ITEM 1. BUSINESS
GENERAL
Telecomunicaciones de Puerto Rico, Inc. (“we” or the “Company”), a Puerto Rico corporation, is the largest telecommunications service provider in Puerto Rico and the seventh largest local exchange carrier in the United States as measured by access lines in service. Wireline service, which has been provided since 1914, is marketed under the Puerto Rico Telephone (“PRT”) brand. At December 31, 2005, we had approximately 1.1 million access lines in service, including 841,000 residential and 269,000 business lines. We market our cellular service under the Verizon Wireless brand, which is Puerto Rico’s second largest wireless service provider.
We have invested approximately $1.4 billion from the date of the Acquisition (as defined below) through December 31, 2005 to expand and enhance our network. In 2006 we expect to invest an additional $154 million in capital expenditures. Our digital switching wireline network encompasses over approximately 90,200 fiber miles with speeds of up to OC-192 and supplies direct fiber optic connections to more office buildings than any other service provider on the island. Our cellular network utilizes the code division multiple access (“CDMA”) standard and the time division multiple access (“TDMA”) standard. During 2003, the Company decided to migrate all TDMA clients to the CDMA network. We have invested approximately $137 million since 2001 in a network overlay using the CDMA standard.
BUSINESS OVERVIEW AND CORPORATE RESTRUCTURING
The Company holds 100% of the common stock of Puerto Rico Telephone Company, Inc. (“PRTC”), PRT Larga Distancia, Inc. (“PRTLD”), and Datacom Caribe, Inc. (“Datacom”). The Company holds a 67% interest in Coqui.net Corporation (“Coqui.net”), in which Popular, Inc., one of our shareholders, holds the remaining 33% interest. The Company also holds a 24% interest in Verizon Information Services Puerto Rico, Inc. S en C. (“VISI”), in which GTE Holdings (Puerto Rico) LLC, our majority shareholder, holds a 36% interest. PRTC, the incumbent local exchange carrier for the island of Puerto Rico, provides both wireline and wireless services (the latter using the Verizon Wireless brand name). The Company’s off-island long distance service is provided by PRTLD and its Internet access service is provided by Coqui.net. Directory publishing revenues are generated through VISI.
GTE Corporation (“GTE”), through its subsidiary GTE Holdings (Puerto Rico) LLC, acquired a 40% interest in and management control over the Company on March 2, 1999 from Puerto Rico Telephone Authority (“PRTA”), an entity of the Commonwealth of Puerto Rico (the “Acquisition”). In connection with the Acquisition, Popular, Inc. acquired a 10% interest in the Company. GTE and Bell Atlantic Corporation merged on June 30, 2000 to form Verizon Communications Inc. (“Verizon”). On January 25, 2002, GTE Holdings (Puerto Rico) LLC and Popular, Inc. acquired an additional 12% and 3% interest in the Company, respectively, by exercising an option each had held since the Acquisition. Verizon and Popular, Inc. acquired the additional ownership interest from PRTA Holdings Corp., a subsidiary of the PRTA (“PRTA Holdings”). Verizon and Popular, Inc. paid PRTA Holdings $138 million and $34 million, respectively, for a total of $172 million in cash for the additional 3,750,000 shares at a $45.9364 per share price established in a share option agreement entered into at the time of the Acquisition. As a result, Verizon owns 52%, Popular owns 13%, PRTA owns 28% and the Employee Stock Ownership Plan (“ESOP”) owns 7% of the outstanding capital stock of the Company. The Company is an affiliate of Verizon, which consolidates the Company’s financial results with its own financial results.
PRTC/VERIZON WIRELESS MERGER
On May 1, 2002, the Company completed a tax-free reorganization whereby it merged Verizon Wireless Puerto Rico, Inc. (“Verizon Wireless”) into PRTC. Prior to the merger, the Company created a new wholly-owned subsidiary, PRTLD, to carry the off-island long distance business previously provided by Verizon Wireless. The objectives of the reorganization were to: (i) enable the Company to integrate its wireline and wireless operations without jeopardizing the continuity of its off-island long distance license, (ii) simplify the Company’s overall corporate structure to reduce administrative costs, and (iii) provide better control and monitoring of the Company’s off-island long distance business and increase its potential for growth in Puerto Rico.
You can find additional business information in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
STRATEGY
We expect to maintain our wireline market leadership position by improving customer service, providing value, and meeting increasing customer bandwidth requirements. Customer value will continue to be delivered through bundled plans, including offerings of long distance, Internet, Digital Subscriber Line (“DSL”), wireless access, and value-added local services, such as caller ID, call forwarding and call waiting. Our network deployment plans are designed to meet business and government requirements for dedicated high-speed bandwidth access, as well as residential consumer demand for DSL service.
Our wireless strategy is to provide the best customer value in wireless services with the highest quality of network. We plan to invest $45 million in 2006 to add the capacity necessary to meet our growing customer base and to extend our high speed EV-DO service beyond the metro area. We believe that we will continue to improve customer satisfaction by providing the latest wireless entertainment and productivity service.
COMPETITION
The Company operates in a highly competitive telecommunications market. All wireline services, including local, long distance, Internet access and data services, face competition from various providers including a facilities-based local carrier, interexchange carriers, resellers, cable providers, and Internet service providers. The Company currently maintains its position as the leading wireline service provider in Puerto Rico.
The wireless telephone service market is significantly competitive. In the wireless market, the Company competes against five other wireless carriers and is second in wireless market share operating under the Verizon Wireless Brand.
We expect competition to intensify as a result of the higher penetration levels that currently exist in the wireless industry, development of new technologies and new products and services. We believe that the most important competitive factors in our wireless industry are the following:
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Pricing: The wireless service and equipment pricing is mainly determined by competition. As a result, wireless market prices have declined over the last several years and may continue to decline in the future due to increased competition.
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Customer Service: The quality customer service is essential to ensure the retention of our customers and to attract new customers.
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Product Development: We are committed to continue pursuing the development of our services, products and devices maximizing the use of new technologies.
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Distribution: The key to achieve sales success in the wireless business is the reach and quality of sales channels and distribution points, which is considered an important ingredient in achieving-leading profitability.
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Capital Resources: In order to expand the capacity and coverage of their networks and introduce new products and services, wireless providers require significant capital resources. As of the result of the competitive environment, the Company has been forced to introduce new service offerings at lower prices, to increase advertising spending, to offer equipment discounts expenses, and to increase the capital investment to ensure we maintain or enhance the service quality.
BUSINESS SEGMENTS
We have two reportable segments: Wireline and Wireless. For additional information on our reportable segments, see Note 17 to our consolidated financial statements included under Part II, Item 8, “Financial Statements and Supplementary Data.”
The Wireline segment consists of:
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Local services, including basic voice, telephone and telecommunications equipment rentals, value-added services, high-speed data services and Internet access;
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Long distance services including direct dial on-island and off-island, operator assisted calls, and prepaid calling cards;
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Access services, to long distance carriers, competitive local exchange carriers, and wireless operators for originating and terminating calls on our network;
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Directory publishing rights revenues; and
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Telecommunication equipment sales and billing and collection services to competing long distance operators in Puerto Rico.
The Wireless segment consists of:
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Postpaid and prepaid cellular service; and
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Wireless equipment sales.
WIRELINE
LOCAL SERVICES
Local services include basic voice services, value-added services, high-speed data services, Internet, and deferred activation and installation services. The following table reflects the breakdown of residential and business access lines in service, excluding public phones, direct inward dialed business lines, wide area telecommunications services lines, and private branch exchange trunks:
ACCESS LINES IN SERVICE
BASIC VOICE SERVICE
Basic voice service is the largest component of local service revenues, generating $340 million, or 27%, of total revenues for the year ended December 31, 2005, representing an increase of $11 million, or 3%, as compared to the same period in 2004. The increase is mainly attributed to the Extended Area Service (“EAS”) surcharge. Basic voice is a regulated service and rate structures have not changed since 1982. Rates are categorized as either residential or business/government and are further divided into four zones based on town boundaries. Residential customers have a choice of selecting an unlimited local calling plan or a measured service plan at a fixed price of 13 cents per message unit within a local calling area.
In 2004, as part of the Company’s value added services, the Company reduced its local calling areas from 68 to 10 larger calling areas as part of a four-phased reduction plan resulting from a study of customers calling patterns and the commercial zones movement.
Business and Government customers pay basic local rate by principal line ranging from $35.00 to $38.25 per month. In 2005, Business and Government average revenue per user (“ARPU”) was $56.50, excluding Internet and long distance services. The unlimited local service plan for residential customers varies significantly by zone. San Juan and Ponce residential customers, who are in zone 1, pay $18.80 per month while customers in the rural area, who are in zone 4, pay $8.45 per month, excluding applicable EAS surcharges. The EAS surcharge of $2.25 per line has been gradually phased in, with implementation completed in December 2005. In 2005, residential basic ARPU was approximately $25.66, excluding Internet and long distance services and a Federal Communications Commission (“FCC”) imposed subscriber line charge of $6.50 per month to primary residential customers. For single-line business customers the subscriber line charge is also equal to $6.50, while $9.20 per month is charged to multi-line business customers. These subscriber line revenues are classified as access revenues. These rates also exclude other enhanced services such as directory assistance and white-page directory listings.
TELEPHONE RENTAL
Approximately 17% of our single-line business customers and 39% of our residential customers rent telephones. We generated $13 million in revenues from telephone rentals for the year ended December 31, 2005, representing a decrease of $1 million, or 7%, as compared to the same period in 2004, as customers have increasingly preferred to purchase telephone equipment over renting. Rental levels are high compared to those of U.S. mainland operators, as we own the inside wire on many of our customer’s premises and must maintain the inside wire and phone.
VALUE - ADDED SERVICES
Value-added services include over 16 voice features, such as caller ID, call waiting, call forward, anonymous call reject and voice mail. Charges for these features range from $1.75 to $7.75 per month. Some of these features are also sold in discounted bundled packages. Approximately 40% of our residential customers purchase at least one of these features. Our revenues from value-added services were $42 million for the year ended December 31, 2005, representing a decrease of $4 million, or 9%, as compared to the same period in 2004, attributed primarily to our decrease in access lines and the increase in discounted bundled packages, which are attractive to the customers due to higher features at lower rates.
SPECIAL SERVICES
Special services include private high-speed dedicated lines marketed to businesses, wireless carriers and other service providers for data transport and network connectivity. Our revenues from special services were $98 million for the year ended December 31, 2005, representing an increase of $8 million, or 9%, as compared to the same period in 2004. The increase in revenue is mainly related to the increase in demand, primarily from expanded network coverage by wireless carriers.
INTERNET ACCESS
We market unlimited dial-up Internet access through Coqui.net, one of our subsidiaries, under two brands (PRT.net and Coqui.net) which averaged revenue is $15 per month for 2005. We generated $33 million of revenue in 2005 from approximately 187,000 Internet access customers at December 31, 2005, same amount of revenues and approximately 19,000 customers over prior year, or 11% in customers. We continue to penetrate the Internet market by offering customers high-speed access at lower or competitive rates.
PUBLIC PHONES
Public telephone revenues in 2005 were $1 million, a decrease of $4 million, or 83%, from the prior year. In May 2005, the Company completed the sale of its public telephone assets to a local telephone service provider.
NETWORK ACCESS
Network access services are provided to long distance carriers, resellers, other local exchange carriers, cellular and paging companies for the origination and termination of calls on our network. These entities pay access charges based on specific agreements, some of which have durations of one to three years. We also collect network access fees directly from our customers from FCC-mandated line charges.
Network access revenues for the years ended December 2005, 2004 and 2003 were $235 million, $269 million and $295 million, respectively, and included the following amounts:
Long-term and High Cost federal subsidies are received through pooling arrangements administered by the National Exchange Carriers Association (“NECA”). On October 21, 1999, the FCC adopted a new high cost support mechanism, which has resulted in the phase out of the Company’s High Cost Subsidy revenues. For 2004 and 2005, the subscriber line charge rates remained constant at $6.50 per month for primary residential and single line business customers and at $9.20 per month for multi-line business customers.
The decrease in network access revenues of $34 million in year 2005 was mainly due to a decrease in intra-island minutes of use (MOU) of $17 million mainly as a result of the elimination of the intrastate carrier common line rate and the decrease in the termination and end office rates. Also, federal long-term support subsidies revenue decreased by $8 million due to a decrease in the actual customer base, and off-island switched & common carrier line revenue decreased by $8 million due to an adjustment to the interstate common line revenue estimate.
LONG DISTANCE
Long distance revenues include direct dial on-island and off-island calls, operator-assisted calls, and prepaid calling cards. The following chart shows our MOU in the on-island and off-island long distance market for the years ended December 31, 2005, 2004 and 2003, respectively:
Long distance revenues of $69 million in 2005 remained constant as compared with 2004. Although, long distance MOU decreased by 51% compared with 2004, revenues remained constant, mainly due to an unfavorable adjustment of receivable balances reflecting billed activity for current and prior periods recognized during year 2004 and the reduction in the number of local calling areas from 68 to 10.
DIRECTORY SERVICES
We received $19 million in publishing revenue in 2005 under a revenue sharing arrangement with VNU World Directories, Inc. (“VNU”). VNU is the publisher of white and yellow page directories distributed in Puerto Rico for which there is no other significant competitive product. We entered into a 95-year agreement in 1999 with Verizon Information Services, Inc. a joint venture among VNU, Verizon, and ourselves which provides us with a right of 35% of yellow page advertising revenues, plus billing and collection fees.
In February 2006, the Company announced that as part of an agreement for the acquisition of the directory operations in Latin American between Verizon and a US investors firm, it signed an agreement to sell its equity interest in the Puerto Rico directory operation and the right to receive 35% of the revenues from the publication of directory advertising. See Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations”
BILLING AND COLLECTION SERVICES
We generated revenues of $5 million in 2005 from billing and collection services primarily from AT&T and TLD, the two largest competitive off-island long distance carriers, which represents a decrease of $2 million from the prior year due to lower retail long distance messages processed for these carriers. Our contracts with TLD and AT&T expire in May 1, 2006 and June 30, 2007, respectively. Together, these carriers represented approximately 77% of our total billing and collection fees for 2005.
WIRELESS
The following table shows the breakdown of our cellular and paging customers:
CELLULAR SERVICE
Cellular demand has grown rapidly in recent years due to increased competition, attractive price plans, prepaid calling cards, and wide market acceptance. We offer digital cellular service under the Verizon Wireless brand in the B block 850-megahertz frequency using both TDMA and CDMA. We have invested $137 million since 2001 in a CDMA overlay network, including $27 million during 2005, and commenced selling this service in December 2001.
At December 31, 2005, there were six facility-based cellular providers offering service with varying coverage in Puerto Rico. Competition in the market has resulted in the emergence of a variety of plans with large bundles of free night and weekend minutes as well as free incoming calls and nation-wide long distance.
We have 32 stores and kiosks throughout the island, which generate approximately half of our postpaid and prepaid gross additions and the remaining portion is sold through various dealers and agent outlets. Roaming agreements have been signed with various cellular carriers, including Verizon Wireless, Inc. and BellSouth to increase coverage for our customers on the U.S. mainland. We also offer roaming in other countries, including the Dominican Republic, through Verizon Dominicana (formerly Codetel), a Verizon affiliate, and in the U.S. Virgin Islands.
The number of postpaid customers grew by 32% over the prior year. Also, we experienced a 6% increase in the number of prepaid customers. The increases reflect our focus on quality, long-term postpaid customers, while still maintaining a substantial prepaid
subscriber base. In late 2001,we began marketing our cellular service under the Verizon Wireless brand as part of our strategy to align our product and service offerings with those of Verizon Wireless in the U.S.
ARPU for all cellular customers was $44 in 2005 resulting in an increase of $1 in comparison with prior year. Postpaid ARPU was $53 in 2005, a $1 decrease from the prior year and prepaid ARPU was $14 in 2005, a $1 decrease from the prior year. Postpaid customer churn was 2.1% per month in 2005, a decrease of approximately 0.5% per month from the prior year.
NETWORK INFRASTRUCTURE
We have invested approximately $1.4 billion from the date of the Acquisition through 2005 to expand and enhance our networks, including $146 million invested in 2005.
WIRELINE NETWORK
Our network has evolved into a multi-protocol network, handling SONET, ATM and IP with the following characteristics:
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Our 100% digital switching network includes 29 local host central offices and two access tandems to ensure redundancy and network reliability. Also, we have a long distance switch to provide access to national and international long distance calls.
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Approximately 90% of our transmission circuits use fiber optic systems consisting of approximately 90,200 miles of fiber optic cable in fiber-ring and point-to-point configurations.
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The entire fiber optic backbone transport network consists of self-healing SONET rings operating at bandwidths up to OC-192, with new equipment installed capable of evolving to DWDM. Fiber optic cable facilities have been provided to over 270 office buildings for business and residential customers. Also, a MAN (Metro Area Network) installed in the Metropolitan Area to provide Ethernet services.
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Approximately 39% of the outside cable serving the local loop is underground and buried.
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Our network is monitored by a network monitoring center, which operates 24 hours per day, with the capabilities to monitor customers’ IP based networks.
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Our Remote Access Server (“RAS”) network includes 28 nodes located throughout the island connecting Internet customers of various ISP providers through more than 40,000 modems.
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DSL service has been extended to 229 sites equipped with an aggregate of 104,000 ports. As of December 31, 2005, we had approximately 77,000 DSL customers, representing an increase of 37,000 customers as compared to last year.
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Our ATM network provides ATM and Frame Relay services and also serves as the transport medium for DSL and RAS networks. This network also provides PRTC with IP capability.
WIRELESS NETWORK
We operate a CDMA and TDMA digital network under the “B” block 850 megahertz (“MHz”) frequency through 280 wireless cell sites covering the entire island. Also, we operate a 10 MHz license in the “E” block of the 1900 MHz frequency band. We have invested approximately $275 million since the Acquisition in our wireless network and approximately $137 million since 2001 in a CDMA overlay network as part of our business strategic plan to fully migrate our customers to the CDMA network by the end of 2005. See Part II, Item 8, “Financial Statements and Supplementary Data”.
By the end of year 2006, we will expand our network adding 199 new carriers and 20 new cell sites. On the data side, we launched the Evolution Data Optimized (“EVDO”) network in 2004 which allows our wireless customers to have internet access with peak speeds up to 2.4 Mega bits per second (“Mbps”).
EMPLOYEES
The Company’s workforce totaled approximately 4,900 full-time employees at December 31, 2005, 76% of which are represented by two unions, the Union of Independent Telephone Workers, known as UIET, and the Brotherhood of Independent Telephone Workers, known as HIETEL.
A new 5-year contract was signed with the UIET union effective January 18, 2006, which covers approximately 2,300 member-employees. The UIET is the larger of the two Company Unions, and is comprised mostly of field and operations technicians. With the HIETEL union, a new 4-year contract was signed effective January 1, 2004, involving approximately 1,400 member-employees.
CONCESSION AND LICENSES
We hold concessions, licenses and permits adequate for the conduct of our business in the markets which we serve. Advances in technology, together with a number of regulatory, legislative and judicial actions, continue to accelerate and increase competition in those markets we serve.
ENVIRONMENTAL REGULATIONS
Our operations are subject to U.S. federal and local laws and regulations governing the use, storage, disposal of, and exposure to, hazardous materials, the release of pollutants into the environment and the remediation of contamination. As an owner or operator of facilities in which hazardous materials are used, we could be subject to environmental laws that impose liability for the entire cost of cleanup at contaminated sites, regardless of fault or the lawfulness of the activity that resulted in the contamination. We believe, however, that our operations are in substantial compliance with applicable environmental laws and regulations.
Many of our properties contain underground and aboveground storage tanks used for the storage of fuel. Some of these tanks may have leaked or otherwise caused contamination. We have cleaned known contamination at a number of properties. We cannot be certain, however, that we have discovered all contamination or that the regulatory authorities will not request additional remediation at sites that have previously undergone remediation.
Our cellular operations are also subject to regulations and guidelines that impose a variety of operational requirements relating to radio frequency emissions. The potential connection between radio frequency emissions and certain negative health effects, including some forms of cancer, has been the subject of substantial study by the scientific community in recent years. To date, the results of these studies have been inconclusive. Although we have not been named in any lawsuits alleging damages from radio frequency emissions, it is possible that we could be sued in the future, particularly if scientific studies conclusively determine that radio frequency emissions are harmful.
REGULATORY ENVIRONMENT IN PUERTO RICO
We are regulated by the FCC and the Telecommunications Regulatory Board of Puerto Rico (“TRB”), and are subject to the Federal Telecommunications Act of 1996 (the “Act”) and the Puerto Rico Telecommunications Act. The Act opened our local exchange market to competition. There is one facility-based competitive local exchange carrier and four resellers of wireline local service on the island. The average discount offered to resellers was approximately 18% from retail rates based on negotiated agreements. Dialing parity, which opened up the on-island long distance market to competition, was introduced in February 1999. The Act, regulatory and judicial actions and the development of new technologies, products and services have created opportunities for alternative telecommunications service providers, many of which are subject to fewer regulatory constraints. We are unable to predict definitively the impact that the ongoing changes in the telecommunications industry will ultimately have on our business, results of operations or financial condition. The financial impact will depend on several factors, including the timing, extent and success of competition in our markets, the timing and outcome of various regulatory proceedings and any appeals, and the timing, extent and success of our pursuit of new opportunities resulting from the Act and technological advances.
The Company’s wireless business is not subject to price regulation.
INFORMATION ON OUR INTERNET WEBSITE
Our website address is www.telefonicapr.com and contains links to our filings with the Securities and Exchange Commission (the “SEC”). Information contained on our website is not incorporated by reference in, and should not be considered a part of, this Annual Report on Form 10-K. We have adopted a written Code of Ethics applicable to all directors, officers and employees which is also available on our website. The Company intends to disclose any amendments to or waivers of the Code of Ethics on behalf of the Company’s Chief Executive Officer, Chief Financial Officer, Controller, and persons performing similar functions on the Company’s website at the Internet website address set forth above.
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
In this Annual Report on Form 10-K, the Company has made forward-looking statements. These statements are based on the Company’s estimates and assumptions and are subject to certain risks and uncertainties. Forward-looking statements include information concerning possible or assumed future results of operations, as well as those statements preceded or followed by such words as “anticipates,” “believes,” “estimates,” “expects,” “hopes,” “targets” or similar expressions.
Future results could be affected by subsequent events and could differ materially from those expressed in the forward-looking statements. If future events and actual performance differ from the Company’s assumptions, the actual results could vary significantly from the performance projected in the forward-looking statements.
The following important factors could affect future results and could cause those results to differ materially from those expressed in the forward-looking statements: (1) materially adverse changes in economic and industry conditions in Puerto Rico, and labor matters, including workforce levels and labor negotiations, and any resulting financial and/or operational impact, in the markets served by us; (2) material changes in available technology; (3) the final resolution of regulatory initiatives and proceedings, including arbitration proceedings pertaining to, among other matters, the terms of interconnection, access charges, universal service, unbundled network elements and resale rates; (4) changes in our accounting policies that may be required by regulatory agencies, including the SEC or that result from changes in the accounting policies or their application, which could result in an impact on earnings; and (5) the extent, timing, success and overall effects of competition from others in the Puerto Rico telecommunications service industry.
Although the Company believes the expectations reflected in its forward-looking statements are reasonable, the Company cannot guarantee its future performance or results of operations. All forward-looking statements in this report are based on information available to the Company on the date of this report; however, the Company is not obligated to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. The risks described above and elsewhere in this report, including in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” should be considered when reading any forward-looking statements in this report. Given these uncertainties and risks, the reader should not place undue reliance on these forward-looking statements.
ITEM 1A.
ITEM 1A. RISK FACTORS
Our business, financial condition or results of operations could be adversely affected by any of the following risk factors.
We face significant competition that may reduce our market share and adversely affect our profit margins.
We face significant competition in our industry, which impacts our ability to retain customers and to attract new customers. In particular, the wireless telephone service is highly competitive. Our wireless segment competes against five other wireless carriers in the markets we serve. Competition for customers is based principally upon services and features offered, system coverage, quality of the wireless system, price, customer service and network capacity. We expect competition to intensify as a result of the development of new technologies, products and services. The rapid development of new technologies, services and products has eliminated the traditional lines between local, long distance, wireless, cable and Internet communication services and brought new competitors to our markets, including other telephone companies, cable companies, wireless service providers, satellite providers, electric utilities, and providers of VoIP services. While these changes have enabled us to offer new types of services, they have also allowed other service providers to broaden the scope of their own competitive offerings. Our ability to compete successfully will depend on how successfully we anticipate and respond to various competitive factors, including new services that may be introduced by our competitors, changes in consumer preferences, demographic trends and pricing pressures. Because many of our competitors are subject to lower cost structures than we are, due in part to the absence of a unionized work force and fewer retirees, they may be able to offer services at lower prices. The resulting pressure on the price of services provided by us may result in reduced profit margins.
If we are unable to meet future advances in competing technologies in the telecommunications industry on a timely basis or at an acceptable cost, we may experience a decline in demand for our services.
For several years, the telecommunications industry has been experiencing dynamic changes as new technologies have developed that offer consumers an array of choices for their communications needs. Some of the changes that the wireless telecommunications industry has been experiencing include development of industry standards, improvements in the capacity and quality of digital technology, development of data and broadband capabilities and migration to next-generation networks. In order to grow and remain competitive, we will need to adapt to future changes in technology, enhance our existing offerings, introduce new offerings to address our customers’ changing demands, and invest in capital projects. If we are unable to meet future advances in competing technologies on a timely basis or at an acceptable cost, we could lose customers to our competitors. In general, the development of new services in our industry requires us to anticipate and respond to the varied and continually changing demands of our customers. We may not be able to accurately predict technological trends or the success of new services in the market. In addition, there could be legal or regulatory restraints to our introduction of new services. If these services fail to gain acceptance in the marketplace, or if costs associated with implementation and completion of the introduction of these services materially increase, our ability to retain and attract customers could be adversely affected.
The final resolution of existing regulatory initiatives and proceedings or the adoption of new laws or regulations could adversely affect our business plans or results of operations.
Our operations are subject to substantial regulation by the FCC, TRB, and other U.S. federal and local government agencies. FCC regulations and government policy generally promote robust competition, and new rules or changes to existing rules and requiring wireless local number portability for customers changing wireless local carriers, increase this trend and contribute to pressure on churn and margins. It is impossible to predict with any certainty the outcome of pending federal and local regulatory proceedings relating to our provision of retail or wholesale services, or the reviews by U.S. federal or local courts of regulatory rulings. Unless we are able to obtain relief, existing laws and regulations may inhibit our ability to expand our business and introduce new products and services. In addition, the adoption of new laws or regulations or changes to the existing regulatory framework could adversely affect our business plans, results of operations and increase subscriber churn. For more information regarding our regulatory matters, see Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Regulatory and Other Matters.” Our operations could be adversely affected to the extent that we are unable to rebalance our tariff structure in order to mitigate the inflation effect and the rise in cost of operations.
We are also subject to environmental protection and health and safety regulation, including limits on radio frequency energy from wireless handsets and towers, the use, storage, disposal of, and exposure to, hazardous material, the release of pollutants into the environment and the remediation of contamination. The failure to comply with any of these regulations, even if hardware and software solutions are not readily available from manufacturers and suppliers, can result in significant penalties.
Our cellular operations are also subject to regulations and guidelines that impose a variety of operational requirements relating to radio frequency emissions. Portable communications devices have been alleged to pose health risks, including cancer, due to radio frequency emissions from these devices. A number of studies have been conducted to examine the health effects of wireless phone use. To date, the results of these studies have been inconclusive. Although we have not been named in any lawsuits alleging damages from radio frequency emissions, it is possible that we could be sued in the future, particularly if scientific studies conclusively determine that radio frequency emissions are harmful, resulting in a material adverse effect on our results of operations, financial condition and/or prospects.
Changes in the labor negotiations and the effect of our labor strikes could affect the results of operations.
The potential impact of any change in our labor negotiations could adversely affect our costs and results of operations. Approximately 76% of our workforce is represented by two unions, the Union of Independent Telephone Workers, or the UIET, and the Brotherhood of Independent Telephone Workers, or the HIETEL. As such, 76% of our labor and benefits expenses relate to union employees. Our cost structures are higher than many of our competitors due in part to the higher costs associated with a unionized work force.
We signed a new five-year contract with the UIET effective January 18, 2006 and a new four-year contract with the HIETEL effective January 1, 2004. We cannot, however, predict the outcome of future collective bargaining negotiations, and labor strikes may occur that could adversely affect our operations.
Changes in economic and industry condition in Puerto Rico could adversely affect the results of operations
Our business depends on the economic and industry conditions in which we operate. Our business may be materially adversely affected by events such as hurricanes, labor strikes, and other factors that may generally affect our operations. These events can adversely affect our ability to offer telecommunication services. Any actual or perceived change in Puerto Rico’s political status with the United States could affect the economy of Puerto Rico. The ultimate effect of possible changes in Puerto Rico’s governmental and political status is uncertain and, accordingly, we cannot assure you that such changes will not materially adversely affect our business and results of operations. Our operations in Puerto Rico may be adversely affected if changes in tax benefits available to businesses in Puerto Rico cause companies to reduce their business activities there.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
ITEM 2. PROPERTIES
PROPERTY, PLANT AND EQUIPMENT
Gross investment in property, plant and equipment was approximately $4.0 billion at December 31, 2005 and 2004, as follows:
“Outside plant” consists primarily of aerial cable, underground cable, conduit and wiring, and telephone poles. “Central office and transmission equipment” mainly consists of switching equipment, transmission equipment and related facilities. “Other equipment” includes public telephones, motor vehicles, special purpose vehicles, furniture, and capital leases. “Land and buildings” consists of land, buildings and leasehold improvements.
PROPERTIES
We have facilities in all the major population centers of San Juan, Mayagüez, Ponce, Fajardo, Humacao, Arecibo, Aguadilla, and Guayama and in some other smaller towns. Facilities as of December 31, 2005 include the following:
We believe that all of these properties are generally in good operating condition and are adequate to satisfy the needs of the business.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company is a defendant in various legal matters arising in the ordinary course of business. Management, after consultation with legal counsel, believes at this time that the resolution of these matters will not have a material adverse effect on the Company’s financial position and results of operations. See Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Regulatory and Other Matters” for more information regarding legal and regulatory matters.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
MARKET FOR COMMON STOCK
There is no established trading market for the Company’s common stock. The shares are valued annually by the ESOP trustee’s financial advisors. The appraisal is used to value cash distributions to ESOP participants and measure the Company’s share performance for employees who participate in the ESOP Plan.
HOLDERS
There were 25 million outstanding shares of common stock and four shareholders of record at March 31, 2006. See Part II, Item 12, “Security Ownership of Certain Beneficial Owners and Management” for shareholder information.
DIVIDENDS
Under the Company’s shareholders agreement, to the extent funds are legally available, the Company is required to pay quarterly dividends on its common stock equal to at least 50% of consolidated net income. During 2005, the Company declared and paid legal dividends of approximately $63 million, or $2.528 per share. During 2004, the Company declared and paid legal dividends of approximately $66 million, or $2.631 per share.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION
OVERVIEW
We are the largest telecommunications service provider in Puerto Rico and the seventh largest local exchange carrier in the United States as measured by access lines in service. We have two reportable segments: Wireline and Wireless. Wireline service, which has been provided since 1914, is marketed under the PRT brand. At December 31, 2005, we had approximately 1.1 million access lines in service, including 841,000 residential and 269,000 business lines. We market our cellular service under the Verizon Wireless brand. The Company’s off-island long distance service is provided by PRTLD and its dial-up Internet access service is provided by Coqui.net. Directory publishing revenues are generated by VISI.
We have invested approximately $1.4 billion from the date of the Acquisition through December 31, 2005 to expand and enhance our network. In 2006 we expect to invest an additional $154 million in capital expenditures. Our digital switching wireline network encompasses over approximately 90,200 fiber miles with speeds of up to OC-192 and supplies direct fiber optic connections to more office buildings than any other service provider on the island. Our cellular network utilizes the code division multiple access (“CDMA”) standard and the time division multiple access (“TDMA”) standard. During 2003, the Company decided to migrate all TDMA clients to the CDMA network. We have invested approximately $137 million since 2001 in a network overlay using the CDMA standard.
The sections that follow provide information concerning our operations and investments, both at the consolidated and segment levels, and include discussions of our results of operations, financial position and sources and uses of cash, as well as significant future commitments. In addition, we have highlighted key trends and uncertainties to the extent practicable. The content and organization of the financial and non-financial data presented in these sections are consistent with information used by our chief operating decision makers for, among other purposes, evaluating performance and allocating resources.
Our results of operations, financial position and sources and uses of cash in the current and future periods reflect management’s focus on the following four key areas:
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Capital Allocation - Capital spending has been, and will continue to be, directed toward growth markets, such as High-speed wireless data or Evolution Data Optimized (EV-DO) technologies. Replacement of the TDMA network and expanded services offered to enterprise markets are some examples of areas of capital spending which support these growth markets.
•
Cash Flow Generation - The financial statements reflect the emphasis of management on using cash provided by our operating and investing activities to significantly reduce debt and to fund our pension plans.
Supporting these key focus areas are continuing initiatives to more effectively package and add value to our products and services. In 2004, we introduced VoIP service that allows customers with DSL or cable-modem broadband service to make telephone calls and utilize advanced service features through an Internet connection rather than through the traditional telephone network. Innovative product bundles include local wireline services, long distance, wireless and DSL for consumer and general business retail customers. We believe that the Company’s marketing and operational efficiency efforts will enable management to counter the effects of competition and technology migration to alternative network platforms, such as wireless and VoIP. During 2004, in response to the evolving competitive landscape and customer preferences, the Company reduced the number of local calling areas from 68 to 10 calling zones.
In December 2004, the Company entered into an agreement to sell its public telephone assets, subject to certain terms and conditions, to a local public telephone service provider. The transaction received regulatory approval and the transfer of assets was completed in May 2005. The disposition of the public telephone assets will enable management to focus on higher growth areas, such as wireless and broadband.
In February 2006, the Company announced that as part of an agreement for the acquisition of the directory operations in Latin America between Verizon and a US investors firm, it signed an agreement to sell its equity interest in the Puerto Rico directory operation and the right to receive 35% of the revenues from the publication of directory advertising for $190 million, with an after-tax gain of $146 million. The Company will continue sharing data for the publication of directories under a new amended publishing agreement, and will also offer billing and collection services for the directory advertising sales to its service subscribers. The transaction is scheduled to close before the close of business on March 31, 2006.
Verizon has advised the Company that it is engaged in negotiations which may lead to the sale of its shares in the Company. If Verizon were to enter into an agreement to sell its shares, Popular, Inc. would have a right of first refusal to purchase Verizon’s shares on the same terms as are offered to Verizon. If Popular, Inc. were to decide not to exercise its right of first refusal, all of the Company’s shareholders (including Popular, Inc.) would have the right to participate in a sale by Verizon of its shares on substantially the same terms as Verizon. In the event that Verizon no longer owns at least 35% plus one share of the outstanding shares of the Company or no longer has the ability to appoint a majority of the Board of Directors of the Company, (i) the lenders under the Company’s bank credit facilities would have the right to demand a repayment of any amounts outstanding and to terminate those facilities, and (ii) if the lenders take such actions, the holders of 25% of the outstanding principal amount of each series of the Company’s senior notes would have the right to demand repayment of such senior notes.
CONSOLIDATED RESULTS OF OPERATIONS
In this section, we discuss our overall results of operations and highlight special and non-recurring items. In the following section, we review our consolidated results and the performance of our two segments.
CONSOLIDATED REVENUES
Consolidated revenues for the year 2005 increased $39 million, or 3%, to $1,253 million from $1,214 million for the same period in 2004. The increase was primarily the result of an increase in local revenues and cellular revenues, partially offset by lower network access revenues. For the year ended December 31, 2004, consolidated revenues decreased $67 million, or 5%, to $1,214 million from $1,281 million for the same period in 2003 primarily as the result of lower network access revenues and long distance revenues.
Local revenues for the year ended December 31, 2005 increased $9 million, or 2%, to $596 million compared to $587 million for the same period in 2004. This increase was driven by an increase in local voice revenues mainly due to the Extended Area Service (EAS) surcharge, partially offset by a decrease in the public phone revenue due to the disposition of these assets during 2005, and a decrease in deferred activation revenues. There was also an increase in local data revenues mainly due to the increase in DSL revenues. For the year ended December 31, 2004, local revenues decreased $18 million, or 3%, to $587 million compared to $605 million for the same period in 2003 mainly due to a decrease in local voice revenues mainly attributed to line substitution due to customer migration to the wireless network, the absence of touch tone charges, and the decrease in business measured services, offset in part by an increase in local data revenues mainly due to the increase in DSL revenues and private lines services.
Network access revenues for the year ended December 31, 2005 decreased $34 million, or 13%, to $235 million compared to $269 million for the same period in 2004. The decrease was driven by a decrease in intra-island access revenues as the Company implemented the final phase of the rate reduction agreed with the TRB in its Resolution and Order issued on February 28, 2002 (the “February 2002 Order”), a decrease in interstate regulated access revenues driven by interstate common line adjusted estimates through the NECA settlement process, and a decrease in off-island switching and special access revenue due to a decrease in average rates. See “Regulatory and Other Matters - Intra-Island Long Distance Access Rate Dispute”. For the year ended December 31, 2004 network access revenues decreased $26 million, or 9%, to $269 million compared to $295 million for the same period in 2003. The decrease was mainly driven by a decrease in intra-island access revenues resulting from the implementation of phase-in access rate reductions required by the TRB in the February 2002 Order. See “Regulatory and Other Matters - Intra-Island Long Distance Access Rate Dispute.”
Long distance revenues for the year ended December 31, 2005 remained constant at $69 million in comparison with the year ended December 31, 2004. For the year ended December 31, 2004 long distance revenues decreased $43 million, or 38%, to $69 million compared to $112 million for the same period in 2003, mainly as the result of the impact of the Extended Area Service (EAS) implementation. See “Regulatory and Other Matters - Intra-Island Long Distance Access Rate Dispute”. The reduction in revenues in 2004 also incorporates an adjustment of receivable balances reflecting billed activity. The prior periods amounts do not have a material impact in the financial statements.
Cellular revenues for the year ended December 31, 2005 increased $45 million, or 23%, to $241 million from $196 million for the same period in 2004. For the year ended December 31, 2004 cellular revenues increased $9 million, or 5%, to $196 million from $187 million for the same period in 2003. These increases were mainly the result of an increase in the number of cellular customers due to attractive price plans and the implementation of marketing strategies to align the Company’s product and service offerings with those of Verizon Wireless in the United States.
CONSOLIDATED OPERATING EXPENSES
Consolidated operating expenses for the year ended December 31, 2005 increased $102 million, or 14%, to $832 million from $730 million for the same period in 2004. For the year ended December 31, 2004 consolidated operating expenses decreased $191 million, or 21%, to $730 million from $921 million for the same period in 2003.
Cost of services and sales for the year ended December 31, 2005 increased $32 million, or 10%, to $344 million from $312 million for the same period in 2004. This increase was mainly due to an increase in cost of equipment sold, mainly wireless expenses, of $24 million, cellular roaming expenses of $5 million and, wireless data expenses of $4 million, all as a result of the significant increase in our wireless subscriber base. These increases were partially offset by lower material usage of $2 million.
For the year ended December 31, 2004, cost of services and sales decreased $2 million, or 1%, to $312 million from $314 million for the same period in 2003. This decrease was mainly due to lower labor and benefits expenses of $12 million due to a reduction in the workforce, and lower cellular roaming expenses of $3 million, partially offset by an increase in cost of equipment sold, mainly wireless, of $12 million, as a result of the corresponding significant increase in our wireless subscriber base.
Selling, general and administrative expenses for the year ended December 31, 2005 increased $70 million, or 17%, to $488 million from $418 million for the same period 2004. This increase was mainly due to the absence of the benefit recognized during the quarter ended June 30, 2004 of a $43 million reserve reversal associated with the February 2002 Order, the increase in bad debt expense of $18 million mainly due to the recognition of late payment fees, an increase in regulatory fees of $6 million due to a review of the Federal Universal Service Fund contributions, an increase in utilities of $5 million due to higher petroleum prices, partially offset by a decrease in management fees of $3 million as the Verizon Management and Technology License Agreement expired on March 2, 2004 and was replaced by a new Service Agreement.
For the year ended December 31, 2004, selling, general and administrative expenses decreased $189 million, or 31%, to $418 million from $607 million for the same period 2003. This decrease was primarily due to the absence of the $66 million pre-tax reserve for the end-user and AT&T refund referred to in the February 2002 Order recognized during the quarter ended September 30, 2003 and the $43 million reserve reversed during year 2004. See “-Regulatory and Other Matters - Intra-Island Long Distance Access Rate Dispute.” Other factors contributing to the reduction were a decrease in bad debt expense of $35 million due to a settlement with the PRDOE regarding amounts owed, the absence of a cancelled project of $29 million that required the write-off of the billing software system abandoned by the Company and recognized for the year ended December 31, 2003, a decrease in management fees of $14 million as the Verizon Management and Technology License Agreement expired on March 2, 2004 and was replaced with a new Service Agreement, and a decrease in building maintenance of $2 million due to fewer office premises.
OTHER CONSOLIDATED RESULTS
Retirement and voluntary separation provisions
In May 2005, 33 eligible HIETEL employees accepted the voluntary separation program offered by the Company in March 2005. In March 2005, 46 eligible management employees accepted the voluntary separation program offered by the Company in December 2004. These programs resulted in a provision of $1.7 million during year ended December 31, 2005.
In January 2004, 19 eligible management employees accepted the early retirement program which was offered by the Company in December 2003, which resulted in a provision of $1.6 million. During the fourth quarter of 2004, 24 eligible management employees accepted the voluntary separation program which was offered by the Company in October 2004, which resulted in a provision of $1.2 million. These programs resulted in a total provision of $2.8 million during year ended December 31, 2004.
In January 2003, 29 eligible management employees accepted the voluntary separation program which was offered by the Company in December 2002, which resulted in a provision of $1.4 million. During the second quarter of 2003, 191 union employees accepted a combined voluntary separation program and retirement program offered by the Company that closed on June 20, 2003 and June 30, 2003, respectively, which resulted in an additional provision of $3.3 million. In December 2003, the Company offered an early retirement program to eligible management employees, for which, a non-cash provision of $12.6 million was recorded relating to 147 employees who had accepted as of December 31, 2003.
Depreciation and amortization expense
Depreciation and amortization expense of $242 million for the year ended December 31, 2005 was $19 million, or 7%, lower than for the comparable 2004 period mainly due to the impact of the periodic review of the plant useful lives and the absence of the accelerated amortization of the TDMA networks during 2004, as a result of the managed migration of TDMA subscribers to the CDMA network.
Effective July 2005, the Company revised its plant useful lives estimates based on a detailed review of the lives underlying the depreciation rates. The depreciation rate revision reflects expected useful lives resulting from the impact of technology and future competition and more closely approximate the assumptions used by other telephone companies. For the year ended December 31, 2005, the revision resulted in lower depreciation expense of approximately $6.5 million than would have been recognized under the previous useful lives estimate.
Depreciation and amortization expense of $261 million for the year ended December 31, 2004 was $9 million, or 4%, higher than for the comparable 2003 period due to accelerated depreciation of the TDMA network resulting from management’s decision during 2003 to migrate all TDMA customers to the CDMA platform in 2004 and an increase in software amortization expense due to the implementation of various operational support systems.
Interest expense, net
Interest expense of $46 million for the year ended December 31, 2005 increased $3 million, or 7%, to $46 million from $43 million for the comparable 2004 period. The increase was primarily due to higher interest yields on bonds and bank debt, to 4.70% from 2.96% for the comparable 2004 period.
Interest expense of $43 million for the year ended December 31, 2004 decreased $10 million, or 19%, to $43 million from
$53 million for the comparable 2003 period. The decrease was primarily due to the absence of $7 million of interest expense associated with the pre-tax reserve recognized during the same period in 2003 for the end-user and AT&T refund referred to in the February 2002 Order and the absence of $3 million of interest expense associated with the write-off for the billing software system abandoned by the Company during year ended December 31, 2003.
Equity income from joint venture
The $3 million, $2 million, and $2 million equity income from joint venture for the years ended December 31, 2005, 2004, and 2003, respectively, were generated from our 24% interest in VISI, the largest yellow page publishing company in Puerto Rico.
Minority interest in consolidated subsidiary
The $3 million, $3 million, and $2 million minority interest included in the Company’s results of operations for the years ended December 31, 2005, 2004, and 2003, respectively, reflects the 33% interest in Coqui.net, held by Popular, Inc., one of our shareholders.
Asset Impairment Charge
Management decided to migrate in 2004 all TDMA clients to the CDMA network and dispose of the TDMA network. The Company determined that an indicator of impairment existed because the expected undiscounted cash flows from TDMA network were lower than its carrying amount. Since the estimated fair value of $26 million was less than the $37.8 million carrying amount of the TDMA network as of December 31, 2003, the Company recorded an impairment loss of $11.8 million.
Income taxes
The effective income tax rate is the provision for income taxes as a percentage of income before tax from continuing operations. A $50.8 million tax provision for the year ended December 31, 2005 reflects a 38.2% effective tax rate. The difference of $1.1 million between the effective and the statutory tax rate of 39%, primarily represents permanent differences related to recognition of equity income from the joint venture and amortization of tax deductible goodwill.
A $67.8 million tax provision for the year ended December 31, 2004 reflects a 37.9% effective tax rate. The difference of $2 million between the effective and the statutory tax rate of 39%, primarily represents permanent differences related to recognition of equity income from the joint venture and amortization of tax deductible goodwill.
Cumulative effect of accounting change
Under the provisions of SFAS No. 143, we are required to exclude costs of removal from our depreciation rates for assets for which the removal costs exceed salvage value. Accordingly, in connection with the initial adoption of this standard on January 1, 2003, we have reversed accrued costs of removal in excess of salvage value from our accumulated depreciation accounts for these assets. The adjustment was recorded as a cumulative effect of an accounting change, resulting in the recognition of an estimated gain of $117 million ($71 million after tax). Effective January 1, 2003, we began expensing costs of removal in excess of salvage value for these assets in the period in which they are incurred.
Effective January 1, 2003, the Company changed its method of accounting for revenues derived from directory publishing rights and related expenses from the point-of-publication method to the amortization method. Although both methods fully comply with accounting principles generally accepted in the United States, the Company adopted the amortization method because it is becoming the industry standard. The cumulative effect of applying this accounting change to prior years was recognized as of January 1, 2003 as a one-time, non-cash loss of $17 million ($13 million, after tax).
SEGMENT RESULTS OF OPERATIONS
The Company has two reportable segments, Wireline and Wireless. See Note 18 to the consolidated financial statements for additional information on the Company’s segments. Reclassifications of prior period’s data have been made to conform to the current period’s presentation.
The Wireline segment consists of:
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Local services, including basic voice, telephone and telecommunications equipment rentals, value-added services, high-speed data services, and Internet access;
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Long distance services including direct dial on-island and off-island, operator assisted calls, and prepaid calling card;
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Access services to long distance carriers, competitive local exchange carriers, and wireless operators for originating and terminating calls on the Company’s network;
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Directory publishing rights services; and
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Telecommunication equipment sales and billing and collection services to competing long distance operators in Puerto Rico.
The Wireless segment consists of:
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Postpaid and Prepaid services; and
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Wireless equipment sales.
RESULTS OF OPERATIONS REVENUE WIRELINE
Wireline revenues include local service, network access, long distance, directory and other revenues. For the year ended December 31, 2005, wireline revenues decreased $10 million, or 1%, to $994 million from $1,004 million for the same period in 2004. For the year ended December 31, 2004, wireline revenues decreased $85 million, or 8%, to $1,004 million from $1,089 million for the same period in 2003.
Local Services
Local service revenues include revenues from basic voice, telephone and telecommunications equipment rental, value-added services, high-speed private line services, and Internet access. Local service revenues for the year ended December 31, 2005 increased $19 million, or 3%, to $615 million from $596 million for the comparable 2004 period. The increase is due to increased revenues from local data services of $21 million, offset in part by a decrease in local voice services revenues of $2 million. The increase in local data services was primarily driven by an increase in the number of customers requesting private services, such as T-1, and special services, such as DSL, resulting in an increase of $11 million in private services revenues and $9 million in DSL revenue. The decrease in revenues from local voice services was driven mainly by a decrease in public phones revenue of $4 million due to the disposition of these assets during year 2005, and a reduction in deferred activation revenues of $3 million. The decreases were offset by an increase of $5 million in the basic voice services as a result of the Extended Area Service (EAS) surcharge, partially offset by lower access lines, and an increase in directory assistance revenue of $4 million due to an increase in directory assistance rates from $.50 to $.75 effective in November 2004.
Local service revenues for the year ended December 31, 2004 decreased $18 million, or 3%, to $596 million from $614 million for the comparable 2003 period. The decrease is due to decreased revenues from local voice services of $32 million partially offset by increased revenues from local data services of $15 million. The decrease in revenues from local voice services was driven mainly by fewer access lines, absence of touch tone charges, and decrease in business measured services. The increase in local data services was primarily driven by an increase in the number of customers requesting our high-speed special services and internet services, which resulted in a $21 million increase in both high-speed special services and internet service revenue, partially offset by the absence of Edunet billing revenues of $7 million.
Network Access
Network access revenues include revenues from services provided to long distance carriers, competitive local exchange carriers, and cellular and paging operators to originate and terminate calls on our network. These revenues for the year ended December 31, 2005 decreased $37 million, or 14%, to $234 million compared to $271 million for the same 2004 period. The decrease was driven by a decrease in intra-island access revenues of $13 million, as the Company implemented the final phase of the rate reduction agreed with the TRB in the February 2002 Order, a decrease of $17 million in interstate regulated access revenues driven by interstate common line adjusted estimates through the NECA settlement process, and a decrease in off-island switching and special access revenue of $7 million due to a decrease in average rates. See “Regulatory and Other Matters - Intra-Island Long Distance Access Rate Dispute”.
For the year ended December 31, 2004, network access revenues decreased $25 million, or 8%, to $271 million compared to $296 million for the same 2003 period. The decrease was driven by a decrease in intra-island access revenues of $22 million due to the implementation of the phase rate reduction required by the TRB in the February 2002 Order, previously defined and included in the integrated plan.
Long Distance
Long distance revenues include direct dial on-island and off-island, operator-assisted calls and prepaid calling cards revenues. Long distance revenues for the year ended December 31, 2005 decreased $1 million, or 2%, to $65 million from $66 million for the comparable 2004 period. The decrease is a result of the reduction in the number of local calling area from 68 to 10.
Long distance revenues for the year ended December 31, 2004 decreased $46 million, or 41%, to $66 million from $112 million for the comparable 2003 period due to a decrease in intra-island long distance revenues as a result of the impact of the Extended Area Service (EAS) implementation and a decrease in long distance call volumes. The reduction in revenues in 2004 also incorporates an adjustment of receivable balances reflecting billed activity. The prior periods amounts do not have a material impact in the financial statements.
Directory and Other
Directory and other revenues include revenues from directory publishing rights, telecommunication equipment sales and billing and collection services provided to competing long distance operators in Puerto Rico. Directory and other revenues for the year ended December 31, 2005 increased $9 million, or 13%, to $80 million from $71 million for the same period in 2004. The increase was mainly due to the recognition of the late payment fees.
Directory and other revenues for the year ended December 31, 2004 increased $4 million, or 6%, to $71 million from $67 million for the same period in 2003 due to an increase in late payment fees of $7 million, which was partially offset by a decrease in billing and collections revenues of $3 million.
RESULTS OF OPERATIONS EXPENSE WIRELINE
Wireline expenses for the year ended December 31, 2005 increased $57 million, or 10%, to $621 million from $564 million for the same period in 2004. Wireline expenses for the year ended December 31, 2004 decreased $203 million, or 26%, to $564 million from $767 million for the same period in 2003.
Cost of services and sales for the year ended December 31, 2005 increased $5 million, or 2%, to $242 million from $237 million for the same period in 2004. This increase was mainly due to the increase in cost of equipment sold of $7 million, partially offset by lower material usage of $2 million.
For the year ended December 31, 2004, cost of services and sales decreased $16 million, or 6%, to $237 million from $253 million for the same period in 2003. This decrease was mainly due to a decrease in labor and benefits expenses of $14 million due to a reduction in the workforce and a decrease in interconnection charges of $2 million, mainly due to lower rates.
Selling, general and administrative expenses for the year ended December 31, 2005 increased $52 million, or 16%, to $379 million from $327 million for the same period 2004. This increase was mainly due to the absence of the benefit recognized during quarter ended June 30, 2004 of a $43 million reserve reversal associated with the February 2002 Order, the increase in bad debt expense of $11 million mainly due to the recognition of late payment fees, offset in part by a decrease in management fees of $3 million as the Verizon Management and Technology License Agreement expired on March 2, 2004 and was replaced with a new Service Agreement.
For the year ended December 31, 2004, selling, general and administrative expenses decreased $187 million, or 36%, to $327 million from $514 million for the same period 2003. This decrease was primarily due to the absence of the $66 million pre-tax reserve for the end-user and AT&T refund referred to in the February 2002 Order recognized during the quarter ended September 30, 2003 and the $43 million reversed during year 2004. See “-Regulatory and Other Matters - Intra-Island Long Distance Access Rate
Dispute.” Other factors contributing to the reduction were a decrease in bad debt expense of $38 million, mainly due to a settlement with the PRDOE regarding amounts owed, the absence of a cancelled project of $29 million that required the write-off of the billing software system abandoned by the Company and recognized for the year ended December 31, 2003, and a decrease in management fees of $12 million as the Verizon Management and Technology License Agreement expired on March 2, 2004 and was replaced with a new Service Agreement.
RESULTS OF OPERATIONS REVENUE WIRELESS
OPERATING DATA
Revenues from cellular services and related equipment sales for the year ended December 31, 2005 increased $63 million, or 28%, to $289 million from $226 million for the comparable 2004 period. Revenues from cellular services and related equipment sales for the year ended December 31, 2004 increased $24 million, or 12%, to $226 million from $202 million for the year ended December 31, 2003.
Cellular Services
Cellular service revenues for the year ended December 31, 2005 increased $46 million, or 23%, to $245 million from $199 million for the same period in 2004. This increase was primarily the result of an increase of 98,000 cellular customers for 2005 compared to the same period in 2004 due to attractive price plans and the implementation of marketing strategies to align the Company’s product and service offerings with those of Verizon Wireless in the United States.
Revenues from cellular services for the year ended December 31, 2004 increased $11 million, or 6%, to $199 million from $188 million for the same period in 2003. This increase was primarily the result of an increase of 34,000 cellular customers for 2004 compared to the same period in 2003 due to attractive price plans and the implementation of marketing strategies to align the Company’s product and service offerings with those of Verizon Wireless in the United States.
Wireless Equipment and other
Revenues from wireless equipment sales and other increased $17 million, or 63%, to $44 million for the year ended December 31, 2005 from $27 million for the comparable 2004 period. This increase is due to an increase in wireless equipment sales of $10 million, as a result of strong customer growth and postpaid contract renewals, an increase of $6 million in access revenues due to the Universal Service Administration Company (“USAC”) certification of our wireless operation to receive Interstate Common Line Support (“ICLS”) payments since October 2005, for which concept the Company will be receiving approximately $20 million in ICLS payments on a yearly basis, and an increase of $1 million in long distance revenues generated by cellular customers.
Wireless equipment sales and other revenues increased $13 million, or 93%, to $27 million for the year ended December 31, 2004 from $14 million for the comparable 2003 period. This increase is due to the increase in wireless equipment sales of $9 million, as a result of postpaid contract renewals and the reseller agreement entered between PRTC and PRTLD in April 2004, regarding long distance revenues generated by cellular customers, resulting in revenue of $5 million during year 2004.
RESULTS OF OPERATIONS EXPENSE WIRELESS
Wireless operating expenses for the year ended December 31, 2005 increased $59 million, or 32%, to $241 million from $182 million for the same period in 2004. Wireless expenses for the year ended December 31, 2004 increased $18 million, or 11%, to $182 million from $164 million for the same period in 2003.
Cost of services and sales for the year ended December 31, 2005 increased $30 million, or 38%, to $110 million from $80 million for the same period in 2004. This increase was mainly due to a higher subsidy of equipment sales of $17 million, an increase in cellular roaming expenses of $5 million, an increase in wireless data expenses of $4 million and an increase of wireless interconnection expenses of $3 million, all as a result of the corresponding significant increase in our wireless subscriber base.
For the year ended December 31, 2004, cost of services and sales increased $18 million, or 29% to $80 million from $62 million for the same period in 2003. This increase was mainly due to higher subsidy on equipment sales of $12 million, higher network management fees of $2 million, higher wireless interconnection expenses of $2 million, and higher long distance settlement fees of $2 million related to the PRTC and PRTLD reselling agreement.
Selling, general and administrative expenses for the year ended December 31, 2005 increased $29 million, or 28%, to $131 million from $102 million for the same period 2004. This increase was mainly due to an increase in transmission costs of $9 million, an increase in regulatory fees of $6 million, an increase in bad debt expense of $7 million, an increase in commission expense of $4 million, and an increase in bank charges of $1 million.
For the year ended December 31, 2004, selling, general and administrative expenses remained constant at $102 million in comparison with the year ended December 31, 2003.
LIQUIDITY AND CAPITAL RESOURCES
CONSOLIDATED FINANCIAL CONDITION
OVERALL LIQUIDITY ASSESSMENT
At December 31, 2005, current liabilities exceeded current assets by $256 million mainly due to the reclassification of the senior notes due on May 15, 2006 from long-term debt to short-term debt. We believe our sources of funds including from operations, from sales of non-strategic assets and from readily available external financing arrangements will be sufficient to meet ongoing requirements.
On February 28, 2006, the Company sold both its equity interest in the Puerto Rico directory operation and the right to receive 35% of the revenues from the publication of directory advertising for $190 million, with an after tax gain of $144 million. The proceeds will be used to pay dividends and long-term debt.
On March 1, 2006, the Company entered into two related, unsecured credit facilities, a $275 million revolving credit facility maturing on February 28, 2009, and a $275 million term credit facility, which is available to be drawn in one borrowing at any time until May 1, 2006 and will mature on February 28, 2011. The Company also has an undrawn $40 million working capital credit facility, which matures on June 30, 2006. See Note 10 to the consolidated financial statements for more detailed information.
OPERATIONS
Cash from operations continued to be our primary source of funds. The $50 million decrease in cash from operations for the year ended December 31, 2005 compared to same period in 2004 was primarily due to an increase in purchases of inventory mainly in wireless handsets, wires, cables and transmission equipment of $25 million, the absence of a government account collection of $16 million received in September 2004, and the final credit refund of $14 million required by the February 2002 Order and provided during the period ended September 30, 2005, offset in part by lower management fees payments of $4 million.
For year ended December 31, 2004, net cash provided by operating activities was $289 million compared to $357 million for the same period in 2003. The $68 million decrease was primarily due to higher pension contributions of $55 million, which are part of management’s strategy to fully fund the pension plans by 2007 and higher OPEBs disbursements of $4 million due to higher claims for retirees.
INVESTING
Net cash used in investing activities for the year ended December 31, 2005 was $143 million compared to $166 million for the same period in 2004. The $23 million decrease in net cash used in investing activities was due to a $26 million decrease in capital expenditures and costs of removal as a result of decreased spending on computer equipment and software, as well as a general decrease in wireless equipment purchases, offset in part by a $3 million decrease in proceeds from the sale of buildings in 2004.
For the year ended December 31, 2004 the net cash used in investing activities was $166 million compared to $170 million for the same period in 2003. The $4 million decrease in net cash used in investing activities was due to a $3 million decrease in capital expenditures and costs of removal as a result of decreased spending on specific software projects, as well as a general decrease in spending, offset in part by a $1 million decrease in proceeds from the sale of buildings in 2003.
We have invested approximately $1.4 billion from the date of the Acquisition through December 31, 2005 to expand and enhance our networks. Our planned capital expenditures for 2006 are approximately $154 million, which we expect to finance with internally generated funds.
FINANCING
Net cash used in financing activities for the year ended December 31, 2005 and 2004 was $105 million and $81 million, respectively. We reduced outstanding debt, including capital leases, by $41 million for the year ended December 31, 2005, and by $60 million for the year ended December 31, 2004. Borrowings under term credit facilities, working capital facilities and commercial paper decreased from $93 million at December 31, 2004 to $52 million at December 31, 2005 and from $153 million at December 31, 2003 to $93 million at December 30, 2004.
During year ended December 31, 2005, the Company repaid its two term loans which totaled $93 million. As of December 31, 2005, the Company had a net commercial paper balance due of $52 million.
During the year ended December 31, 2004, the Company prepaid $30 million of principal of term loans, reducing the outstanding balance to $93 million at December 31, 2004. During the year ended December 31, 2003, the Company prepaid $102 million of principal of term loans, reducing the outstanding balance to $123 million at December 31, 2003 and reduced the interest rate thereon to 70 basis points over LIBOR.
In connection with the Acquisition, PRTA agreed to contribute cash or stock worth a total of $200 million as a capital contribution in five equal $40 million installments over five years beginning on March 2, 2000 to partially fund its under funded pension and other post-employment benefit obligations. In March 2004, the Company received the fifth and final $40 million installment in cash from PRTA. See Note 13 to the consolidated financial statements for more information.
The shareholders’ agreement requires the payment of dividends equal to at least 50% of consolidated net income, payable quarterly to the extent funds are legally available. The Company declared and paid legal dividends of $63 million, $66 million, and $68 million during 2005, 2004, and 2003, respectively. However, these the legal dividends were adjusted for the dividends of the ESOP unallocated shares by $2 million and $4 million during 2005 and 2004, respectively, only for financial reporting purposes. The senior note indentures and credit facility agreements do not contain restrictions on the payment of dividends.
OFF-BALANCE SHEET ARRANGEMENTS
The Company currently does not have any off-balance sheet arrangements that have or are reasonably likely to have a material current or future effect on the Company’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.
CONTRACTUAL OBLIGATIONS AND OTHER COMMERCIAL COMMITMENTS
The following table provides a summary of our contractual obligations and commercial commitments at December 31, 2005. Additional detail about these items is included in the notes to the consolidated financial statements.
REGULATORY AND OTHER MATTERS
REGULATORY AND COMPETITIVE TRENDS
Regulatory activity at the federal and local levels has been primarily directed at meeting challenges in maintaining support for local exchange rates and Universal Service while putting into effect the rate rebalancing and regulatory restructuring required by an increasingly competitive environment. Among the regulatory issues are: rate rebalancing, intercarrier compensation and insular relief.
We continue to meet the wholesale requirements of new competitors and have signed agreements with various wireless and wireline carriers. These agreements permit them to purchase unbundled network elements, to resell retail services, and to interconnect their networks with ours.
INTRA-ISLAND LONG DISTANCE ACCESS RATE DISPUTE (K-2)
In 1997, several long-distance carriers filed a complaint against the Company before the TRB alleging that the Company’s access tariff was not cost-based as required by law. On February 28, 2002, the TRB issued the February 2002 Order instructing the Company to reduce such access rates and requiring other obligations from the Company. The Company appealed the TRB’s February 2002 Order but subsequently settled with the complainants and the TRB. As part of its settlement with the TRB, the Company agreed to reduce the access charge, eliminate touch tone charges and provide its single line residential customers certain credits on their phone bills. In return, the Company was allowed to reduce its local calling zones from 68 to 10 and phase in an “Extended Area Service” surcharge on all of its local customers. As of the date of this report, the Company has complied with all of its obligations under the settlement agreement and has completely phased in the surcharge except in a reduced area of its territory. In December 2005, the last credits of the surcharge were granted and all customers are now paying the $2.25 surcharge on their monthly bills. PRTC has complied with all the terms and conditions of the K-2 Settlement.
SINGLE ZONE
On April 6, 2005, PRTC filed with the TRB a new tariff structure for basic telephone service which would have eliminated all intra-LATA long distance charges by reducing its existing local calling areas from 10 to 1 (the “Single Zone Plan”).
On May 17, 2005 and May 20, 2005, TLD and WorldNet, respectively, filed separate complaints challenging the legality of the Single Zone Plan, alleging in their complaint that PRTC’s new tariff structure under the Single Zone Plan is not based on cost and that the tariff would eliminate the intra-island long distance market.
As a result of repeated delays in the administrative proceeding, on February 3, 2006, the Company withdrew the tariff structure proposed under the Single Zone Plan and filed a motion to dismiss in the related complaint, which motion has been granted by the TRB. PRTC plans to file a new tariff structure in the second quarter of year 2006 that will rebalance residential and business within the context of the current 10 zone calling areas.
PUBLIC TELEPHONE SERVICE PROVIDER - ANTI COMPETITIVE ACTIONS
On August 16, 2002, PSA, the parent company of Phoenix of Puerto Rico, filed a lawsuit against PRTC in the United States Bankruptcy Court for the District of Delaware, claiming anti competitive acts. The claims have since been transferred to the United States District Court of Delaware. The disputes between the two parties include an administrative claim by PRTC against PSA, and a claim of over $9 million by PSA against PRTC. The United States District Court of Delaware granted a PRTC motion to change venue to Puerto Rico and the motion to dismiss is currently pending before the United States District Court of Puerto Rico. On September 24, 2004, the Court issued an Opinion and Order granting PRTC’s motion to dismiss. PSA appealed the Order and oral arguments were presented on September 8, 2005 before the Circuit Court. On October 17, 2005, the parties executed a settlement agreement resolving the dispute. On November 16, 2005, the Circuit Court dismissed the appeal.
TOUCHTONE CHARGES
On November 17, 2003, six residential subscribers and eight business service subscribers filed a class action suit with the Court of First Instance of Puerto Rico (the “Court”) under the Puerto Rico Telecommunications Act of 1996 (the “Act”) and the Puerto Rico Class Action Act of 1971. The plaintiffs have claimed that the Company’s charges for touchtone service are not based on cost, and therefore violate the Act. The plaintiffs have requested that the Court (i) issue an order certifying the case as a class action, (ii) designate the plaintiffs as representative of the class, (iii) find that the charges are illegal, and (iv) order the Company to reimburse every subscriber for excess payments made since September 1996.
On November 1, 2004 PRTC filed a Motion for Summary Judgment requesting the dismissal of plaintiff’s claim due to plaintiff’s failure to follow the procedure to object charges, established by Law 33. Law 33 establishes that a telecommunication services user has a twenty days period from the receipt of the telecommunications service company invoice to object charges in the same. PRTC argues that since admittedly plaintiffs failed to comply with said procedure their claims are time barred. Said motion is still under the consideration of the Court.
On May 10, 2005 the Court issued an Order certifying the case as a class action. PRTC sought reconsideration of that decision and an argumentative hearing was held on June 20, 2005 to discuss the merits of PRTC’s position. On June 22, 2005 the Court issued an Order confirming its previous decision. In consequence, a certiorari writ was filed on June 22, 2005. On September 19, 2005 the P.R. Appeals Court denied the same. PRTC sought reconsideration of that decision on October 4. 2005. Said reconsideration request was denied on October 11, 2005, therefore PRTC filed a Certiorari Writ with the P.R. Supreme Court on November 10, 2005. The same was denied on January 18, 2006.
On January 11, 2006, the PRTC filed a Motion to Dismiss alleging lack of subject matter jurisdiction based on the enactment of Law No. 138 of November 4, 2005. This new law grants the TRB exclusive primary jurisdiction to entertain class actions related to telecommunication services. The hearing scheduled for January 24, 2006 was rescheduled for May 16, 2006 in response to plaintiff’s request for time to oppose PRTC’s Motion to Dismiss. The court granted the plaintiffs until March 24, 2006 to submit their opposition. In addition it granted PRTC until April 24, 2006 to submit its reply. On March 24, 2006 plaintiffs filed a request for sixty additional days to submit their opposition. On March 29, 2006 PRTC opposed this request and asked the Court to rule on the jurisdictional matter brought forth by PRTC. In consequence, the Motion to Dismiss is pending.
CTI ASSET TRANSFER
Prior to the Acquisition, PRTC transferred its net wireless assets on September 1, 1998 to CTI (which subsequently became Verizon Wireless, a division of PRTC, on May 1, 2002). Our predecessors later filed a waiver request in 1998 with the FCC to record this transfer at book value instead of fair value. Since our predecessors had not included the costs of wireless operations in the regulated rate setting process, we argued that ratepayers did not bear the cost of our predecessors’ wireless investment. The FCC denied the Company’s waiver petition in April 2001, but recognized that the cellular and paging assets had been removed from the interstate rate base even though it had questions concerning certain costs and expenses.
Separately, the TRB initiated an agreed upon procedures audit of the Company, which included an audit of its compliance with the FCC’s affiliate transactions rules and the CTI asset transfer. On May 5, 2005, the Agreed upon Procedures Audit Report was delivered to PRTC. The report confirms that PRTC complied with the affiliate transaction rules. With respect to the CTI asset transfer, the audit report essentially repeats the FCC’s conclusions. The Audit is pending final approval by the TRB.
PRICE CAP REGULATION
Under the FCC’s “all or nothing” rule, telecommunications carriers that set interstate access rates based on a price cap formula are required to use the price cap formula for all of their affiliates. The price cap formula is based on a plan adopted by the FCC called the Coalition of Affordable Local and Long Distance Service (“CALLS”), which uses rate-of-return as a basis for setting rates. The Company would have been required to implement price caps by March 2, 2000 under the FCC’s rules. Prior to March 2, 2000, the Company had set its interstate access rates based on rate-of-return principles.
The FCC delayed conversion to price cap regulation until June 30, 2002, and the Company requested an extension until June 30, 2003. Under an order issued by the FCC on April 18, 2002, the Company was no longer required to file a waiver request until the FCC had completed its review of the “all-or-nothing” rule. In addition, upon the issuance of an Order and Second Further Notice of Proposed Rulemaking (the “Order”) by the FCC on February 28, 2004, the FCC deferred further action on the all-or-nothing rule until it had reviewed the record compiled in response to the notice included in the Order. Additionally, in the Order the FCC stated that all outstanding interim waivers of the all-or-nothing rule that depend on the FCC’s decision shall continue to be effective until the FCC issues a final order on this matter. As a result, the Company currently continues to set its interstate access rates based on rate-of-return principles.
On May 10, 2004, PRTC filed comments in response to the Order, requesting that the FCC eliminate the “all or nothing rule” or, in the alternative, if the rule is not eliminated, that the FCC grant PRTC’s 1999 waiver request to permit PRTC to remain a carrier that sets its interstate access rates based on rate-of-return principles. The basis of PRTC’s request is that if PRTC were no longer eligible to receive Interstate Common Line Support (“ICLS”), PRTC would require $139 million in additional universal service support to offset lost ICLS revenues and that the CALLS plan cannot accommodate PRTC since there is a $650 million cap on the equivalent support in the CALLS plan, which was based on the anticipated universal service needs of price cap carriers that were participating in the plan at the time of its adoption. There has been no announcement regarding the expected timing for the completion of this proceeding.
INSULAR RELIEF
On December 9, 2005, the FCC issued a Notice of Proposed Rulemaking in which it tentatively concluded to establish a non-rural insular universal service mechanism. The FCC’s proposed mechanism is based on a proposal made by the Company on May 6, 2005. PRTC filed comments in support of the Commission’s tentative conclusion on March 27, 2006. If the FCC’s tentative conclusion were adopted, the Company would be eligible to receive approximately $33 million in annual support based on current investment levels. The Company would be eligible for additional support for its wireless service based on the same per-line support received by the Company. There is no timetable for FCC action on its tentative conclusion, nor any assurances that the FCC will adopt the mechanism as proposed. While the Company currently does not receive high-cost loop support from the FCC, PRTC does receive significant universal service money under other FCC universal service programs.
MUNICIPAL RIGHT OF WAY FEES
A number of cities in Puerto Rico have sought to impose fees upon the Company for using municipal rights of way. The exact manner in which these fees are calculated varies, but they generally seek to collect five percent of the Company’s gross revenue generated in the municipality. The Company has challenged each of these fees in federal court and in the Puerto Rico courts. In the Guayanilla case, on January 28, 2005, the federal district court granted the Company’s motion for summary judgment and held that the fee proposed by the municipality violated federal law, because the municipality could not show that the fee was related to rights of way use. The municipality appealed the district court’s ruling, and oral argument was heard on this appeal in the First Circuit Court of Appeals on November 8, 2005. It is unknown when this decision will be reached or what the outcome will be. All local court cases have been stayed pending the outcome of the Guayanilla appeal. Cases challenging other similar ordinances have been filed. The Commonwealth Legislature has empowered the TRB to adopt regulations governing fees for use of municipal rights of way consistent with local and federal law, but the TRB has not yet taken any action. Other municipalities may adopt similar ordinances. To the extent such fees are upheld, PRTC will either pass the costs along to customers, impacting its competitiveness, or absorb them, impacting its profitability. The following is a list of all right of way open cases:
Right of Way Litigations
Status
US District Court:
1. PRTC v. Municipality of Caguas
PRTC’s challenge of Caguas ordinance is stayed pending resolution of the Guayanilla case.
2. PRTC v. Municipality of Guayanilla
Federal District Court found the ordinance violative of Section 253. Guayanilla’s appeal is pending before the First Circuit Court of Appeals.
3. PRTC v. Municipality of Ponce
Declaratory judgment action filed in federal and local court on November 22 and November 28, 2005, respectively. Ponce was served with summons.
4. PRTC v. Municipality San Juan
The case was dismissed when San Juan withdrew its ordinance.
5. PRTC v. Municipality of Vega Baja
Declaratory judgment action filed in federal and local court on February 22, 2006. Vega Baja was served with summons.
6. PRTC v. Municipality of Cataño
Declaratory judgment action filed in federal and local court on February 28, 2006. Cataño served with summons.
7. PRTC v. Municipality of Utuado
Declaratory judgment action filed in federal and local court on March 24, 2006. Pending summons.
Local Courts:
1. PRTC v. Municipality of Caguas
Filed a motion to stay. Waiting for First Circuit Court decision on Guayanilla’s case.
2. PRTC v. Municipality of Ponce
Filed a motion to stay. Waiting for First Circuit Court decision on Guayanilla’s case.
3. PRTC v. Municipality San Juan
Filed a motion to stay. Waiting for First Circuit Court decision on Guayanilla’s case.
4. PRTC v. Municipality of Vega Baja
Filed a motion to stay. Waiting for First Circuit Court decision on Guayanilla’s case.
5. PRTC v. Municipality of Cataño
Filed a motion to stay. Waiting for First Circuit Court decision on Guayanilla’s case.
6. PRTC v. Municipality of Utuado
Filed a motion to stay. Waiting for First Circuit Court decision on Guayanilla’s case.
INTERCONNECTION DISPUTE
On or about October 2004, the TRB arbitrated an interconnection contract between WorldNet Telecommunications Inc. (“WorldNet”) and the Company. Among the more significant decisions reached by the TRB, it adopted the arbitrator’s decision to approve a provision that established performance parameters under the contract but rejected the imposition of liquidated damages for failure to meet the performance parameters. Both WorldNet and the Company cross-appealed certain aspects of the TRB’s rulings to the U.S. District Court for the District Court of Puerto Rico pursuant to the federal Communications Act and moved for summary judgment The District Court affirmed in part and reversed in part the disputed TRB rulings in early February 2006. Both the Company and the TRB filed notices of appeal to the U.S. Court of Appeals for the First Circuit, which remain pending. The timing and outcome of this appeal are unknown. WorldNet has also requested further proceedings before the TRB with respect to the ruling of the District Court. That request is pending.
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
In this Annual Report on 10-K, the Company has made forward-looking statements. These statements are based on the Company’s estimates and assumptions and are subject to certain risks and uncertainties. Forward-looking statements include information concerning possible or assumed future results of operations, as well as those statements preceded or followed by such words as “anticipates,” “believes,” “estimates,” “expects,” “hopes,” “targets” or similar expressions.
Future results could be affected by subsequent events and could differ materially from those expressed in the forward-looking statements. If future events and actual performance differ from the Company’s assumptions, the actual results could vary significantly from the performance projected in the forward-looking statements.
The following important factors could affect future results and could cause those results to differ materially from those expressed in the forward-looking statements: (1) materially adverse changes in economic and industry conditions in Puerto Rico and labor matters, including workforce levels and labor negotiations, and any resulting financial and/or operational impact in the markets served by us; (2) material changes in available technology; (3) the final resolution of regulatory initiatives and proceedings, including arbitration proceedings pertaining to, among other matters, the terms of interconnection, access charges, universal service, unbundled network elements and resale rates; (4) changes in our accounting policies that may be required by regulatory agencies, including the SEC or that result from changes in the accounting policies or their application, which could result in an impact on earnings; and (5) the extent, timing, success and overall effects of competition from others in the Puerto Rico telecommunications service industry.
Although the Company believes the expectations reflected in its forward-looking statements are reasonable, the Company cannot guarantee its future performance or results of operations. All forward-looking statements in this report are based on information available to the Company on the date of this report; however, the Company is not obligated to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. The risks described above and elsewhere in this report, including in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” should be considered when reading any forward-looking statements in this report. Given these uncertainties and risks, the reader should not place undue reliance on these forward-looking statements.
CRITICAL ACCOUNTING POLICIES
General
The Company’s discussion and analysis of its financial condition and results of operations are based upon the Company’s consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and the rules and regulations of the SEC.
The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported interim amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, the Company evaluates its estimates, including those related to bad debts, intangible assets, income taxes, financing operations, contingencies and litigation. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
The Company believes the following critical accounting policies affect its more significant judgments and estimates used in the preparation of its consolidated financial statements.
Allowance for Doubtful Accounts
The Company maintains allowances for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. If the financial condition of the Company’s customers were to deteriorate and their ability to make payments was affected, additional allowances may be required. Because of uncertainties inherent in the estimation process, the Company’s estimate of losses and the related allowance may change. The Company does not depend on any single customer for its business.
Deferred Taxes
The Company uses an asset and liability approach in accounting for income taxes in accordance with the provisions of SFAS No. 109, “Accounting for Income Taxes.” Deferred tax assets and liabilities are recognized for temporary differences between the way certain income and expense items are reported for financial reporting purposes and for tax purposes.
The Company records a valuation allowance to reduce its deferred tax assets to the amount that is more likely than not to be realized. While the Company has considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, in the event the Company were to determine that it would be able to realize its deferred tax assets in the future in excess of its net recorded amount, an adjustment to the deferred tax asset would increase income in the period in which such determination was made. Similarly, should the Company determine that it would not be able to realize all or part of its net deferred tax asset in the future, an adjustment to the deferred tax asset would be charged to income during the period in which such determination was made.
The Puerto Rico Treasury Department concluded the ordinary audit of the 2001 corporate income tax return of one of our subsidiaries resulting in an additional tax liability of $0.5 million.
A new Puerto Rico law was passed in August 2005, providing for an additional 2.5% tax to corporate taxpayers with taxable income of $20,000 or more for tax years 2005 and 2006. The effectiveness of the law was contingent upon the approval of Joint Resolution 445 which related to the 2005-2006 Governmental Budget. The Governor of Puerto Rico vetoed Joint Resolution 445; therefore, the deferred taxes as of December 31, 2005 do not reflect the additional tax of 2.5%. Should this law take effect, its estimated impact would be to increase the deferred tax asset by $3.2 million and to decrease the income tax provision by $2.8 million as of December 31, 2005.
Property, Plant and Equipment and Depreciation
Property, plant and equipment is stated at original cost, including interest on funds borrowed to finance the acquisition of capital additions. Repair and maintenance costs are expensed as incurred. Depreciable property disposed of in the ordinary course of business, less salvage value, is charged to accumulated depreciation with no gain or loss recognized. Gains or losses from the sale of land are recorded in results of operations.
The Company’s depreciation expense is based on the composite group remaining life method using straight-line composite rates. This method provides for the recognition of the cost of the remaining net investment in telephone plant over the remaining asset lives. This method also requires a periodic evaluation of the average remaining useful lives related to the expected recoverability of the carrying value of assets based on changes in technology, environmental factors, the federal and local regulatory environment, industry and other competitive forces. Effective July 2005, the Company revised its plant useful lives estimates based on a detailed review of the lives underlying the depreciation rates. The depreciation rate revision reflects expected useful lives resulting from the impact of technology and future competition and more closely approximate the assumptions used by other telephone companies. For the year ended December 31, 2005, the revision resulted in lower depreciation expense of approximately $6.5 million than would have been recognized under the previous useful lives estimate.
Pensions
The Company accounts for its defined benefit pension plans in accordance with SFAS No. 87, “Employers’ Accounting for Pensions” which requires that amounts recognized in financial statements be determined on an actuarial basis. SFAS No. 87 and the policies used by the Company, notably the use of a calculated value of plan assets (which is further described below), generally reduces the volatility of pension income (expense) from changes in pension liability discount rates and the performance of the pension plan’s assets.
The most significant element in determining the Company’s pension income (expense) in accordance with SFAS No. 87 is the expected return on plan assets. At December 31, 2005, the Company assumed that the expected long-term rate of return on plan assets is 8.5%, which remained constant in comparison with the prior year. Historically, the Company’s pension plan assets have earned in excess of 8.5%; therefore, the Company believes that its assumption of future returns of 8.5% is reasonable.
At the end of each year, the Company determines the rate used to discount plan liabilities. The discount rate reflects the current rate at which the pension liabilities could be effectively settled at the end of the year. In estimating this rate, the Company looks to rates of return on high quality, fixed-income investments that receive one of the two highest ratings given by a recognized ratings agency. At December 31, 2005, the Company determined this rate to be 5.75%, which remained constant in comparison with the prior year. The decrease in the pension liability resulting from the change has been deferred in accordance with the amortization provisions of SFAS No. 87.
Other Post Employment Benefits
We provide retiree health benefits for employees that retire under our pension plan. We use various actuarial assumptions including the discount rate and the expected trend in health care costs to estimate the costs and benefit obligations for our retiree health plan.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
INTEREST RATE SENSITIVITY
We are exposed to market risk in the normal course of business, resulting primarily from changes in the interest rates on our senior notes and interest rate swap agreements.
The following table summarizes the fair value of our senior notes and interest rate swap agreements at December 31, 2005 and December 31, 2004 and provides a sensitivity analysis of the fair values of these instruments assuming a 100 basis point increase or decrease in the yield curve. The sensitivity analysis does not include the fair values of our floating-rate debt since they are not significantly affected by changes in market interest rates.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
TELECOMUNICACIONES DE PUERTO RICO, INC. AND SUBSIDIARIES
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets as of December 31, 2005 and 2004
Consolidated Statements of Operations for the Years Ended December 31, 2005, 2004 and 2003
Consolidated Statements of Changes in Shareholders’ Equity for the Years Ended December 31, 2005, 2004 and 2003
Consolidated Statements of Cash Flows for the Years Ended December 31, 2005, 2004 and 2003
Notes to Consolidated Financial Statements for the Years Ended December 31, 2005, 2004 and 2003
Schedule I - Condensed Consolidating Information for the Years Ended December 31, 2005 and 2004
Schedule II - Valuation and Qualifying Accounts for the Years Ended December 31, 2005, 2004 and 2003
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Shareholders of Telecomunicaciones de Puerto Rico, Inc.:
We have audited the accompanying consolidated balance sheets of Telecomunicaciones de Puerto Rico, Inc. and subsidiaries (the “Company”) as of December 31, 2005 and 2004, and the related consolidated statements of operations, changes in shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2005. Our audits also included the financial statement schedules listed in the index at Item 15 (a). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statements and financial statement schedules 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. We were not engaged to perform an audit of the Company’s 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, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Telecomunicaciones de Puerto Rico, Inc. and subsidiaries at December 31, 2005 and 2004, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
Ernst & Young LLP
San Juan, Puerto Rico
March 10, 2006
Telecomunicaciones de Puerto Rico, Inc. and Subsidiaries
Consolidated Balance Sheets
(In thousands)
The accompanying notes are an integral part of these financial statements.
Telecomunicaciones de Puerto Rico, Inc. and Subsidiaries
Consolidated Statements of Operations
(In thousands)
The accompanying notes are an integral part of these financial statements.
Telecomunicaciones de Puerto Rico, Inc. and Subsidiaries
Consolidated Statements of Changes in Shareholders’ Equity
(In thousands)
The accompanying notes are an integral part of these financial statements.
Telecomunicaciones de Puerto Rico, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
(In thousands)
The accompanying notes are an integral part of these financial statements.
TELECOMUNICACIONES DE PUERTO RICO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2005, 2004 AND 2003
1.
Business / Corporate Structure
Telecomunicaciones de Puerto Rico, Inc., a Puerto Rico corporation (the “Company” or “we”), holds 100% of the common stock of Puerto Rico Telephone Company, Inc. (“PRTC”), PRT Larga Distancia, Inc. (“PRTLD”), and Datacom Caribe, Inc. (“Datacom”). The Company also holds a 67% interest in Coqui.net Corporation (“Coqui.net”), in which Popular, Inc., one of the Company’s shareholders, holds the remaining 33% interest. The Company also holds a 24% interest in Verizon Information Services Puerto Rico, Inc. S. en C. (“VISI”), in which GTE Holdings (Puerto Rico) LLC, the Company’s majority shareholder also holds a 36% interest. The Company is the largest telecommunications service provider in Puerto Rico. PRTC is the incumbent local exchange carrier for the island of Puerto Rico. Wireline service is provided by PRTC and cellular service is provided by the wireless division of PRTC, under the brand of Verizon Wireless Puerto Rico (“Verizon Wireless”). The Company’s off-island long distance service is provided by PRTLD. The Company’s dial-up Internet access service is provided by Coqui.net and the directory publishing revenues are generated by VISI.
GTE Corporation (“GTE”), through its subsidiary GTE Holdings (Puerto Rico) LLC, acquired a 40% interest and management control over the Company on March 2, 1999 from the Puerto Rico Telephone Authority (“PRTA”), an entity of the Commonwealth of Puerto Rico (the “Acquisition”). In the Acquisition, Popular, Inc. acquired a 10% interest in the Company. GTE and Bell Atlantic Corporation merged on June 30, 2000 to form Verizon Communications Inc. (“Verizon”). On January 25, 2002, GTE Holdings (Puerto Rico) LLC and Popular, Inc. acquired an additional 12% and 3% interest in the Company, respectively, by exercising an option each held since the Acquisition (the “Option Exercise”). Verizon and Popular, Inc. obtained the additional ownership interest from PRTA Holdings Corp., a subsidiary of the PRTA (“PRTA Holdings”). Verizon and Popular, Inc. paid PRTA Holdings $138 million and $34 million, respectively, for a total of $172 million in cash for the additional 3,750,000 shares at a $45.9364 per share price established in the Share Option Agreement, an agreement entered into at the time of the Acquisition. As a result, Verizon now owns 52%, PRTA owns 28%, Popular Inc. owns 13% and the Employee Stock Ownership Plan owns 7% of the outstanding capital stock of the Company. The Company is an affiliate of Verizon, which consolidates the Company’s financial results with its own financial results.
2.
Summary of Significant Accounting Policies
Basis of Presentation
The accompanying audited consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles and with the rules and regulations of the Securities and Exchange Commission (“SEC”). The Company is a holding company with no significant assets or operations other than its investment in its subsidiaries. PRTC is a wholly owned subsidiary of the Company, and fully and unconditionally guarantee payment of the senior notes and the commercial paper.
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and its controlled subsidiary companies, which are wholly owned or majority owned. All significant intercompany accounts and transactions have been eliminated.
Use of Estimates
The preparation of financial statements in conformity with U.S. generally accepted accounting principles, 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
Revenues are recognized when services are rendered or products are delivered to customers.
Common carrier line access revenues are generated based on the participation by the PRTC in revenue pools with other telephone companies managed by the National Exchange Carriers Association (“NECA”), which are funded by access charges authorized by the Federal Communications Commission (“FCC”) and long-term support amounts received from the Universal Service Fund. Pooled amounts are divided among telephone companies based on allocations of costs and investments in providing interstate services. Revenues are based on preliminary allocations and cost studies and are subject to final settlement in subsequent periods.
Revenues from prepaid cellular cards are recognized based upon usage with any residual balances recognized at the expiration date.
Customer activation fees, along with the related costs up to but not exceeding the activation fees, are deferred and amortized over the customer relationship period, which are 5 years for wireline and 3 years for wireless, as required by Staff Accounting Bulletin “SAB” 104. However, customer activation fees are subject to additional consideration when wireless handsets are sold to the customers at a discount and recorded as equipment sales revenue.
Equipment sales consist principally of revenues from the sale of wireless handsets and accessories to new and existing subscribers and to agents and other third-party distributors. The revenue and related expenses associated with the sale of wireless handsets and accessories through our indirect sales channels are recognized when the products are delivered and accepted by the agent or third-party distributor, as this is considered to be a separate earnings process from the sale of wireless services and probability of collection is likely. Shipping and handling costs for wireless handsets sold to agents and other third-party distributors are classified as costs of equipment sales.
The Company has determined that the sale of wireless services through its direct sales channels with an accompanying handset constitutes a revenue arrangement with multiple deliverables in accordance with Emerging Issues Task Force (EITF) No. 00-21, Accounting for Revenue Arrangements with Multiple Deliverables. The Company accounts for these arrangements as separate units of accounting, including the wireless service and handset. Arrangement consideration received for the handset is recognized as equipment sales when the handset is delivered and accepted by the subscriber. Arrangement consideration received for the wireless service is recognized as service revenues when earned. As the non-refundable, up-front activation fee charged to the subscriber does not meet the criteria as a separate unit of accounting, the Company allocates the additional arrangement consideration received from the activation fee to the handset (the delivered item) to the extent that the aggregate handset and activation fee proceeds do not exceed the fair value of the handset. Any activation fees not allocated to the handset would be deferred upon activation and recognized as service revenue on a straight-line basis over the expected customer relationship period. The Company determined that the sale of wireless services through its indirect sales channels (agents) does not constitute a revenue arrangement with multiple deliverables. For indirect channel sales, the Company continues to defer non-refundable, up-front activation fees and associated costs to the extent of the related revenues in accordance with SAB 104. These deferred fees and costs are amortized on a straight-line basis over the estimated customer relationship period. The Company has recorded deferred revenues and deferred expenses of equal amounts in the consolidated balance sheets. As of December 31, 2005 and 2004, deferred revenues and expenses were $68 million and $73 million, respectively.
In 2004 the Company reduced its revenues to incorporate an adjustment to its receivable balances to reflect billed activity from prior year. The prior periods amounts do not have a material impact in the financial statements.
Cash and Cash Equivalents
Short-term investments with original maturities of three months or less are classified as cash equivalents.
Allowance for Doubtful Accounts
The allowance for doubtful accounts is an amount that management believes will be adequate to absorb possible losses on existing receivables that may become uncollectible based on evaluations of the collectibility of the receivables and prior loss experience. Because of uncertainties inherent in the estimation process, management’s estimate of losses and the related allowance may change. The Company is not dependent on any single customer.
Inventory and Supplies
Inventory and supplies are stated at lower of cost or market cost is determined using the average cost, net of obsolescence reserves.
Property, Plant and Equipment and Depreciation
Property, plant and equipment is stated at original cost, including interest on funds borrowed to finance the acquisition of capital additions. Repairs and maintenance are expensed as incurred. Depreciable property disposed of in the ordinary course of business, less salvage value, is charged to accumulated depreciation with no gain or loss recognized. Gains or losses from the sale of land are recorded in results of operations.
The Company’s depreciation expense is based on the composite group remaining life method and straight-line composite rates. This method provides for the recognition of the cost of the remaining net investment in telephone plant, less anticipated net salvage value, over the remaining asset lives. This method also requires a periodic evaluation of the average remaining useful lives related to the expected recoverability of the carrying value of assets based on changes in technology, environmental factors, the federal and local regulatory environment, and other competitive forces. Effective on July 1, 2005, the Company changed its accounting estimates relating to depreciation. Refer to Note 4 to the consolidated financial statements for further details.
Goodwill and Other Intangible Assets
Goodwill
Goodwill is the excess of the acquisition cost of businesses over the fair value of the identifiable net assets acquired. Impairment testing for goodwill is performed at least annually unless indicators of impairment exist. The impairment test for goodwill uses a two-step approach, which is performed at the reporting unit level. Reporting units may be operating segments or one level below an operating segment, referred to as a component. Businesses for which discrete financial information is available are generally considered to be components of an operating segment. Components that are economically similar and managed by the same segment management group are aggregated and considered a reporting unit under SFAS No. 142, “Goodwill and Other Intangible Assets.” Step one compares the fair value of the reporting unit (calculated using a discounted cash flow method) to its carrying value. If the carrying value exceeds the fair value, there is a potential impairment and step two must be performed. Step two compares the carrying value of the reporting unit’s goodwill to its implied fair value (i.e., fair value of reporting unit less the fair value of the unit’s assets and liabilities, including identifiable intangible assets). If the carrying value of goodwill exceeds its implied fair value, the excess is required to be recorded as an impairment. The Company has evaluated its goodwill using the fair value approach for each reporting unit to determine if there is an impairment exposure and the impact it would have on the Company’s results of operations for 2005. The evaluation of the two reporting units revealed no impairment exposure.
Indefinite Life Intangible Assets
The indefinite life intangible assets are those intangibles not subject to amortization and consist principally of wireline concessions and FCC cellular licenses.
A significant portion of our intangible assets are cellular licenses that provide our wireless operations with the exclusive right to utilize designated radio frequency spectrum to provide cellular communication services. While licenses are issued for only a fixed time, generally ten years, such licenses are subject to renewal by the Federal Communications Commission (FCC). Renewals of licenses have occurred routinely and at nominal cost. Moreover, we have determined that there are currently no legal, regulatory, contractual, competitive, economic or other factors that limit the useful life of our wireless licenses. As a result, we treat the wireless licenses as an indefinite-lived intangible asset under the provisions of SFAS No. 142. We reevaluate the useful life determination for cellular licenses each reporting period to determine whether events and circumstances continue to support an indefinite useful life.
We have tested our indefinite life intangible assets for impairment at least annually unless indicators of impairment exist. We began using the direct value approach in 2005 performing our annual impairment test on our indefinite life intangible assets in accordance with a September 29, 2004 Staff Announcement from the staff of the Securities and Exchange Commission (SEC), “Use of the Residual Method to Value Acquired Assets Other Than Goodwill.” The direct value approach determines fair value using estimates of future cash flows associated specifically with the licenses. Previously, we used a residual method, which determined the fair value of the business by estimating future cash flows of the operations. The fair value of aggregate licenses
was determined by subtracting from the fair value of the business the fair value of all of the other net tangible and intangible (primarily recognized and unrecognized customer relationship intangible assets) assets of our operations. We determined the fair value of our customer relationship intangible assets based on our average customer acquisition costs. Under either the direct method or the residual method, if the fair value of the aggregated licenses was less than the aggregated carrying amount of the licenses, an impairment would have been recognized. The Company has evaluated its indefinite life intangible assets using the fair value approach for each reporting unit to determine if there is an impairment exposure and the impact it would have on the Company’s results of operations for 2005. The evaluation revealed no impairment exposure.
Definite Life Intangible Assets
The definite life intangible assets are those intangibles assets subject to amortization and consist principally of trade names and software licenses. The Company amortizes trade names and software licenses on a straight-line basis over 25 and 5 years, respectively.
For information related to the breakdown of the carrying amount of goodwill as well as the major components of our other intangible assets, see Note 5.
Software Costs
The Company defers and amortizes software development project costs over a five-year period beginning at the project completion date.
Advertising Costs
The Company expenses advertising costs as incurred, and recorded advertising costs of $17 million, $16 million and $15 million in 2005, 2004 and 2003, respectively.
Repairs and maintenance
The Company charges the cost of repairs and maintenance as these costs are incurred.
Employee Benefit Plans
Pension and post-employment health care and life insurance benefits earned interest on projected benefit obligations are accrued currently. Prior service costs and credits resulting from changes in plan benefits are amortized over the average remaining service period of the employees expected to receive the benefits.
Impairment or Disposal of Long-lived Assets
Assets are assessed for impairment when changes in circumstances indicate that their carrying values are not recoverable in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”. Losses are recognized in circumstances where impairment exists, at the amount by which the carrying value of assets exceeds fair value. Fair value is determined based on quoted market prices, if not available, the estimate of fair value is based on various valuation techniques, including a discounted value of estimated future cash flows and fundamental analysis.
For the last three years, the Company has been operating a TDMA network and CDMA network for its wireless clients. During 2003 management decided to migrate in 2004 all TDMA clients to the CDMA network and subsequently dispose of the TDMA network. The expected undiscounted future cash flow from operations on the TDMA network was estimated to be $27 million ($47.4 million estimated cash flows from operations less $20.4 million of related expenses). The discounted fair value of the network was estimated to $26 million and was determined by discounting anticipated discounted future cash flows at a risk free rate of 3.76%.
Since the estimated fair value of $26 million was lower than the $37.8 million carrying amount of the TDMA network as of December 31, 2003, the Company recorded an impairment loss of $11.8 million.
Income Taxes
The Company uses an asset and liability approach in accounting for income taxes following the provisions of SFAS No. 109, “Accounting for Income Taxes.” Deferred tax assets and liabilities are established for temporary differences between the way certain income and expense items are reported for financial reporting and tax purposes. Deferred tax assets and liabilities are adjusted, to the extent necessary, to reflect tax rates expected to be in effect when the temporary differences reverse. A valuation allowance is established for deferred tax assets for which realization is more likely than not.
Interest Rate Risk
The Company uses interest rate swap agreements to manage exposures to changes in the fair value of its senior notes to achieve a targeted mix of fixed and variable rate debt. The Company does not hold interest rate swaps for trading purpose. Interest rate swaps are marked-to-market in the consolidated balance sheet as a component of other assets.
Minority Interest in Consolidated Subsidiary
The minority interest in the consolidated balance sheet reflects Popular Inc.’s 33% net investment in Coqui.net at year-end.
Reclassifications
Reclassifications of prior years’ data have been made to conform to the current year’s presentation.
3.
Accounting Change
Directory Revenue Recognition
Effective January 1, 2003, the Company changed its method of accounting for directory-publishing revenues and related expenses from the point-of-publication method to the amortization method. The cumulative effect of applying this accounting change to prior years was recognized as of January 1, 2003 as a one-time, non-cash loss of $17 million ($13 million, after tax).
Asset Retirement Obligations
On January 1, 2003, we adopted SFAS No. 143, “Accounting for Asset Retirement Obligations.” This statement provides the accounting for the cost of legal obligations associated with the retirement of long-lived assets. SFAS No. 143 requires that companies recognize the fair value of a liability for asset retirement obligations in the period in which the obligations are incurred and capitalize that amount as part of the book value of the long-lived asset. We have determined that the Company does not have a material legal obligation to remove long-lived assets as described by this statement. However, we have included estimated removal costs in our group depreciation models. These costs have increased depreciation expense and accumulated depreciation for future removal costs for existing assets. These removal costs are recorded as a reduction to accumulated depreciation when the assets are retired and removal costs are incurred.
For some assets, such as telephone poles, the removal costs exceed salvage value. Under the provisions of SFAS No. 143, we are required to exclude costs of removal from our depreciation rates for assets for which the removal costs exceed salvage. Accordingly, in connection with the initial adoption of this standard on January 1, 2003, we have reversed accrued costs of removal in excess of salvage from our accumulated depreciation accounts for these assets. The adjustment was recorded as a cumulative effect of an accounting change, resulting in the recognition of an estimated gain of $117 million ($71 million after-tax). Effective January 1, 2003, we began expensing costs of removal in excess of salvage for these assets as incurred. The impact of this change in accounting resulted in a decrease in depreciation expense and an increase in operational and support expenses. The net increase to operating income in 2003, excluding the cumulative effect adjustment, was approximately $12 million ($7 million after-tax).
Additionally, no later than December 31, 2005, FASB Interpretation (FIN) No. 47, “Accounting for Conditional Asset retirement Obligations - an interpretation of FASB Statement No. 143” became effective. There was no impact of the adoption of FIN No. 47 on the Company’s results of operations or financial position.
4.
Property, Plant and Equipment
Property, plant and equipment consist of:
Effective July 2005, the Company performed its periodic review of plant useful lives estimates based on a comprehensive analysis of the useful lives underlying the depreciation rates. The review incorporates the impact of technology, future competition and assumptions employed in the industry relative to depreciation and retirement rates. For the year ended December 31, 2005, the revision resulted in lower depreciation expense of approximately $6.5 million than would have been recognized under the previous useful lives estimate.
Following is a breakdown of goodwill.
Intangible asset amortization expense was $23 million, $17 million and $14 million for the years ended December 31, 2005, 2004 and 2003. The following table presents expected amortization expense of existing intangible assets as of December 31, 2005 for each of the following years (in thousands):
8.
Pension Plan
The Company has noncontributory pension plans for full-time employees, which are tax qualified as they meet Employee Retirement Income Security Act of 1974 (the “ERISA”) requirements. The Company realizes tax deductions when contributions are made to the trusts. The trusts invest in equity and fixed income securities to meet benefit obligation.
The pension benefit is composed of two elements. An employee receives an annuity at retirement when they reach the rule of 85 (age plus years of service). The annuity is calculated by applying a percentage times years of service to the last three years of salary. The second element is a lump sum based on years of service, approximating nine to twelve months of salary.
There are separate trusts for the annuity and the lump sum benefit with a further separation of the annuity benefit into a plan for the UIET union, for the HIETEL union and management employees. Health care and life insurance benefits are provided to retirees.
The following table sets forth the status of the plans and the amounts in the financial statements as of December 31, 2005 and 2004:
(In thousands)
Changes in benefit obligations were caused by factors including changes in actuarial assumptions (see “Assumptions”).
The accumulated benefit obligation for all defined benefit pension plans was $1,240 million and $1,187 million at December 31, 2005 and 2004, respectively.
Information for pension plans with an accumulated benefit obligation in excess of plant assets follows:
(In thousands)
Net Periodic Cost
The components of the net pension and other post-employment benefit expenses for years ended December 31,
(In thousands)
Additional Information
We evaluate the pension plan to determine whether any additional minimum liability is required. The adjustment is necessary to reflect as a net liability at a minimum the fair value of benefit obligation less plan assets with the fair value of benefit obligation calculated on an accumulated benefit obligation basis. An offsetting deferred pension asset of $42 million and $24 million was recorded at December 31, 2005 and 2004 as part of this calculation to recognize all unrecognized prior service costs. The difference between the additional liability adjustment and the additional asset was recorded as a component of other comprehensive income and all accumulated amounts recorded in other comprehensive income, net of tax, is reflected as a separate account within shareholders equity.
Assumptions
The weighted-average assumptions used in determining benefit obligations at December 31,
The weighted-average assumptions used in determining net periodic cost for years ended December 31,
In order to project the long-term target investment return for the total portfolio, estimates are prepared for the total return of each major asset class over the subsequent 10-year period, or longer. Those estimates are based on a combination of factors including the following: observable current market interest rates, consensus earnings expectations, historical long-term performance and value-added, and the use of conventional long-term risk premiums. To determine the aggregate return for the pension trust, the projected returned of each individual asset class is then weighted according to the allocation to that investment area in the Trust’s long-term asset allocation policy. The projected long-term results are then also compared to the investment return earned over the previous 10-years.
The assumed health care cost trend rates at December 31,
Assumed health care trend rates have a significant effect on the amounts reported for the health care plan. A one-percentage-point change in the assumed health care cost trend rate would have the following effects:
One-percentage-point
Plan Assets
The weighted-average assets allocation for the pension plans assets at December 31, 2005 and 2004 by category are as follows:
The portfolio strategy emphasizes a long-term equity orientation, significant global diversification, the use of both public and private investments and professional financial and operational risk controls. Assets are allocated according to a long-term policy neutral position and held within a relatively narrow and pre-determined range. Both active and passive management approaches are used depending on perceived market efficiencies and various other factors.
Cash Flows
Federal legislation was enacted on April 10, 2004 that provides temporary pension funding relief for the 2004 and 2005 plan years. The legislation replaced the 30-year treasury rate with a higher corporate bond rate for determining the current liability. In 2005, we contributed $143 million to our qualified pension trusts, $1 million to our nonqualified pension plans and $28 million to our other postretirement benefit plans. Our estimate of the amount and timing of required qualified pension trust contributions for 2006 is based on current regulations, including continued pension funding relief, and is approximately $102 million. We anticipate approximately $1 million in contributions to our non-qualified pension plans and approximately $24 million to our other post-retirement benefit plans in year 2006. We have adequate liquidity resources to fund this amount.
Estimated Future Benefit Payments
The benefits payments, which reflect expected future service, are expected to be paid as follows:
Medicare Prescription Drug subsidies expected to offset the future other post-retirement benefit payments noted above are as follows:
Early Retirement and Voluntary Separation Provision
In May 2005, 33 eligible HIETEL employees accepted the voluntary separation program offered by the Company in March 2005. In March 2005, 46 eligible management employees accepted the voluntary separation program offered by the Company in December 2004. These programs resulted in a provision of $1.7 million during year ended December 31, 2005.
On September 30, 2004, the Company offered a voluntary separation program, expiring on December 3, 2004, to eligible management employees, resulting in a provision of $1.2 million covering 24 employees who accepted the separation plan. In January 2004, the Company recorded a provision of $1.6 million associated with 19 eligible management employees who accepted the early retirement program offered by the Company in December 2003. These programs resulted in a total provision of $2.8 million during year ended December 31, 2004.
In January 2003, 29 eligible management employees accepted the voluntary separation program, offered by the Company to eligible management employees during the fourth quarter of 2002, representing an expense of $1.4 million, which was recorded in the first quarter 2003. During the second quarter of 2003, the Company offered to members of one of the unions a voluntary separation program that closed on June 20, 2003, which 44 eligible employees accepted. Also, during the second quarter of 2003, an additional 147 employees in the craft union accepted a retirement program offered by the Company that closed on June 30, 2003. As a result of these two programs, an additional non-cash provision of $3.3 million was recorded in the second quarter
2003. In December 2003, the Company offered an early retirement program to eligible management employees. A non-cash provision of $12.6 million was recorded relating to 147 employees who had accepted as of December 31, 2003.
9. Other Current Liabilities
10. Debt
The senior notes and term credit facilities are unsecured and non-amortizing. PRTC is the guarantor of these debt instruments. See Schedule I for additional information about guarantees of operating debt. The senior notes indentures and term credit facility agreements do not contain dividend restrictions.
The Company had a $400 million commercial paper program with maturities not to exceed 364 days, backed by a working capital facility. As of February 28, 2006, the Company decreased the commercial paper program to $275 million.
On March 1, 2005 the Company entered into an unsecured, $400 million 364-day revolving credit facility. Amounts borrowed under this facility are guaranteed by PRTC, and bear interest at the applicable LIBOR rate plus a margin or at the base rate; which is the higher of the base rate publicly announced by the administrative agent from time to time or the Federal Funds rate plus 0.5%, plus a margin. The Company is also required to pay a quarterly facility fee on commitments under the facility and a quarterly utilization fee on borrowed amounts that exceed 50% of the commitments under the facility. Accrued interest on Eurodollar rate borrowings is payable based on elected intervals of one, two, three or six months or other interest period as the Company may select, subject to certain conditions. Accrued interest on base rate borrowings is payable quarterly. This facility contains negative covenants, including covenants which limit the Company’s ability to grant or permit liens on its or subsidiaries’ properties, merge or sell all or substantially all of its assets and permit its subsidiaries to incur debt. This facility also requires that the Company maintain certain financial ratios. Upon the occurrence of a default or an event of default, the lenders have various remedies or rights, which may include termination of the lenders’ obligations to make advances and declare all borrowed amounts and interest
thereon immediately due and payable. The intended purpose of this facility is for working capital purposes and serves as backstop facility for the commercial paper program. At December 31, 2005, the Company had no outstanding debt balance under this facility. This facility matured on February 28, 2006, on which date the Company entered into a replacement facility.
The replacement facility consists of two related, unsecured credit facilities, a $275 million revolving credit facility maturing on February 28, 2009, and a $275 million term credit facility, which is available to be drawn in one borrowing at any time until May 1, 2006 and will mature on February 28, 2011. At the option of the Company, the maximum amount which may be borrowed under the revolving credit facility may be increased at any time prior to maturity to $300 million, and the amount which may be borrowed under the term credit facility may be increased at any time until May 1, 2006 to $300 million. Amounts borrowed under these facilities are guaranteed by PRTC, and bear interest at the applicable LIBOR rate plus margins applicable to each facility or at the base rate; which is the higher of the base rate publicly announced by the administrative agent from time to time or the Federal Funds rate plus 0.5%, plus margins applicable to each facility. Accrued interest on Eurodollar rate borrowings is payable based on elected intervals of one, two, three or six months or other interest period as the Company may select, subject to certain conditions. Accrued interest on base rate borrowings is payable quarterly. The Company is also required to pay a quarterly facility fee on commitments under the revolving credit facility, irrespective of usage, and a commitment fee on commitments under the term credit facility until utilized. The revolving credit facility and the term credit facility contain covenants, including negative covenants and financial ratios, and events of default which are substantially the same as those which existed under the 364-day facility that was replaced. The revolving credit facility is for working capital purposes and serves as backstop facility for the commercial paper program, and the term credit facility is intended to be utilized, to the extent necessary, to repay the senior notes maturing on May 15, 2006.
The Company also had an undrawn $40 million working capital credit facility with Banco Popular de Puerto Rico, an affiliate of Popular, Inc. that was scheduled to mature on June 30, 2006. Amounts outstanding under this facility bear interest at a rate of 40 basis points over LIBOR. This facility also serves as additional backstop for the commercial paper program. At December 31, 2005, the Company had no outstanding debt balance under this facility. This facility was cancelled as of February 28, 2006 by mutual agreement of the parties. No balance was outstanding under this facility as of the cancellation date.
On August 31, 2001, the Company entered into an interest rate swap contract with a notional amount of $150 million. In September 2002, the Company drew the value out of the hedge position without changing the fixed/floating funding mix of the original swap transaction. This transaction resulted in cash proceeds of $11 million, reflected in cash from operations as required by SFAS No. 104, and created a deferred derivative, which will be amortized until 2006. As of December 31, 2005, the unamortized balance of the deferred derivative is $1 million. The purpose of the swap is to hedge against changes in the fair market value of the Company’s senior notes to achieve a targeted mix of fixed and variable rate debt. The swap receives interest at a fixed rate of 6.65% and pays interest at a net variable rate equal to six month LIBOR plus 170 basis points, with semiannual settlements and reset dates every May 15 and November 15 until maturity of the May 15, 2006 senior notes. The swap was entered into “at market” and as a result, there was no exchange of premium at the initial date of the swap. The Company designates the swap as a hedge of the changes in fair market value of the senior notes due to changes in the designated benchmark interest rate. PRTC is the guarantor of the interest rate swap.
Aggregate maturities of the senior notes are as follows:
11. Other Non-Current Liabilities
Other non-current liabilities consist of:
12.
Deferred ESOP Compensation
The Employee Stock Ownership Plan (“ESOP”) acquired a 3% interest in the Company in 1999, which was financed by a $26 million, twenty-year note borrowed from the Company to establish a contributory investment fund for employees. The ESOP only invests in shares of the Company’s common stock. Shares are held by the ESOP’s trustee and maintained in a suspense account until they are released to employee participants. The yearly release of shares to participants is based on the greater of participant contributions plus a Company match of 30% up to 5% of wages or a minimum based on an amortization schedule. The minimum is based on the ratio of annual debt service to total debt service multiplied by the initial 750,000 shares.
During year 2005, the ESOP entered into a new loan agreement amounting $2.0 million with the Company to finance the ESOP’s acquisition of Company stocks. Also, during year 2000 and 2001, subsequent to ESOP’s commencement, the ESOP entered into various loan agreements amounting to $4.9 million with the Company to finance the ESOP’s acquisition of Company stocks from former employees.
Salaried, regular, full and part-time employees of the Company actively employed on March 2, 1999 were eligible to receive a portion of the Initial Grant of the Company’s stock. Employees that were not actively employed on March 2, 1999 were also eligible to receive the Initial Grant provided that they met the following condition:
Employees who were on short-term disability, workers’ compensation, Family and Medical Care Leave Act (FMLA) leave, layoff with recall rights, or other Company approved leave of absence; and the employees returned to active employment with the Company as soon as they were eligible to do so and within 180 days after March 2, 1999.
Compensation expense is recorded based on the release of shares at market value, which is based on an independent appraisal performed annually. The ESOP released approximately 33,000 and 32,000 shares in 2005 and 2004, respectively. This release resulted in compensation expense of $2 million for the years ended December 31, 2005, 2004 and 2003, respectively, reflecting the market value of the shares. The release of shares, based upon the per share price established at the Acquisition, amounted to $1 million for December 31, 2005 and 2004, respectively, which is reflected as a reduction of deferred ESOP compensation in equity.
13.
Shareholders’ Equity
Common Stock
Common stock consisted of fifty million authorized no par value shares, of which twenty five million shares were outstanding at December 31, 2005 and 2004.
Subscription Receivable
The subscription receivable reflects receipts from the PRTA originally recorded at its present value (at an 8% discount rate). As part of the Acquisition agreement, the PRTA agreed to contribute a total of $200 million in cash or stock as a capital
contribution in equal installments of $40 million over five years beginning on March 2, 2000. The Company employed the $200 million capital contribution to partially fund it under funded pension and other post-employment benefit obligations, as agreed. The stock purchase agreement required the Company to contribute $66 million, which included the $40 million received from PRTA, to the pension plan immediately upon receipt of the proceeds each year. The Company received the final $40 million installment in March 2004 and made the required pension payment of $66 million. All installments were made in cash.
Accumulated Other Comprehensive Loss
The accumulated other comprehensive loss represents unrecognized losses, other than unrecognized prior service costs which are reflected as an other asset, associated with the hourly employee pension fund, since the accumulated benefit obligation exceeds the fair value of plan assets.
The accumulated other comprehensive loss amount as of December 31, 2005 and 2004 has been adjusted in the amount of $5 million and $65 million, respectively, in order to reflect the after-tax amount in accordance with the provisions of SFAS No.130, “Reporting Comprehensive Income”.
Dividends
To the extent funds are legally, The Company’s shareholders’ agreement requires the payment of dividends equal to at least 50% of consolidated net income to be paid in the following quarter.
Declared dividends for financial reporting purposes were the following:
•
The Company also enters into transactions with affiliates for the purchase of materials and supplies used in the construction and expansion of its telecommunications network. Such transactions are subject to conditions similar to transactions with independent third parties. The Company also participates with affiliates of shareholders in sharing the cost of development of computer software programs by third party vendors. The shareholders receive no compensation for arranging the development of such systems. In addition, the Company reimburses shareholders and affiliates for the direct cost of a limited number of employees that work at the Company in management positions.
16.
Fair Value of Financial Instruments
The carrying amounts and fair values of the Company’s financial instruments at December 31 are as follows:
17.
Segment Reporting
The Company has two reportable segments: Wireline and Wireless.
The Wireline segment consists of:
•
Local services, including basic voice, telephone and telecommunications equipment rentals, value-added services, high-speed private line services, Internet access and public phone service;
•
Access services to long distance carriers, competitive local exchange carriers, and cellular and paging operators to originate and terminate calls on our network;
•
Long distance services including direct dial on-island and off-island, operator assisted calls and prepaid calling card;
•
Directory publishing rights services; and
•
Telecommunication equipment sales and billing and collection services to competing long distance operators in Puerto Rico.
The Wireless segment consists of:
The accounting policies of the segments are the same as those followed by the Company (see Note 2). The Company accounts for intersegment revenues at market prices.
Segment results for the Company are as follows:
On February 28, 2006, the Company signed an agreement to sell its participation in both the equity interest in the Puerto Rico directory operation and the right to receive 35% of the revenues from the publication of directory advertising for $190 million, with an after tax gain of $146 million. The proceeds will be used to pay dividends and long-term debt. The transaction is scheduled to close before the close of business on March 31, 2006.
REGULATORY AND COMPETITIVE TRENDS
Regulatory activity at the federal and local levels has been primarily directed at meeting challenges in maintaining support for local exchange rates and Universal Service while affecting the rate rebalancing and regulatory restructuring required by an increasingly competitive environment. Among the regulatory issues are: rate rebalancing, intercarrier compensation and insular relief.
We continue to meet the wholesale requirements of new competitors and have signed agreements with various wireless and wireline carriers. These agreements permit them to purchase unbundled network elements, to resell retail services, and to interconnect their networks with ours.
INTRA-ISLAND LONG DISTANCE ACCESS RATE DISPUTE (K-2)
In 1997, several long-distance carriers filed a complaint against the Company before the TRB alleging that the Company’s access tariff was not cost-based as required by law. On February 28, 2002, the TRB issued the February 2002 Order instructing the Company to reduce such access rates and requiring other obligations from the Company. The Company appealed the TRB’s February 2002 Order but subsequently settled with the complainants and the TRB. As part of its settlement with the TRB, the Company agreed to reduce the access charge, eliminate touch tone charges and provide its single line residential customers certain credits on their phone bills. In return, the Company was allowed to reduce its local calling zones from 68 to 10 and phase in an “Extended Area Service” surcharge on all of its local customers. As of the date of this report, the Company has complied with all of its obligations under the settlement agreement and has completely phased in the surcharge except in a reduced area of its territory. In December 2005, the last credits of the surcharge were granted and all customers are now paying the $2.25 surcharge on their monthly bills. PRTC has complied with all the terms and conditions of the K-2 Settlement.
SINGLE ZONE
On April 6, 2005, PRTC filed with the TRB a new tariff structure for basic telephone service which would have eliminated all intra-LATA long distance charges by reducing its existing local calling areas from 10 to 1 (the “Single Zone Plan”).
On May 17, 2005 and May 20, 2005, TLD and WorldNet, respectively, filed separate complaints challenging the legality of the Single Zone Plan, alleging in their complaint that PRTC’s new tariff structure under the Single Zone Plan is not based on cost and that the tariff would eliminate the intra-island long distance market.
As a result of repeated delays in the administrative proceeding, on February 3, 2006, the Company withdrew the tariff structure proposed under the Single Zone Plan and filed a motion to dismiss in the related complaint, which motion has been granted by the TRB. PRTC plans to file a new tariff structure in the second quarter of year 2006 that will rebalance residential and business within the context of the current 10 zone calling areas.
PUBLIC TELEPHONE SERVICE PROVIDER - ANTI COMPETITIVE ACTIONS
On August 16, 2002, PSA, the parent company of Phoenix of Puerto Rico, filed a lawsuit against PRTC in the United States Bankruptcy Court for the District of Delaware, claiming anti competitive acts. The claims have since been transferred to the United States District Court of Delaware. The disputes between the two parties include an administrative claim by PRTC against PSA, and a claim of over $9 million by PSA against PRTC. The United States District Court of Delaware granted a PRTC motion to change venue to Puerto Rico and the motion to dismiss is currently pending before the United States District Court of Puerto Rico. On September 24, 2004, the Court issued an Opinion and Order granting PRTC’s motion to dismiss. PSA appealed the Order and oral arguments were presented on September 8, 2005 before the Circuit Court. On October 17, 2005, the parties executed a settlement agreement resolving the dispute. On November 16, 2005, the Circuit Court dismissed the appeal.
TOUCHTONE CHARGES
On November 17, 2003, six residential subscribers and eight business service subscribers filed a class action suit with the Court of First Instance of Puerto Rico (the “Court”) under the Puerto Rico Telecommunications Act of 1996 (the “Act”) and the Puerto Rico Class Action Act of 1971. The plaintiffs have claimed that the Company’s charges for touchtone service are not based on cost, and therefore violate the Act. The plaintiffs have requested that the Court (i) issue an order certifying the case as a class action, (ii) designate the plaintiffs as representative of the class, (iii) find that the charges are illegal, and (iv) order the Company to reimburse every subscriber for excess payments made since September 1996.
On November 1, 2004 PRTC filed a Motion for Summary Judgment requesting the dismissal of plaintiff’s claim due to plaintiff’s failure to follow the procedure to object charges, established by Law 33. Law 33 establishes that a telecommunication services user has a twenty days period from the receipt of the telecommunications service company invoice to object charges in the same. PRTC argues that since admittedly plaintiffs failed to comply with said procedure their claims are time barred. Said motion is still under the consideration of the Court.
On May 10, 2005 the Court issued an Order certifying the case as a class action. PRTC sought reconsideration of that decision and an argumentative hearing was held on June 20, 2005 to discuss the merits of PRTC’s position. On June 22, 2005 the Court issued an Order confirming its previous decision. In consequence, a certiorari writ was filed on June 22, 2005. On September 19, 2005 the P.R. Appeals Court denied the same. PRTC sought reconsideration of that decision on October 4. 2005. Said reconsideration request was denied on October 11, 2005, therefore PRTC filed a Certiorari Writ with the P.R. Supreme Court on November 10, 2005. The same was denied on January 18, 2006.
On January 11, 2006, the PRTC filed a Motion to Dismiss alleging lack of subject matter jurisdiction based on the enactment of Law No. 138 of November 4, 2005. This new law grants the TRB exclusive primary jurisdiction to entertain class actions related to telecommunication services. The hearing scheduled for January 24, 2006 was rescheduled for May 16, 2006 in response to plaintiff’s request for time to oppose PRTC’s Motion to Dismiss. The court granted the plaintiffs until March 24, 2006 to submit their opposition. In addition it granted PRTC until April 24, 2006 to submit its reply. On March 24, 2006 plaintiffs filed a request for sixty additional days to submit their opposition. On March 29, 2006 PRTC opposed this request and asked the Court to rule on the jurisdictional matter brought forth by PRTC. In consequence, the Motion to Dismiss is pending.
CTI ASSET TRANSFER
Prior to the Acquisition, PRTC transferred its net wireless assets on September 1, 1998 to CTI (which subsequently became Verizon Wireless, a division of PRTC, on May 1, 2002). Our predecessors later filed a waiver request in 1998 with the FCC to record this transfer at book value instead of fair value. Since our predecessors had not included the costs of wireless operations in the regulated rate setting process, we argued that ratepayers did not bear the cost of our predecessors’ wireless investment. The FCC denied the Company’s waiver petition in April 2001, but recognized that the cellular and paging assets had been removed from the interstate rate base even though it had questions concerning certain costs and expenses.
Separately, the TRB initiated an agreed upon procedures audit of the Company, which included an audit of its compliance with the FCC’s affiliate transactions rules and the CTI asset transfer. On May 5, 2005, the Agreed upon Procedures Audit Report was delivered to PRTC. The report confirms that PRTC complied with the affiliate transaction rules. With respect to the CTI asset transfer, the audit report essentially repeats the FCC’s conclusions. The Audit is pending final approval by the TRB.
PRICE CAP REGULATION
Under the FCC’s “all or nothing” rule, telecommunications carriers that set interstate access rates based on a price cap formula are required to use the price cap formula for all of their affiliates. The price cap formula is based on a plan adopted by the FCC called the Coalition of Affordable Local and Long Distance Service (“CALLS”), which uses rate-of-return as a basis for setting rates. The Company would have been required to implement price caps by March 2, 2000 under the FCC’s rules. Prior to March 2, 2000, the Company had set its interstate access rates based on rate-of-return principles.
The FCC delayed conversion to price cap regulation until June 30, 2002, and the Company requested an extension until June 30, 2003. Under an order issued by the FCC on April 18, 2002, the Company was no longer required to file a waiver request until the FCC had completed its review of the “all-or-nothing” rule. In addition, upon the issuance of an Order and Second Further Notice of Proposed Rulemaking (the “Order”) by the FCC on February 28, 2004, the FCC deferred further action on the all-or-nothing rule until it had reviewed the record compiled in response to the notice included in the Order. Additionally, in the Order the FCC stated that all outstanding interim waivers of the all-or-nothing rule that depend on the FCC’s decision shall continue to be effective until the FCC issues a final order on this matter. As a result, the Company currently continues to set its interstate access rates based on rate-of-return principles.
On May 10, 2004, PRTC filed comments in response to the Order, requesting that the FCC eliminate the “all or nothing rule” or, in the alternative, if the rule is not eliminated, that the FCC grant PRTC’s 1999 waiver request to permit PRTC to remain a carrier that sets its interstate access rates based on rate-of-return principles. The basis of PRTC’s request is that if PRTC were no longer eligible to receive Interstate Common Line Support (“ICLS”), PRTC would require $139 million in additional universal service support to offset lost ICLS revenues and that the CALLS plan cannot accommodate PRTC since there is a $650 million cap on the equivalent support in the CALLS plan, which was based on the anticipated universal service needs of price cap carriers that were participating in the plan at the time of its adoption. There has been no announcement regarding the expected timing for the completion of this proceeding.
INSULAR RELIEF
On December 9, 2005, the FCC issued a Notice of Proposed Rulemaking in which it tentatively concluded to establish a non-rural insular universal service mechanism. The FCC’s proposed mechanism is based on a proposal made by the Company on May 6, 2005. PRTC filed comments in support of the Commission’s tentative conclusion on March 27, 2006. If the FCC’s tentative conclusion were adopted, the Company would be eligible to receive approximately $33 million in annual support based on current investment levels. The Company would be eligible for additional support for its wireless service based on the same per-line support received by the Company. There is no timetable for FCC action on its tentative conclusion, nor any assurances that the FCC will adopt the mechanism as proposed. While the Company currently does not receive high-cost loop support from the FCC, PRTC does receive significant universal service money under other FCC universal service programs.
MUNICIPAL RIGHT OF WAY FEES
A number of cities in Puerto Rico have sought to impose fees upon the Company for using municipal rights of way. The exact manner in which these fees are calculated varies, but they generally seek to collect five percent of the Company’s gross revenue generated in the municipality. The Company has challenged each of these fees in federal court and in the Puerto Rico courts. In the Guayanilla case, on January 28, 2005, the federal district court granted the Company’s motion for summary judgment and held that the fee proposed by the municipality violated federal law, because the municipality could not show that the fee was related to rights of way use. The municipality appealed the district court’s ruling, and oral argument was heard on this appeal in the First Circuit Court of Appeals on November 8, 2005. It is unknown when this decision will be reached or what the outcome will be. All local court cases have been stayed pending the outcome of the Guayanilla appeal. Cases challenging other similar ordinances have been filed. The Commonwealth Legislature has empowered the TRB to adopt regulations governing fees for use of municipal rights of way consistent with local and federal law, but the TRB has not yet taken any action. Other municipalities may adopt similar ordinances. To the extent such fees are upheld, PRTC will either pass the costs along to customers, impacting its competitiveness, or absorb them, impacting its profitability. The following is a list of all right of way open cases:
Right of Way Litigations
Status
US District Court:
1. PRTC v. Municipality of Caguas
PRTC’s challenge of Caguas ordinance is stayed pending resolution of the Guayanilla case.
2. PRTC v. Municipality of Guayanilla
Federal District Court found the ordinance violative of Section 253. Guayanilla’s appeal is pending before the First Circuit Court of Appeals.
3. PRTC v. Municipality of Ponce
Declaratory judgment action filed in federal and local court on November 22 and November 28, 2005, respectively. Ponce was served with summons.
4. PRTC v. Municipality San Juan
The case was dismissed when San Juan withdrew its ordinance.
5. PRTC v. Municipality of Vega Baja
Declaratory judgment action filed in federal and local court on February 22, 2006. Vega Baja was served with summons.
6. PRTC v. Municipality of Cataño
Declaratory judgment action filed in federal and local court on February 28, 2006. Cataño served with summons.
7. PRTC v. Municipality of Utuado
Declaratory judgment action filed in federal and local court on March 24, 2006. Pending summons.
Local Courts:
1. PRTC v. Municipality of Caguas
Filed a motion to stay. Waiting for First Circuit Court decision on Guayanilla’s case.
2. PRTC v. Municipality of Ponce
Filed a motion to stay. Waiting for First Circuit Court decision on Guayanilla’s case.
3. PRTC v. Municipality San Juan
Filed a motion to stay. Waiting for First Circuit Court decision on Guayanilla’s case.
4. PRTC v. Municipality of Vega Baja
Filed a motion to stay. Waiting for First Circuit Court decision on Guayanilla’s case.
5. PRTC v. Municipality of Cataño
Filed a motion to stay. Waiting for First Circuit Court decision on Guayanilla’s case.
6. PRTC v. Municipality of Utuado
Filed a motion to stay. Waiting for First Circuit Court decision on Guayanilla’s case.
INTERCONNECTION DISPUTE
On or about October 2004, the TRB arbitrated an interconnection contract between WorldNet Telecommunications Inc. (“WorldNet”) and the Company. Among the more significant decisions reached by the TRB, it adopted the arbitrator’s decision to approve a provision that established performance parameters under the contract but rejected the imposition of liquidated damages for failure to meet the performance parameters. Both WorldNet and the Company cross-appealed certain aspects of the TRB’s rulings to the U.S. District Court for the District Court of Puerto Rico pursuant to the federal Communications Act and moved for summary judgment The District Court affirmed in part and reversed in part the disputed TRB rulings in early February 2006. Both the Company and the TRB filed notices of appeal to the U.S. Court of Appeals for the First Circuit, which remain pending. The timing and outcome of this appeal are unknown. WorldNet has also requested further proceedings before the TRB with respect to the ruling of the District Court. That request is pending.
22. Quarterly Financial Data
The following table reflects the unaudited quarterly results of the Company for the years ended December 31, 2005, 2004 and 2003.
(1)
During the second quarter of 2003, the Company changed its method of accounting for directory-publishing revenues and related expenses from the point of publication method to the amortization method, effective January 1, 2003 (see Note 3). The quarterly information for the first quarter of 2003, which had been previously reported, has been restated.
Telecomunicaciones de Puerto Rico, Inc.
Schedule I - Condensed Consolidating Information for the Years Ended December 31, 2005, 2004 and 2003
The following summarizes the condensed consolidating financial information as of December 31, 2005, 2004 and 2003, and for the years then ended, presents the financial position, results of operations and cash flows of (i) the Company as if it accounted for its subsidiaries on the equity method, (ii) the Guarantor Subsidiary (as defined below); and (iii) the Non-Guarantor Subsidiaries (as defined below) on a combined basis. The consolidation entries eliminate investments in subsidiaries and intercompany balances and transactions.
The Notes are guaranteed by PRTC (“the Guarantor Subsidiary”), a wholly owned subsidiary of the Company, but not guaranteed by the Company’s other subsidiaries, Coqui.net, PRTLD, and Datacom (the “Non-Guarantor Subsidiaries”). The guarantee by the guarantor subsidiary is full and unconditional.
Condensed Consolidating Balance Sheets
December 31, 2005
(In thousands)
Condensed Consolidating Balance Sheets
December 31, 2004
(In thousands)
Condensed Consolidating Statements of Income
For the year ended December 31, 2005
(In thousands)
Condensed Consolidating Statements of Income
For the year ended December 31, 2004
(In thousands)
Condensed Consolidating Statements of Income
For the year ended December 31, 2003
(In thousands)
Condensed Consolidating Statements of Cash Flows
For the year ended December 31, 2005
(In thousands)
Condensed Consolidating Statements of Cash Flows
For the year ended December 31, 2004
(In thousands)
Condensed Consolidating Statements of Cash Flows
For the year ended December 31, 2003
(In thousands)
Telecomunicaciones de Puerto Rico, Inc.
Schedule II - Valuation and Qualifying Accounts for Years Ended December 31, 2005, 2004 and
NOTES:
(a)
Reserved write-offs.
(b)
Other adjustments and recoveries of amounts written off in prior years.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
The Company maintains disclosure controls and procedures as defined in Rules 13a-15(e) or 15d-15(e) of the Securities Exchange Act of 1934, as amended (the Exchange Act”) that are designed to ensure that information required to be disclosed in the Company’s reports that are filed under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. In designing and evaluating the Company’s disclosure controls and procedures, the Company’s Chief Executive Officer and Chief Financial Officer recognized that any controls and procedures, no matter how well-designed and operated, can provide only reasonable assurance of achieving the desired control objectives. The Company’s Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of the Company’s disclosure controls and procedures, as of the end of the period covered by this report (the “Evaluation Date”). They have concluded that as of the Evaluation Date, the Company’s disclosure controls and procedures were effective at the reasonable assurance level.
There has been no change in the Company’s internal control over financial reporting during the Company’s fourth fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company internal control over financial reporting.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
Not applicable.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
BOARD OF DIRECTORS
As of March 31, 2006, the directors of the Company, all of whom serve until their successors are appointed, are as follows:
Daniel C. Petri is the Group President-International responsible for Verizon’s wireless and wireline operations in the Americas and Europe. He is also responsible for management of Verizon Airfone. Prior to this appointment he served as President-International Europe & Asia. During his communications career of more than 30 years, Mr. Petri has held a number of key positions in domestic as well as international operations. He served as managing director-Worldwide Operations for NYNEX from 1994 to 1995. From 1988 to 1994, Mr. Petri served as vice president and general manager for Central New York and then for Midtown Manhattan, overseeing customer care operations in each region. He holds a bachelor’s degree in mechanical engineering from Rutgers University and a master’s degree in management science from Long Island University. He has also completed management programs in General Management, Finance and Marketing at the Columbia University’s Graduate School of Business.
Edward J. McQuaid is Vice President and Chief Financial Officer for Verizon International since February 2005. He is responsible for Verizon International’s finance, strategy and business development opportunities. He was Vice President of Finance in Verizon’s Domestic Telecom Finance organization. During 2004 he was responsible for all financial matters for Verizon’s Network Services Group including financial planning, analysis, resource allocation and management and financial reporting. He had similar responsibilities for the Enterprise Solutions Group in 2003 and for the National Operations organization in 2002. Also, he was Vice President of Corporate Financial Planning & Analysis at Verizon Communications. Ed received a Bachelor’s Degree in 1977 and Master’s Degree in 1981 both from Babson College. He received his CMA in 1983.
Jeanne M. Dennison leads the Human Resources and Public Affairs function for Verizon International. In this capacity, Ms. Dennison is responsible for providing value-added strategies and solutions in support of Verizon International’s objectives. Prior to this role, she led the international Human Resources merger integration efforts for both the Bell Atlantic/GTE and the Bell Atlantic/NYNEX mergers. Ms. Dennison’s career spans nearly 20 years focusing on global human resources policies and practices. She holds a master’s degree in business administration from the University of Connecticut and a bachelor’s degree in communications from Albertus Magnus College in New Haven, Connecticut where she serves on the Board of Trustees.
Cristina M. Lambert was appointed our President and Chief Executive Officer in September, 2003. Prior to assuming her current role, Ms. Lambert served as Vice President and General Manager of Wireline Services for PRTC since June 3, 1999. In this capacity, she was responsible for managing the sales/marketing and network operations functions, leading a team of 2,400 employees and serving more than 1.2 million customers. Before joining the leadership team in Puerto Rico, she was the assistant vice-president -
Customer Care for GTE. Her telecommunications career began in 1974 with Contel. Ms. Lambert earned a bachelor’s degree in Business Management from Indiana University and an MBA from Indiana Wesleyan University.
John J. Lack is Senior Vice President of Verizon International Operations. As such, he is responsible for supporting international units in the areas of wireline, wireless, advanced communications and Internet protocol, information technology, operations and engineering and marketing and sales. Formerly, he was vice president - Asia for Verizon, responsible for investment management, partnership management, regional business development activities, and operations management, including oversight of new ventures and investments. Prior to the Bell Atlantic/GTE merger, Mr. Lack was vice president and regional manager - Asia/Pacific Operations for Bell Atlantic International Wireless (BAIW). He was responsible for Bell Atlantic’s wireless operations and future business development in the world’s most populous region. He also served as the chief operating officer and a member of the board for Bell Atlantic’s investment in Indonesia, Excelcomindo Pratama, since 1995.
Richard L. Carrión has been Chairman, President and Chief Executive Officer of Popular, Inc., since 1990 and has been a director since 1982. He chairs the Committee for the Economic Development of Puerto Rico and actively participates in other business boards and civic organizations, including Banco Popular Foundation, Verizon, Telecomunicaciones de Puerto Rico, Inc. and Wyeth. A member of the International Olympic Committee since 1990, Carrión is Chairman of its Finance Commission and a member of the Marketing Commission and the TV & Internet Rights Commission. He earned a bachelor’s degree from The Wharton School of Finance and Commerce at the University of Pennsylvania and a master’s degree in Management Information Systems from the Massachusetts Institute of Technology.
Mr. Alfredo Salazar was appointed member of the Government Development Bank for Puerto Rico (“GDB”)’s Board of Directors by Governor Anibal Acevedo-Vilá on February 4, 2005 and elected Chairman of the Board in March 2005. Since August 20, 2005 he also occupies the position of Acting President of the Bank, an institution he presided from 1975 to 1976. Mr. Salazar has devoted most of his professional life to commercial banking. He began working with Banco Popular de Puerto Rico and then moved on to Chase Manhattan Bank (today JP Morgan Chase), where he occupied several positions including Head of Operations in Puerto Rico, Argentina and Brazil. In 1989 he was appointed President of Banco de Ponce, just before it merged into Banco Popular. From 1993 to 1998, Mr. Salazar was based in New York as head of operations for PaineWebber (today USB Financial Services) in Latin America. He then returned to Puerto Rico as President of Palmas del Mar Properties, Inc., the development company of the renowned residential and tourist complex in Humacao. Mr. Salazar has a degree in economy from the University of Villanova. He also did post-graduate coursework in finance at New York University and the Harvard Business School.
José F. Rodríguez Perelló is an insurance broker with a successful trajectory in the financial world and the industry of insurances. He has been executive and director of Ledesma & Rodriguez Insurance Group, Inc. since February 1990. Mr. Rodríguez served as President of Prudential Bache Puerto Rico, Inc. from 1980 thru 1990. Currently, he is Vice President of the Board of Directors of CDB and Director and Secretary of the board of directors of the foundation of the Levis family, Chana & Samuel Levis Foundation, Inc. Mr. Rodríguez holds a bachelors degree from Marquette University in Wisconsin.
Rafael F. Martínez Margarida is a certified public accountant with more than 30 years of experience advising local and multinational companies, and public organizations in the areas of planning and financial analysis. Currently, is a member of the board of directors of GDB. He is a business consultant since 2004. Mr. Martínez was a partner of Pricewaterhouse Coopers LLP in Puerto Rico from 1988 to the 2004. He holds a bachelor’s degree from Fairfield University and a master’s degree from Columbia University.
Since March 17, 1999, the Board of Directors has had a standing Audit Committee. Currently, the Audit Committee is comprised of John J. Lack, Edward McQuaid, and Alfredo Salazar. The Audit Committee oversees the financial reporting process for which management is responsible, approves the engagement of the independent auditors for audit and non-audit services, monitors the independence of the independent auditors and reviews and approves all audit and non-audit services and fees, consults with the independent auditors in regard to our audits and proposed audits, reviews the need for internal auditing procedures and the adequacy of internal controls and performs other fiduciary oversight responsibilities including but not limited to significant business transactions. The Board of Directors has determined that no current member of the Audit Committee qualifies as an “audit committee financial expert,” as that term is defined under the rules and regulations of the SEC, although the Board of Directors has determined that each member of the Audit Committee possesses the requisite knowledge and experience in financial affairs to effectively perform his or her duties. The Company has no present plans to conduct a search for an audit committee financial expert because the Board of Directors has determined that the absence of an audit committee financial expert will not impair the ability of the Audit Committee to provide effective oversight of the Company’s financial reporting and to perform the other duties for which it is responsible.
EXECUTIVE OFFICERS
The executive officers of the Company as of March 31, 2006, are as follows:
Cristina M. Lambert was appointed our President and Chief Executive Officer in September 2003. Prior to assuming her current role, Ms. Lambert served as Vice President and General Manager of Wireline Services for PRTC since June 3, 1999. In this capacity, she was responsible for managing the sales/marketing and network operations functions, leading a team of 2,400 employees and serving more than 1.2 million customers. Before joining the leadership team in Puerto Rico, she was the assistant vice-president - Customer Care for GTE. Her telecommunications career began in 1974 with Contel. Ms. Lambert earned a bachelor’s degree in Business Management from Indiana University and an MBA from Indiana Wesleyan University.
Aldo Figueroa was appointed as Vice President Operations and Chief Operations Officer in November 2005. Mr. Figueroa obtained a master’s degree in Economics and a bachelor’s degree in Industrial Engineering from Texas Tech University. Prior to the appointment, Mr. Figueroa served as Country Manager of DHL Peru since 2003. Prior thereto, he served as Vice President of the Integrated Service Division of Bellsouth Peru from 1999 to 2002. From 1998 to 1999, he served as Chief Executive Officer of FirstCom Peru which merged with AT&T in 1999.
Héctor Houssay was appointed Vice President Finance and Chief Financial Officer in August 2005. Prior to assuming his position, Mr. Houssay was Vice President of Finance and Chief Financial Officer of Verizon Dominicana since May 2001 and was Director of Corporate Finance and Treasurer of CTI Holdings from October 1998 through May 2001. He graduated from the University of Buenos Aires in Argentina with a bachelor’s degree in Business Administration and holds a master’s degree in Business Administration from Babson College in Massachusetts.
Adail Ortiz was appointed as Vice President Revenue Assurance and Billing in August 2005. Prior to assuming his current role, Mr. Ortiz was Vice President of Finance and Chief Financial Officer of the Company since September 2003. Since joining PRTC over 23 years ago, Mr. Ortiz has held a variety of positions of increasing responsibility in the Finance organization. His roles have included Comptroller, Corporate Accounting Manager, Billing and Collections Director, Senior Director of Revenue Accounting and Assistant Comptroller. Prior to joining PRTC, Mr. Ortiz worked for Price Waterhouse & Co. and was a Professor of Accounting at the Interamerican University. He is a Certified Public Accountant, and holds a bachelor’s degree in Accounting from the University of Puerto Rico.
Thomas Pérez-Ducy was appointed Vice President Marketing and Chief Marketing Officer in January 2005. He joined PRTC in 2004 as Vice President of Sales & Marketing of the Company. Prior to joining PRTC, Thomas Pérez-Ducy was the Executive Vice President-Mobile Services at Cable & Wireless. Previously, Mr. Pérez-Ducy spent ten years with Verizon Dominicana, formerly Codetel, in a variety of roles including Vice President-Mobile Communications and Customer Service, Senior Director-International Services, Director-Strategic Projects and Product Development, Director-Corporate Communications and Government Affairs. He holds a bachelor’s degree in Economics from Pontificia Universidad Católica Madre y Maestra, as well as a Master of Science degree in International Finance and Accounting from the London School of Economics.
Mari Evelyn Rodríguez was appointed Vice President of Sales in December 2005. Prior to assuming her position, Mrs. Rodríguez was Strategic Planning and Marketing Director since January 2005. Mrs. Rodríguez held a variety of positions in the Company. Her roles have included Marketing Director of Verizon Wireless since June 2003 and General Manager of Coqui.net since February 2001. She holds a bachelor’s degree in Politics Sciences from Harvard University, as well as a master’s degree in Business
Administration from the University of Michigan at Ann Arbor.
Roberto García Rodríguez was appointed Vice President Legal Affairs on September 7, 2004. Prior to joining the Company, Mr. García served as legal counsel for Mountain Union Telecom of Puerto Rico, Inc. Previously, Mr. García was an associate at the law firm Pietrantoni, Méndez & Alvarez. Mr. García holds a bachelor’s degree from Harvard University, a MBA from Stanford University and a J.D. also from Stanford University in California.
Benito Fernández was appointed Vice President Human Resources in June 2001. Prior to joining the Company, Mr. Fernández held the position of Vice President of Human Resources for Montefiore Medical Center. Prior to that, he was Vice President of the Columbia Presbyterian Medical Center and Labor Counsel for Westvaco Corporation and also served as an associate in the law firm Arthur, Dry & Kalish. Mr. Fernández holds a bachelors degree from the College of the City of New York, a juris doctorate from Brooklyn Law School and an L.L.M. from New York University School of Law.
Ileana Molina joined PRTC in August 1999 as Vice President Corporate Communications. She came to PRTC following a career in marketing with Procter & Gamble (Puerto Rico), Johnson & Johnson (Dominican Republic), R.J. Reynolds (Mexico, Puerto Rico, and Dominican Republic) and Pepsico Foods (Puerto Rico). Prior to joining PRTC, she was Senior Vice President - Marketing at Suiza Foods Caribbean. Ms. Molina is a graduate of the Boston College School of Management.
Roberto A. Correa was appointed Vice President and General Manager Coqui.net in December 2004. He previously held the positions of Vice President of Regulatory Affairs and Vice President Engineering and Technical Planning since February 2000. During his 24 years in the company, Mr. Correa has occupied various managerial positions such as Director of Network Planning and Network Engineering, Director of Sales for Mobile Services and others. He holds a bachelor’s degree in Electrical Engineering from the University of Puerto Rico and a master’s degree in Electrical Engineering from Georgia Institute of Technology in Atlanta, Georgia.
Jorge Samalot was appointed Vice President Information Technology on October 2003. He has been working with the Company for over 26 years. Mr. Samalot has held various positions of increased responsibilities within the Information Technology Department. Prior to his current position, he was the Director of Business Support in the IT organization, where he was responsible for the implementation of critical applications including the local number portability project.
Manuel E. Hernández was appointed Vice President Network Services, Engineering and Technical Planning in January 2005. During the last 27 years Mr. Hernández has contributed to PRTC’s network development in a variety of roles including Director of Data Engineering and Private Networks, Director of Operations, and Telephone Network Planning Director. He holds a bachelor’s degree in Electrical Engineering from the University of Puerto Rico, Mayaguez Campus.
Hector Rosario was appointed as Vice President Network Operations on January 2005. Mr. Rosario was previously the Director of Network Configuration & Special Services Engineering and Director of Technology Planning. His telecommunications career began in 1975 in the Puerto Rico Communications Authority. Before joining Puerto Rico Telephone, he held various management positions as Network Operations Consultant and Senior Manager, Network and Technology Planning with GTE-Overseas Corporations at CODETEL in Santo Domingo, Dominican Republic. He holds a bachelor’s degree in Sciences in Electrical Engineering from the University of Puerto Rico-Mayaguez Campus and a master’s degree in Business Administration from University of Phoenix, Guaynabo.
Rafael Otaño was appointed as Controller on August 2005. Mr. Otaño is a Certified Public Accountant and a Certified Financial Planner. He obtained a bachelor’s degree of Science in Accounting from Marquette University. Since July 2004, Mr. Otaño has been an investment management consultant for Consultiva Internacional, Inc., an international investment management consulting firm. He started his own business in 2002 by providing consulting services to PRTC in the areas of financial reporting, financial systems and rate structure. From 1999 thru 2001, he was Director of Budget, Planning and Financial Analysis for PRTC. In 1998, he was Director of Budget, Financial and Strategic Planning for GTE Wireless in Atlanta.
María E. De La Cruz was appointed Treasurer of the Company on December 3, 2002. Ms. De La Cruz has been with the Company in the Treasury Department since May 2002 serving as Assistant Treasurer. Ms. De La Cruz has over 15 years of banking and financial management experience in private industry and public accounting. She holds a bachelor’s degree in Finance from the University of Puerto Rico and is a Certified Public Accountant.
We have adopted a written Code of Ethics applicable to all directors, officers and employees which is also available on our website at www.telefonicapr.com. The Company intends to disclose any amendments to or waivers of the Code of Ethics on behalf of the Company’s Chief Executive Officer, Chief Financial Officer, Controller, and persons performing similar functions on the Company’s website at the Internet website address set forth above.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
SUMMARY COMPENSATION TABLE
The following table sets forth compensation for the periods indicated for the Company’s chief executive officer and its four most highly compensated executive officers (the “Named Executive Officers”):
During 2005 were not granted options in Verizon shares to the Named Executive Officers.
The following table provides information as to options and stock appreciation rights (referred to as SARs) for Verizon shares exercised by each of the Named Executive Officers during 2005. The table also sets forth the value of options and SARs for Verizon shares held by such officers at 2005 year-end.
Aggregated Option/SAR Exercises
in Last Fiscal Year and FY-End Option/SAR Values
VERIZON RETIREMENT PROGRAMS
VERIZON PENSION PLANS
The Verizon Management Pension Plan is a noncontributory, tax-qualified pension plan for salaried employees that provides for distribution of benefits in a lump sum or an annuity, at the participant’s election. Pension benefits under this plan are calculated for all participants using a cash balance formula that provides for pay credits equal to four to seven percent (depending on age and service) of annual eligible pay up to the statutory limit on compensation ($210,000 in 2005), for each year of service following the conversion to cash balance. Ms. Lambert and Mr. Fernández began participating in the Verizon Management Pension Plan as of January 1, 2002. Messrs. Pérez, Ortiz and Correa participate in the Company’s own pension plan.
In general, eligible pay includes base salary, commissions and short-term incentives, exclusive of overtime, certain senior manager or other incentive compensation, and other similar types of payments. Additionally, monthly interest credits are made to the participant’s account balance based upon the prevailing market yields on certain U.S. Treasury obligations. In order to record these pay and interest credits, the plan administrator maintains a hypothetical account balance for each participant. However, as part of the transition to a cash balance formula, participants with at least 10 years of service with Verizon as of January 1, 2002, receive benefits under an alternative formula, referred to as the “highest average pay formula,” if that formula provides a higher benefit than the cash balance formula. Under this formula, pensions are computed until 2008 on 1.35% of eligible pay for average annual salary for the five highest consecutive years up to the statutory limit on compensation ($210,000 in 2005), for each year of service. In 2008, the Verizon Management Pension Plan shifts from this highest average pay formula to a career average pay formula under which an employee’s pension is computed on 1.35% of eligible pay for average annual salary over the remainder of the employee’s career with Verizon up to the statutory limit on compensation, for each year of service. As of December 31, 2005, the actual years of service credited under the Verizon Management Pension Plan for Ms. Lambert and Mr. Fernández are 31 and 4, respectively.
The following table illustrates the estimated annual benefits payable pursuant to the highest average pay formula under the Verizon Management Pension Plan based on a maximum compensation limit of $210,000. The table assumes normal retirement at age 65 and is calculated on a single life annuity basis, based upon final average earnings and years of service:
Employees who do not have at least 10 years of service generally do not qualify for the highest average pay formula under the plan. Accordingly, Mr. Fernández’s cash balance account was $62,863 as of December 31, 2005.
Section 415 of the Internal Revenue Code places certain limitations on pension benefits that may be paid from the trusts of tax-qualified plans, such as the Verizon Management Pension Plan. Pension amounts for certain executive officers that exceed such Section 415 limitations will be paid from Verizon’s assets under the Verizon Income Deferral Plan. Ms. Lambert and Mr. Fernández began participating in the Verizon Income Deferral Plan as of January 1, 2002. This plan is a nonqualified, unfunded, supplemental retirement and deferred compensation plan under which an individual account is maintained for each participant. The plan allows the participants to defer voluntarily the receipt of up to 100% of their eligible compensation, and also provides retirement and other benefits to certain executives through Verizon credits to the participant’s account under the plan. Eligible compensation consists of:
I.
a participant’s base salary in excess of the Internal Revenue Code limit on compensation for qualified retirement plans ($210,000 in 2005);
II.
all of the participant’s short-term incentive award; and
III.
other bonuses that the plan administrator determines are eligible for deferral.
If a participant elects to defer eligible income, Verizon provides a matching contribution equal to the rate of match under the qualified savings plan for management employees. That rate is 100% of the first 4% of eligible compensation deferred and 50% of the next 2% of eligible compensation deferred. In addition, until December 31, 2004, the Company made retirement contributions to a participant’s account equal to 32% of the base salary, in excess of $205,000, and short-term incentive award components of the participant’s eligible compensation, for the first 20 years of participation in the plan and, thereafter, equal to 7% of such eligible compensation. Beginning July 1, 2006, the Company will provide an enhanced savings opportunity under the qualified savings plan for management employees. Verizon will provide a matching contribution equal to 100% of 6% of eligible compensation deferred or contributed to the savings plan. In addition, management employees may be eligible for an additional performance related matching contribution of up to 3% of eligible compensation if certain pre-established performance criteria are met. The following table shows the aggregate portion of each named executive officer’s account attributable to the Company’s contributions as of December 31, 2005.
The actual annual Company contribution for 2005 has been reflected in the “All Other Compensation” column of the Summary Compensation Table.
EXECUTIVE RETIRED LIFE INSURANCE PLAN
Verizon’s Executive Retired Life Insurance Plan provides executives a postretirement life insurance benefit of up to three times final base salary. Benefits may be paid as life insurance or, alternatively, an equivalent amount equal to the present value of the life insurance amount as a lump sum payment, as an annuity or in installment payments.
COMPANY’S PENSION PLAN
The following table illustrates the estimated annual benefits payable under the Company’s defined benefit pension plan. The table assumes normal retirement age 65 and is calculated on a single life annuity basis, based upon final average earnings (integrated with social security as described below) and years of service:
PENSION PLAN TABLE
The retirement plan for salaried employees is a noncontributory pension plan for the benefit of all our employees who are not covered by the collective bargaining agreements, unless the agreement provides for coverage under the retirement plan for salaried employees. It provides a benefit based on a participant’s years of service and earnings. Our pension benefits and contributions to the retirement plan for salaried employees are related to basic salary differentials, exclusive of overtime differentials, incentive compensation and other similar types of payments. Under the retirement plan for salaried employees, participants are entitled to annual pension benefits at normal retirement age (65) equal to the sum of: (a) 2% of the average salary highest 36 months during their ten consecutive calendar employment years multiplied by their years of credited service (not over 25 years), plus (b) 1.5% of such average multiplied by credited service over 25 years (but not greater than 15 years), (c) minus an offset factor, varying form .21% to .635% depending upon age at retirement, multiplied by the covered compensation and further multiplied by credited service (up to 35 years).
Under federal law, an employee’s benefits under a qualified pension plan, such as the retirement plan for salaried employees, are limited to certain maximum amounts. We maintain a supplemental executive retirement plan, which supplements the benefits of any participant in the retirement plan for salaried employees in an amount by which any participant’s benefits under the retirement plan for salaried employees are limited by law.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
The Company has a Compensation Committee, which for fiscal year 2005 was comprised of: Richard L. Carrión, Daniel C. Petri and Cristina Lambert. This Compensation Committee is responsible for establishing and administering the policies and plans related to compensation of the Company’s management, including the executives listed in the “Executive Officers” table included in Item 10 of this Form 10-K.
Richard L. Carrión, a Director of the Company, serves as Chairman of the Compensation Committee. Mr. Carrión is Chairman, President and Chief Executive Officer of Popular, Inc. He also serves as a Director of Verizon.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
SHAREHOLDERS AND SHAREHOLDER RELATIONSHIPS
SHARE OWNERSHIP
At December 31, 2005, there were 50 million authorized shares of the Company’s no par value common stock, 25 million of which were issued and outstanding. As of March 31, 2006, the beneficial owners of the Company’s common stock are as follows:
CHANGE OF SHAREHOLDER OWNERSHIP PERCENTAGE
On January 25, 2002, Verizon, through its subsidiary GTE Holdings (Puerto Rico) LLC, and Popular, Inc. acquired an additional 12% and 3% interest in the Company, respectively, by exercising an option each held since the Acquisition on March 2, 1999. Verizon and Popular obtained the additional ownership interest from PRTA Holdings.
Verizon and Popular paid PRTA Holdings $138 million and $34 million, respectively, for a total of $172 million in cash for the additional 3,750,000 shares at a $45.936 per share price established in the Share Option Agreement.
OWNERSHIP REQUIREMENTS
Verizon must maintain at least a 35% ownership interest through March 2, 2004. If Verizon proposes to transfer shares as permitted by the shareholders agreement, other than to any of its affiliates or other than in a public offering or widely distributed private placement, which is for more than 7.5% of the total number of our shares or which would result in the transferee owning over 20% of our shares, then the Government of Puerto Rico shall have the right to participate in this sale, by selling the applicable pro-rata portion of the aggregate number of shares then owned by all of the Puerto Rico Entities. If the Puerto Rico Entities would own 5% or less of our shares after exercising this right, Verizon shall have the option of requiring that the Puerto Rico Entities sell all of their remaining shares to the buyer, or requiring that the Puerto Rico Entities sell to the buyer the shares that the buyer is willing to purchase and sell any remaining shares owned by the Puerto Rico Entities to Verizon.
Under the Popular Shareholders Agreement, Popular, Inc. has the right to require Verizon to permit Popular, Inc. to participate on a pro-rata basis in any transfer of shares to non-affiliates by Verizon, other than an underwritten public offering or widely distributed private placement.
The Company has agreed to use all commercially reasonable efforts to support an initial public offering of the Government of Puerto Rico’s remaining 28% interest.
SHAREHOLDERS’ AGREEMENT
The board of directors has nine members, who are appointed as follows: five directors are appointed by Verizon; one director is appointed by Popular, Inc., pursuant to an agreement with Verizon; and three directors are appointed by PRTA Holdings, a subsidiary of an entity of the Government of Puerto Rico. The ESOP does not have the right to appoint any directors. The number of directors that the Government of Puerto Rico can appoint is related to its share ownership in the Company. The Government of Puerto Rico is entitled to appoint three, two or one director(s) as long as it (or its successor) holds at least a 25%, 15%, or 4% ownership interest, respectively. Unanimous approval is required for the following actions:
o
an acquisition, strategic alliance, or joint venture exceeding 15% of the Company’s assets;
o
issuance of equity, convertible equity securities, or debt;
o
changes in the dividend policy; and
o
transactions with Verizon and Popular, Inc. exceeding $1 million, annually.
Unanimous approval is required for the additional following matters as long as the Government of Puerto Rico holds at least a 10% ownership interest:
o
asset sales of 25% or more of the Company’s assets;
o
amendments to the Certificate of Incorporation, which adversely affect the Government of Puerto Rico; and
o
the liquidation, merger or consolidation of the Company.
Verizon and the Government of Puerto Rico agreed that neither party, nor a Verizon affiliate, will compete in the telecommunications business (subject to certain exceptions) until the earlier of:
o
the date when the Government of Puerto Rico ceases to own at least 5% of the shares; and
o
the later of seven years after the sale or one year after an initial public offering.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
TRANSACTIONS WITH VERIZON
VERIZON SERVICE AGREEMENT
Verizon, which owns 52% of the outstanding capital stock of the Company, provides management advice and services, general legal and regulatory advice, as well as a license to use certain technology, under an annual agreement with automatic renewal periods. Total fees accrued under this agreement for the years ended December 31, 2005, 2004 and 2003 were $7 million, $10 million and $24 million, respectively.
REIMBURSEMENT AGREEMENT
The Company has a reimbursement agreement with Verizon, under which actual out-of-pocket expatriate salaries and related benefit expenses are billed to the Company. Total expatriate expenses for the years ended December 31, 2005, 2004 and 2003 were $4 million, $3 million and $8 million, respectively. For further details, refer to Part III, Item 11, “Executive Compensation”.
OTHER AFFILIATED TRANSACTIONS
The Company also enters into transactions with affiliates for the purchase of materials and supplies used in construction and expansion of its telecommunications network. Such transactions are subject to conditions similar to transactions with independent third parties. The Company also participates with affiliates of shareholders in sharing the cost of development of computer software programs by third party vendors. The shareholders receive no compensation for arranging the development of such systems.
DIRECTORY AGREEMENTS
We entered into a 95-year agreement in 1999 with VISI, a joint venture among VNU, Verizon, and the Company, which provides us a publishing right of 35% of yellow page advertising revenues, plus billing and collection fees which generated $19 million of directory advertising revenues for the year ended December 31, 2005 and $20 million for each of the years ended December 31, 2004 and 2003.
TRANSACTIONS WITH POPULAR, INC.
Popular, Inc., which owns 13% of the outstanding capital stock of the Company, provided wireline bill collection, lock-box, cash management, and wireless bill processing services at a cost of approximately $9 million for year 2005 and $10 million for each of the years 2004 and 2003. These services were negotiated at arms-length market value rates.
At December 31, 2005, the Company maintained a $40 million working capital credit facility with Banco Popular de Puerto Rico, which is a subsidiary of Popular, Inc. No balance was outstanding under this facility as of December 31, 2005.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
INDEPENDENT AUDITOR FEE INFORMATION
Audit Fees
Fees for audit services totaled approximately $720,000 and $490,000 for the years ended December 31, 2005 and 2004, respectively, including services for the audit of the Company’s annual financial statements for SEC and local statutory reporting purposes, reviews of the Company’s quarterly reports on Form 10-Q, the audit of the Company’s ARMIS 43-03 reports filed with the FCC.
Audit-Related Fees
Fees for audit-related services totaled approximately $96,000 and $61,000 for the years ended December 31, 2005 and 2004, respectively. Audited-related services principally include the audit of the Employee Benefit Plan and ESOP in connection with annual reports on Form 11-K, Section 404 meetings, audit schedules for specific purposes and accounting consultations.
All Other Fees
No fees were paid for other services for the years ended December 31, 2004 and 2005.
Audit Committee Pre-approval Policies and Procedures
The Audit Committee reviews and approves audit and permissible non-audit services performed by our independent auditors, Ernst & Young LLP, as well as the fees billed by Ernst & Young LLP for such services. In its review of non-audit service fees and its appointment of Ernst & Young LLP as our independent accountants, the Audit Committee considers whether the provision of such services is compatible with maintaining Ernst & Young LLP’s independence.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) (1) and (2) List of Financial Statements and Financial Statements Schedules:
See Index to Consolidated Financial Statements under Part II, Item 8, “Financial Statements and Supplementary Data.”
(All other schedules for which provision is made in the applicable accounting regulations of the SEC are not required under the related instructions or are inapplicable and, therefore, have been omitted.)
See Exhibit Index on pages following signature pages.
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.
TELECOMUNICACIONES DE PUERTO RICO, INC.
By:
/s/ Cristina M. Lambert
Name: Cristina M. Lambert
Title: President and Chief Executive Officer
Date: March 31, 2006
By:
/s/ Héctor Houssay
Name: Héctor Houssay
Title: Vice President Finance and Chief Financial Officer
Date: March 31, 2006
By:
/s/ Rafael Otaño
Name: Rafael Otaño
Title: Controller
Date: March 31, 2006
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
EXHIBIT INDEX