital investment. Under this provision, the maximum amount payable to holders of the Redeemable Preferred Interests at December 31, 2004 was $787,668. Since the return to be paid to preferred interest holders upon redemption would vary based upon the total value of the enterprise available to be distributed to holders of the Redeemable Preferred Interests, the fair value of this liability is determined based upon the enterprise value of the Company. As such, the Company did not record accretion on the Redeemable Preferred Interests. The Company has measured this liability at December 31, 2004 as the amount of cash that would be paid if settlement occurred at the reporting date in accordance with paragraph 22 of SFAS 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” Any change in the estimated fair value of Redeemable Preferred Interests in a reporting period would be recorded as interest expense. This requires the Company to make an estimate of its enterprise value at each reporting date to properly measure this liability. The Company concluded that this liability had been fairly stated at an amount equal to the initial contribution of $1.00 per
VALOR COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
interest for all of the outstanding preferred interests. The Company recognized no changes in the fair value of the liability since inception.
On November 10, 2004, the Company refinanced its existing indebtedness resulting in the repayment of existing indebtedness and return of capital to investors, including $134,102 to holders of Redeemable Preferred Interests (see Note 6). In February 2005, the Company completed its Offering. Concurrent with the Company’s Offering, the Company completed a reorganization resulting in the exchange of Redeemable Preferred Interests for common stock in Valor.
Information about the Redeemable Preferred Interests is as follows:
In 1999, VTC authorized the issuance of 353,119,750 Class A Preferred interests and 22,505,106 Class B Preferred interests. On January 1, 2002, the LLC agreement for VTC was amended to reflect total authorized Class A Preferred interests of 500,000,000 and total authorized Class B Preferred interests of 29,305,106.
The Class A and Class B Preferred interests have no stated or par value. 365,733,249 of the Class A Preferred interests were issued for aggregate proceeds of $365,542 or approximately $1 per preferred interest. The balance of 4,498,101 Class A Preferred interests were issued to the founders of the Company in connection with the Company’s formation in 1999. Additionally, 22,505,106 Class B Preferred interests were issued to the founders of the Company in connection with the Company’s formation in 1999. No cash proceeds were received for the issuance of the founder’s interests. No cash proceeds were received by the Company for the issuance of the Class B Preferred interests. 6,077,500 of the Class B interests were issued pursuant to the Valor Telecom Executive Incentive Plan in 2002 (see Note 15).
The number of Class B interests outstanding is as follows:
(12)
Stockholders’ Equity
Concurrent with the Company’s Offering, the Company completed a reorganization resulting in the exchange of common interests for common stock in Valor. The shares of common stock issued in connection with the Offering have the same voting and dividend rights.
The outstanding Class A common interests, Class B common interests, and Class C interests have no stated or par value. Each of the Class A common interests and Class C interests are entitled to one vote. Dividends may be paid based on certain restrictions related to the preferred interests. Any dividends must be paid in equal amounts on the Class A and Class B common interests out of proceeds associated with operations from sources other than VTS II. Dividends paid on the Class C interests must arise from earnings and profits attributable to the VTS II operations.
In the event of a liquidation of the VTS operations, the holders of the Class A common interests are entitled to $1.00 per interest, (or, if less, the amount of the related capital contribution paid for such interest),
VALOR COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
after the effects of distributions (other than dividends) and share ratably with the Class B common interest holders in the remaining net assets available for distribution.
In the event of a liquidation of the VTS II operations, the holders of the Class C interests are entitled to $1.00 per interest, (or, if less, the amount of the related capital contribution paid for such interest), after the effects of distributions (other than dividends) and share ratably in the remaining net assets available for distribution.
On November 10, 2004, the Company refinanced its existing indebtedness resulting in $16,458 of redemption of Class C interests (see Note 6).
(13)
Earnings Per Share
On February 9, 2005, the Company completed its Offering, registering 29,375,000 shares of common stock. Concurrent with the Offering, the Company issued 41,458,333 shares of common stock in exchange for all outstanding ownership interests in VTC and its subsidiaries outstanding prior to the offering and issuance of shares to management under the Long-Term Incentive Plan. As of December 31, 2005, the Company had 71,134,034 shares of common stock issued and 71,130,634 outstanding (net of treasury shares), including restricted shares issued to management and to the board of directors. The following tables set forth the computation of earnings per share:
VALOR COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(1)
Represents the period prior to the Company’s Offering from January 1, 2005 through February 8, 2005.
(14)
Supplemental Cash Flow Information
Cash payments for interest were $109,368, $113,536 and $73,997 for the years ended December 31, 2003, 2004 and 2005, respectively.
Cash payments for income taxes were $2,390 and $1,250 for the years ended December 31, 2003 and 2004, respectively. There were no cash payments for income taxes for the year ended December 31, 2005.
A note payable was issued for insurance policies of $3,770 and $3,479 during the years ended December 31, 2003 and 2004, respectively.
The Company entered into long-term capital leases of $1,949 and $863 for the purchase of vehicles for the years ended December 31, 2003 and 2004, respectively.
The Company recognized an intangible pension asset adjustment for $157 and ($24) for the years ended December 31, 2004 and 2005, respectively. The Company also has a minimum pension liability adjustment of $3,054, $414, and $1,528 for the years ended December 31, 2003, 2004 and 2005, respectively.
VALOR COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
In connection with the Offering, the Company redeemed all outstanding interests for 39,537,574 shares of Valor common stock and recorded a net deferred tax liability from the existing equity owners of VTC prior to becoming a federal corporate taxpayer as follows:
The Company issued 2,352,792 shares of restricted stock in the year ended December 31, 2005. The Company recorded $34,553 to deferred equity compensation with a corresponding offset to either common stock, additional paid-in capital or treasury stock (if issued from treasury stock). The Company recorded $12,699 of non-cash stock based compensation expense related to the issuance of restricted stock to management and the board of directors for the year ended December 31, 2005.
Concurrent with the Offering, the Company exchanged shares of Valor common stock with a value of $1,351 for all outstanding units under the Valor Telecom Executive Incentive Plan.
For the year ended December 31, 2005, certain unvested shares of restricted stock were forfeited. Restricted stock forfeitures of 224,806 shares for $3,372 were recorded as a reduction to deferred equity compensation with a corresponding offset to paid-in capital and treasury stock.
The company wrote off $555, $44,827 and $9,869 of unamortized debt issuance costs in connection with amendments of the credit facility for the year ended December 31, 2003, 2004 and 2005, respectively.
In December 2005, the Company declared a cash dividend of $25,138 that was payable in January 2006.
(15)
Equity Based Compensation
Long-term incentive plan - In connection with the Offering in 2005, the Company approved the long-term incentive plan (“LTIP”). The LTIP provides for grants of stock options, restricted stock and performance awards. The Company’s directors, officers and other employees and persons who engage in services for the Company are eligible for grants under the plan. The Company authorized 2,500,000 shares of the Company’s common stock for issuance under the LTIP. The Company has only granted restricted stock under the LTIP. The following table summarizes information about restricted stock grants:
VALOR COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The weighted average grant-date fair value of the restricted stock for the year ended December 31, 2005 is $14.69.
Equity Incentive Non-Qualifying Stock Options - In 1999, VTS (a majority-owned subsidiary of the Company) reserved 9,000,000 Class B common interests for issuance to employees of the Company in accordance with the Valor Telecommunications Southwest, LLC 2000 Equity Incentive Non-Qualifying Option Agreement (“the Plan”). The vesting period for these options ranges from immediate to five years and the options expire ten years after the date of grant. The weighted average remaining life of the options outstanding at December 31, 2004 was 5.8 years. The options were granted at the $1.00 stated price of the Class B common interests. The stated price was equivalent to the estimated fair value of the interests.
*
number of options expressed in thousands
The fair value for each of the Company’s options was estimated at the date of grant using a Black-Scholes option pricing model and the following weighted average assumptions for 2003:
There were no option grants in 2004 or 2005.
In 2000, the Company granted an Equity Incentive Non-Qualifying Stock Option to one of its key executives in the amount of 300,000 Class A common interests and 1,700,000 Class A Preferred interests of VTC. The options vested immediately and were granted at a $1.00 stated price. The stated price is equivalent to the estimated fair value of the interests. This option was exercisable at December 31, 2003 and 2004.
Concurrent with the Offering, the Company terminated the Valor Telecom Executive Incentive Plan and cancelled all equity incentive non-qualifying stock options in Class B common interests. The Company
VALOR COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
finalized the 2005 Long-Term Incentive Plan resulting in the issuance of restricted stock. The Company recorded expense as a result of the issuance of the restricted stock.
Phantom Stock Units - The Valor Telecom Executive Incentive Plan was implemented on April 1, 2002 and allowed for awards of up to 1,200,000 Class B common interests and 6,800,000 Class B Preferred interests (collectively, “Phantom Stock Units”) to select executive employees of VTC and its subsidiaries. These interests allowed the selected executives to participate in the appreciation on a pro-rata basis with the Class A Preferred interests and Class A common interests held by the Equity Sponsors and Individual Investors. In accordance with FIN 28, “Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans,” the amount by which the market value of these Phantom Stock Units exceeds the value specified under the plan is charged to compensation expense over the vesting period. Certain of the awards vested 20% immediately and 20% on January 1 for each of the following four years. The remaining awards vest evenly over five years from the date the award was granted. Unvested units are subject to cancellation upon expiration or termination of employment. Concurrent with the Offering, the Company valued the Phantom Stock Units, which resulted in a compensation charge of $1,345 for the year ended December 31, 2004. VTC issued 1,072,500 Class B Common units and 6,077,500 Class B Preferred units to the Executive Incentive Plan in 2002. These units were granted to Executives as follows:
*
number of phantom stock units expressed in thousands
Concurrent with the Offering, the Company terminated the Valor Telecom Executive Incentive Plan and exchanged all Phantom Stock Units for shares of Valor common stock. The Company finalized the 2005 Long-Term Incentive Plan resulting in the issuance of restricted stock. The Company recorded expense as a result of the issuance of the restricted stock.
(16)
Fair Value of Financial Instruments
The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:
Cash and cash equivalents - The carrying amount approximates fair value because of the short maturity of these instruments.
VALOR COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
RTFC equity certificate - It is not practicable to estimate the fair value of this investment because there is no quoted market price.
Debt - The book value of the long-term debt for 2004 approximates the fair value due to the debt recapitalization in November 2004. The fair value of long-term debt for 2005 was estimated based on the Company’s current incremental borrowing rate for debt of the same remaining maturities and quoted market prices.
Interest Rate Swap and Cap Agreements - The fair value of interest rate swaps is the estimated amount that the respective bank would receive or pay to terminate the swap agreements at the reporting date, taking into account current interest rates and the current credit worthiness of the swap counterparties. The estimated fair value of the Company’s interest rate swap and cap agreements is as follows:
(17)
Risks and Uncertainties
Certain financial instruments potentially subject the Company to concentrations of credit risk. These financial instruments consist primarily of trade receivables and cash and cash equivalents.
The Company places its cash and temporary cash investments with high credit quality financial institutions and limits the amount of credit exposure to any one financial institution. The Company also periodically evaluates the credit worthiness of the institutions with which it invests. The Company does, however, maintain unsecured cash and cash equivalent balances in excess of federally insured limits.
The Company recorded revenue from the Texas Universal Service Fund of 20.7%, 20.1% and 19.8% of total revenue for the years ended December 31, 2003, 2004 and 2005, respectively. The Texas Universal Service Fund is administered by the Texas Public Utility Commission and any legislative change to this program could adversely impact the Company’s results of operations and financial condition.
The Company currently outsources much of the billing function to Alltel. Although the Company may be exposed to risk of non-performance of Alltel and transitioning these services to another provider could take a significant period of time and involve substantial costs, the Company considers the risk to be remote. See Note 1 regarding proposed merger with Alltel.
VALOR COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(18)
Related Party Transactions
The Company had the following transactions with related parties:
The Company had the following balances with related parties:
Under the terms of the CGKC&H partnership agreement, the general partners have designated the Company to act as the operating partner of CGKC&H. The agreement provides that the Company is to be reimbursed for all reasonable and necessary expenses incurred on behalf of CGKC&H. During 2003, 2004 and 2005, the Company was reimbursed approximately $958, $1,046 and $1,123, respectively, from CGKC&H for these services.
Effective January 1, 2005, the Company terminated the management agreement, whereby the Company had paid its sponsors management fees for advisory services.
VALOR COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(19)
Restructuring Charges
In December 2002, the Company eliminated 81 positions as a result of a restructure in the Company’s workforce. Remaining obligations, as a result of this event, comprise the beginning balance in this liability at January 1, 2003. The Company had a subsequent restructuring in December 2003, resulting in the elimination of 15 additional positions. The Company recorded $141 of expense for termination benefits for these 15 employees. In 2004, the Company announced workforce reductions of 99 employees. The Company recorded $625 of expense for termination benefits for these 99 employees. As of December 31, 2005, approximately $5 of the severance obligation remains and the Company expects this amount to be settled in 2006. The following table provides a reconciliation of the changes in the termination benefits obligation for the years ended December 31:
(20)
Significant Events
Agreement with Former Chief Executive Officer - On April 9, 2004, the Company entered into a new employment agreement with its former Chief Executive Officer (“CEO”). The new agreement replaces the existing employment agreement between the Company and the former CEO and is effective through March 31, 2007. Under the new agreement, the former CEO will be employed by the Company on a part-time basis and will serve on its board of directors as Vice-Chairman. In conjunction with the termination of the former CEO’s prior employment agreement, the Company paid the former CEO a one-time cash payment of $5,000, which was recorded as expense and is included in “Selling, general and administrative” in the accompanying Consolidated Statements of Operations for the year ended December 31, 2004. As amended, the Company paid the CEO $750 in connection with the debt recapitalization (see Note 6) and agreed to pay an additional $750 on the earlier of either an initial public offering or the termination of his agreement on March 31, 2007. The Company paid the former CEO $750 in connection with the Offering.
Agreement with Individual Investors - On April 20, 2004, the Company entered into an agreement with a group of individual investors who own direct equity interests in the Company’s majority-owned subsidiaries VTS, a Delaware limited liability company, and VTS II, a Delaware limited liability company. This agreement provided for the Company to purchase all of the outstanding equity interests of this group of the individual investors for $18,646 in cash. The Company made this cash payment to the group of investors on April 20, 2004. The purchase was accounted for under the guidance provided by SFAS No. 141 and FASB Technical Bulletin, 85-6. Accordingly, approximately $17,988 was allocated to expense and is included in “Other income and (expense), net” in the accompanying Consolidated Statements of Operations for the year ended December 31, 2004.
VALOR COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Offering Costs - In April 2004, the Company filed Form S-1 with the Securities and Exchange Commission (“SEC”) for the proposed offering of Income Deposit Securities. In connection with the offering, the Company incurred approximately $6,957 of offering costs. In the third quarter of 2004, the Company decided not to pursue the offering process and instead completed a debt recapitalization of all its existing debt. Upon making this decision, the Company recorded the $6,957 in offering costs as expense, which is included in “Other income and (expense), net” in the accompanying Consolidated Statements of Operations for the year ended December 31, 2004.
Debt Recapitalization - On November 10, 2004, the Company completed its debt refinancing and entered into a new $1,300,000 senior credit facility, consisting of a $100,000 senior secured revolving facility and a $1,200,000 term loan (see Note 6). At the same time, we entered into a $265,000 senior secured second lien and a $135,000 senior subordinated loan. In connection with the debt recapitalization, the Company recorded approximately $5,118 in compensation expense related to bonuses paid to executive management and others as a result of their efforts with the debt recapitalization and past services to the Company.
(21)
Cumulative Effect of Change in Accounting Principle
In March 2005, the FASB issued FIN 47, “Accounting for Conditional Asset Retirement Obligations, an interpretation of FASB Statement No. 143,” which clarifies the term conditional asset retirement obligation as used in SFAS 143. The term conditional asset retirement obligation refers to an obligation to perform an asset retirement activity in which the timing and (or) method of settlement are conditional on a future event that may or may not be within the control of the entity. An obligation exists when a law, regulation or contract requires an entity to perform an asset retirement activity. The interpretation requires an entity to recognize a liability - generally upon acquisition, construction or development - for the fair value of a conditional asset retirement obligation if the fair value of the liability can be reasonably estimated. In circumstances where sufficient information is not available, the liability should be recognized in the period in which sufficient information becomes available to estimate its fair value. The Company adopted FIN 47 in the fourth quarter of 2005. As a result of the adoption, the Company recorded an asset retirement obligation related to chemically treated poles and certain other assets of $981 and a cumulative effect of accounting change of $269, net of tax of $156. If the provisions of FIN 47 had been followed prior to 2005, the Company’s net income (loss) on a pro forma basis would have been as follows:
VALOR COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The asset retirement obligation on a pro-forma basis would have been as follows:
(22)
Quarterly Data (unaudited)
In the first quarter of 2005, the Company completed the Offering and amended its senior credit facility. Expenses related to the Offering that were recorded in the three months ended March 31, 2005 include the following:
•
$29,262 in fees and expenses associated with the Company’s repayment of existing indebtedness, including write-off of certain deferred debt costs, prepayment premiums and breakage fees;
•
$1,693 in compensation expense for the portion of cash transaction bonuses that were paid to members of the Company’s management team; and
•
$6,387 in compensation expense for restricted shares issued to members of the Company’s management team.
In the third quarters of 2005 and 2004, the Company recorded impairment charges of $2,339 and $6,678, respectively, related to its unconsolidated cellular partnerships (see Note 5 for further information).
In the fourth quarter of 2005, the Company incurred $3,306 of costs related to its pending merger with Alltel.
In the second quarter of 2004, the Company made a transition payment of $5,000 to its Chief Executive Officer and expensed $17,988 due to the purchase of substantially all outstanding equity interests from a group of individual investors in connection with its reorganization (see Note 20 for further information).
In the third quarter of 2004, the Company expensed $6,957 of offering costs as a result of our decision to not pursue the previously planned public offering of income deposit securities (see Note 20 for further information).
In the fourth quarter of 2004, the Company recorded a $62,975 loss on extinguishment of debt and recorded approximately $5,118 in compensation expense related to bonuses paid to executive management and others as a result of their efforts to complete the debt recapitalization and their past service to Valor (see Note 20 for further information).
VALOR COMMUNICATIONS GROUP, INC.
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
(1)
Deductions represent write-offs net of recoveries.
S-1