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ALSK > SEC Filings for ALSK > Form 10-Q on 2-Aug-2013All Recent SEC Filings

Show all filings for ALASKA COMMUNICATIONS SYSTEMS GROUP INC

Form 10-Q for ALASKA COMMUNICATIONS SYSTEMS GROUP INC


2-Aug-2013

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

FORWARD-LOOKING STATEMENTS AND ANALYSTS' REPORTS

This Form 10-Q and our future filings on Forms 10-K, 10-Q and 8-K and the documents incorporated therein by reference include forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934 ("Exchange Act"), as amended. We intend such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements. All statements other than statements of historical fact are "forward-looking statements" for purposes of federal and state securities laws, including statements about anticipated future operating and financial performance, financial position and liquidity, growth opportunities and growth rates, pricing plans, acquisition and divestiture opportunities, business prospects, strategic alternatives, business strategies, regulatory and competitive outlook, investment and expenditure plans, financing needs and availability and other similar forecasts and statements of expectation and statements of assumptions underlying any of the foregoing. Words such as "anticipates", "believes", "could", "estimates", "expects", "intends", "may", "plans", "projects", "seeks", "should" and variations of these words and similar expressions are intended to identify these forward-looking statements. These forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from our historical experience and our present expectations or projections. Forward-looking statements by us are based on estimates, projections, beliefs and assumptions of management and are not guarantees of future performance. Such forward-looking statements may be contained in this Form 10-Q under "Item 2 - Management's Discussion and Analysis of Financial Condition and Results of Operations" and elsewhere. Actual future performance, outcomes, and results may differ materially from those expressed in forward-looking statements made by us as a result of a number of important factors. Examples of these factors include (without limitation):

• the future impact of Verizon Wireless ("Verizon") continued build out of its wireless network in Alaska which became operational in May 2013

• the ability of Alaska Wireless Network, LLC ("AWN") to integrate, operate, and improve the wireless assets contributed to it while maintaining effective interfaces with our retail business

• our substantial debt which requires us to dedicate a significant portion of our cash flow from operating activities to make debt payments and places pressure on our ability to access the capital markets

• our ability to comply with the covenants and other terms contained in our Senior Credit Facility

• governmental and public policy changes, including on-going changes in our revenues resulting from regulatory actions affecting inter-carrier compensation, Universal Service Funding ("USF") for high cost support, and lifeline revenues

• the cost and availability of future financing in the amounts, at the terms, and subject to the conditions necessary, to support our business and pursue growth opportunities

• our ability to keep pace with rapid technological developments and changing standards in the telecommunications industry, including on-going capital expenditures needed to upgrade our access network to industry competitive speeds, and our limited access to in-state middle mile infrastructure

• our ability to develop attractive, integrated products and services making use of our substantial investments in fiber optic cable facilities, including our Alaska Oregon Network ("AKORN®") and Northstar fiber optic cables that connect Alaska to the contiguous states

• unanticipated damage to one or more of our fiber optic cables resulting from construction or digging mishaps, fishing boats or other reasons

• changes in general industry and market conditions, and structural declines for voice and other legacy services within the telecommunications industry

• a maintenance or other failure of our network or data centers

• a failure of back-office information technology ("IT") systems

• a third party claim that the Company is infringing upon their intellectual property, resulting in significant litigation or licensing expenses, or the loss of our ability to sell or support certain products including certain wireless devices

• changes in overall national, regional or local economic conditions

• unanticipated costs required to fund our post-retirement benefit plans, or contingent liabilities associated with our participation in a multi-employer pension plan


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• the success or failure of any future acquisitions or other major transactions

• geologic or other natural disturbances relevant to the location of our operations

• the ability to attract, recruit, retain and develop the workforce necessary for implementing our business plan

• the matters described under "Item 1A, Risk Factors" in our Annual Report on Form 10-K for the fiscal year ended December 31, 2012 and this Quarterly Report on Form 10-Q

In light of these risks, uncertainties and assumptions, you should not place undue reliance on any forward-looking statements. Additional risks that we may currently deem immaterial or that are not currently known to us could also cause the forward-looking events discussed in this Form 10-Q or our other reports not to occur as described. Except as otherwise required by applicable securities laws, we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events, changed circumstances or any other reason after the date of this Form 10-Q.

Investors should also be aware that while we do, at various times, communicate with securities analysts, it is against our policy to disclose to them any material non-public information or other confidential information. Accordingly, investors should not assume that we agree with any statement or report issued by an analyst irrespective of the content of the statement or report. To the extent that reports issued by securities analysts contain any projections, forecasts or opinions, such reports are not our responsibility.

OVERVIEW

We provide leading integrated communications services to consumer and business customers in and out of Alaska. Our communications network extends throughout Alaska and connects to the contiguous states via our two diverse undersea fiber optic cable systems. Our network is among the most expansive in Alaska and forms the foundation of service to our customers.

The sections that follow provide information about important aspects of our operations and investments and include discussions of our results of operations, financial condition and sources and uses of cash. 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 we use in evaluating our own performance and allocating our resources. We also monitor the state of the economy in general. In doing so, we compare Alaska economic activity with broader economic conditions. In general, we believe that the Alaska telecommunications market, as well as general economic activity in Alaska, is affected by certain economic factors, which include:

• investment activity in the oil and gas markets

• tourism levels

• governmental spending and activity of military personnel

• the price and price trends of bandwidth

• the growth in demand for bandwidth

• decline in demand for voice and other legacy services

• local customer preferences

• unemployment levels

• housing activity and development patterns

We have observed variances in the factors affecting the Alaska economy as compared to the U.S. as a whole. Some factors, particularly the price of oil and gas, usually have a greater direct impact on the Alaska economy compared to other macro-economic trends impacting the U.S. economy as a whole.

Prior to 2012, although the Company had been experiencing a steady decline in its retail customer base, total revenues remained relatively unchanged. This was accomplished by generating higher foreign roaming and wireless CETC revenue to offset lower retail revenue. Two significant events are expected to impact this overall revenue stability. The first is Verizon's entry into the Alaska market, and the second, is declines in wireless CETC and other wireline high cost support revenue as a result of changes enacted by the FCC. Foreign roaming revenue, CETC and high cost support revenues represented approximately 26% and 25% of our total revenue in 2012 and 2011, respectively, and profit margins on these revenues streams are relatively high.

As a result of these adverse events, management in 2012 implemented a long-term business plan that focused on driving sustained growth in retail broadband revenue across multiple market segments - business and wholesale, consumer and wireless. Previously, the Company had focused on select market segments, primarily wireless and enterprise, with the intent to maximize returns. These adverse external events necessitated a broader view of all market segments, and a move away from reliance on support and roaming revenues.


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Management's assessment of the telecom market in Alaska indicated an estimated $1.0 billion market growing approximately five to six percent annually. To generate sustained growth in this market, our long-term business plan requires investments in sales, service, marketing and product development and other initiatives, such as incorporating LEAN methodologies, to eliminate waste in our business.

In conjunction with the commencement of this long term plan and these future adverse impacts, management and the Board of Directors recognized that the Company needed to reduce its outstanding debt to sustainable levels. Consequently, in the fourth quarter of 2011 our Board of Directors reduced our quarterly common stock dividend from $0.215 to $0.050 and, in the fourth quarter of 2012, completely suspended the cash dividend.

This long-term plan is resulting in improved financial results. Broadband revenue growth has accelerated, the Company is adding customers across many different market segments, and the Company has made debt payments totaling $49.8 million since January 1, 2012.

In addition to this plan, on July 23, 2013, the Company announced the closing of the AWN Transaction, allowing us to combine our wireless network with that of GCI. ACS is a 33.33% owner of AWN, while GCI owns the remaining 66.67%. GCI and ACS are leading wireless providers in Alaska, and in forming AWN, they both have each contributed their respective wireless assets, including spectrum licenses, cell sites, backhaul facility usage rights, and other assets necessary for AWN to operate an infrastructure company that designs, builds, and operates a statewide wireless network. AWN's network will cover more of Alaska's population than the network of any other wireless provider, and will provide the latest wireless services, including LTE, to its owners. GCI and ACS will independently sell these services to their respective retail customers and continue to operate as competitors in Alaska.

Under the AWN structure, AWN will generate earnings based upon: (i) wholesale revenues it will receive from its two retail owners, which are impacted by the number of connections and the retail revenue per connection each of the owners of AWN maintain, and are about 70% of these retail revenues, (ii) 100% of CETC revenues, (iii) roaming revenues from other wireless carriers, and (iv) revenues by selling back-haul to other wireless carriers. AWN will incur all costs associated with operation of the wireless network, and will provide a mechanism to support its owners for their wireless equipment subsidies. AWN has no debt, other than a working capital revolver, and the governance of AWN is designed to maximize the agreed upon financial objectives of its owners - to maximize its free cash flow ("FCF").

As an owner, ACS will profit from AWN three ways:

1. GCI paid ACS $100.0 million at closing, and we used $65.0 million of these proceeds to pay down our senior term loan facility. Of the remaining $35.0 million of liquidity, $3.8 million is dedicated to unwind interest rate swaps, $8.9 million to fund fees and expenses due at closing, and $7.5 million is set aside to fund certain changes in working capital associated with the transaction.

2. AWN will pay ACS a preferred distribution over the first four years, after formation, totaling up to $190.0 million.

3. After four years, we will receive future distribution of FCF in proportion to our interest.

ACS will continue to provide wireless services to its retail wireless customers, and our margins on wireless services will now be based on the wholesale charges paid to AWN. Historical costs, such as roaming COGS and wireless equipment subsidies, are now primarily the responsibility of AWN. This retail services business is not anticipated to generate significant FCF for ACS.

We believe that AWN's future financial performance, and the preferred distribution structure will result in a higher degree of certainty for our future wireless cash flow performance than we otherwise would have expected to generate as a standalone wireless operator, in particular with the entry of Verizon into our market.

Finally, the long-term plan called for systematic expense management to ensure we operate efficiently and deliver the highest level of customer service. In 2013, the company formally adopted LEAN as a framework to eliminate waste and simplify how we do business. We have established a team of process improvement experts who have adopted LEAN and we are implementing LEAN, with a particular area of focus in 2013 being supply chain management and certain corporate functions. LEAN will empower our employees to eliminate waste which will improve our customer experience. We will spend less over time and improve our profitability.


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Regulatory Update

The items reported under Part I, Item 1: "Business - Regulation" in our Annual Report on Form 10-K for the fiscal year ended December 31, 2012, are updated as follows. This section should be read in conjunction with the corresponding items previously disclosed in our Annual Report.

Federal Universal Service Support

The Connect America Fund

Price-cap ILECs, such as us, must use the frozen universal service support we receive under Connect America Fund ("CAF") Phase I to support modern communications networks capable of supporting broadband and voice services, and over time must increasingly target areas that are substantially unserved by any unsupported competitor providing such services. Specifically, under FCC rules, the ACS ILECs receive a total of $19.7 million annually in frozen CAF Phase I support. In 2013, we must spend one-third of this total to build and operate broadband-capable networks used to offer our own retail broadband service in areas substantially unserved by an unsubsidized competitor. On April 9, 2013, we filed a request for the FCC to waive certain restrictions on the use of this portion of our frozen CAF Phase I support in order to permit us to use this support more effectively to achieve the purposes of the rule. That petition remains pending at the FCC.

On April 22, 2013, the FCC adopted a model platform that will be used to establish CAF Phase II support levels for price-cap carriers operating in the 48 contiguous states. In its order, the FCC made clear that it was not deciding whether to apply this platform to other areas of the U.S., including Alaska. Previously, in February 2013, the FCC sought comment on alternate means through which it might determine CAF Phase II support levels for areas outside of the contiguous 48 states. We have advocated that the FCC should establish a separate, dedicated portion of its CAF Phase II fund for these areas because we believe that the FCC's model platform, as adopted, provides insufficient support to Alaska and other insular areas of the nation. Subsequently, we have advocated that the FCC's model can be made to work for Alaska if the Commission agrees to modify a number of the inputs to reflect the unique conditions that exist in Alaska.

The Mobility Fund

The FCC has scheduled the $50.0 million "Tribal Mobility Fund Phase I" reverse auction for October 24, 2013. That auction will allocate one-time support to deploy mobile voice and broadband services to unserved Tribal lands, including Alaska Native regions established pursuant to the Alaska Native Claims Settlements Act. In March 2013, the FCC sought comment on the rules that will govern this auction. Once those rules are established, we will evaluate the level of our participation in that auction.

2013 Focus

Our results of operations, financial position and sources and uses of cash in the current and future periods reflect our focus on being the most successful broadband solutions company in Alaska by delivering the best customer experience in the markets we choose to serve. To do this we will continue to:

• Develop Our Workforce to Build Our Sales and Service Capabilities. We believe an engaged workforce is critical to our success.

• Provide a Delightful Customer Experience Every Time. We believe the economics of retaining a customer always prevails over those of adding a customer. We invest in training, process and systems improvements to continuously improve the customer experience we create.

• Simplify How We Do Business. We believe we must reduce waste in non-value-added activities. We are accelerating our investments in technology and process improvement and adopting LEAN methodologies and expect these efforts to meaningfully impact our financial performance in the long-term.

• Offer Broadband Solutions to Our Customers at Home, at Work and Everywhere in Between. We are building on strength in designing, building and operating quality networks and providing new products and solutions to our customers.


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We believe we can create value for our shareholders by driving sustained revenue growth through increasing broadband revenues. By managing our cost structure and selectively investing capital back into our business, we expect to generate FCF which will be used to reduce debt.

For the remainder of 2013 we are focused on the following key initiatives:

Continued product roll-outs to provide value-added services to our customers. For instance, we anticipate expanded product offerings to include Voice over Internet Protocol ("VoIP") products to our larger business customers, the introduction of additional managed, professional and cloud-based services to our business and governmental customers and offering of higher bandwidth speed to our residential customers. We also anticipate providing shared data plans for our wireless customers, and expanding our prepaid wireless offerings.

We are also pursuing a program of investment in our broadband capabilities through a fiber-to-the-node construction plan, focused primarily in Anchorage. This plan will allow us to shorten loop lengths in our service areas and expand the speeds we can offer to our customers, with a primary focus on business customers.

We are also working with the FCC to seek ways to provide more predictable and appropriate long-term funding sources to fulfill our broadband build out obligations throughout Alaska, as required by this agency.

Revenue Sources by Customer Group

We manage our revenues based on the sale of services and products to the following major customer groups:

• Business and Wholesale: We provide voice and broadband services and other value-added products and services such as managed and professional services, customer network hosting, billing and collection, backhaul services to wireless carriers, and wholesale long distance services to carriers.

• Consumer: We provide broadband, Internet access, local and long distance voice, and other communications products and services to residential customers.

• Wireless: We provide wireless voice and broadband services, and other value-added wireless products and services, such as wireless devices and other equipment, statewide across Alaska with roaming coverage available in the contiguous states, Hawaii and Canada.

• Access and CETC: We provide voice and broadband termination services to interstate and intrastate carriers who provide services to our retail customers. We also receive interstate and intrastate high cost universal support funds and other revenue streams as structured by state and federal regulatory agencies that have historically allowed us to recover our costs of providing universal service in Alaska.

Executive Summary

The following summary should be read in conjunction with "Non-GAAP Financial Measures" included in this Management's Discussion and Analysis of Financial Condition and Results of Operations.

Operating Revenues

Consolidated operating revenue of $97.7 million increased $7.7 million, or 8.6%, in the second quarter of 2013 compared with the second quarter of 2012. Revenue growth was driven by $6.1 million of higher foreign roaming revenue and $3.9 million of higher broadband revenue, partially offset by $2.2 million of lower voice revenue across all customer groups and $0.6 million lower Access and CETC revenues.

Adjusted EBITDA

Adjusted EBITDA, as defined in "Non-GAAP Financial Measures" ("Adjusted EBITDA") of $34.0 million increased $8.4 million, or 32.9%, compared with the second quarter of 2012, due primarily to $7.7 million of higher revenue, $3.8 million of lower subsidies on wireless equipment, partially offset by $0.9 million higher COGS, mainly attributable to higher roaming expenses, and $1.9 million in Selling General and Administrative, mainly attributable to higher labor costs.

Operating Metrics

Business broadband connections of 19,539 and average monthly revenue per user ("ARPU") of $171.29 at June 30, 2013 and in the second quarter of 2013, respectively, were up from connections of 19,069 and ARPU of $147.25 in the comparable periods of 2012. Business broadband connections counts have been restated to correct how certain high bandwidth circuit-types are measured. These changes have no affect on our financial


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results, but will affect connection count and ARPU amounts presented above as compared to their presentation in prior periods. The growth in broadband ARPU reflects customer demand for increasing amounts of bandwidth. We count connections on a unitary basis regardless of the size of the bandwidth. For example, a customer that has a 10MB connection is counted as one connection as does a customer with a 1MB connection. We believe that ARPU is an important metric indicating the increasing amounts of bandwidth that we provide to our customers, and that it is expected to grow at a faster rate than connections.

In the second quarter of 2013, consumer broadband connections of 39,559 increased for the third consecutive quarter and were up 2.5% year-over-year. Consumer broadband ARPU also improved to $47.37 in the second quarter of 2013 compared with $39.01 in the second quarter of 2012 as the result of customers taking our higher bandwidth products.

Wireless connections of 114,419 at June 30, 2013 decreased 4.7% from 120,050 at June 30, 2012 partially as a result of new certification rules for lifeline customers enacted by FCC which resulted in the disconnection of 3,115 customers in the fourth quarter of 2012. Lifeline customers are treated as postpaid wireless connections and, in addition to lifeline impacts, we are experiencing an erosion of our postpaid customer base, which is being partially offset by strength in our prepaid wireless business. Postpaid wireless connections fell to 88,876 at June 30, 2013 from 95,322 at June 30, 2012. Weakness in postpaid was attributable to several factors, including: (i) erosion of customers from the Lifeline certification process; (ii) erosion in our 3G MiFi devices of approximately 500 as we tightened our usage policies and as customers enabled the Wi-Fi feature on their phones; (iii) delay in availability of the iPhone 5 devices relative to our competition; (iv) market share losses to competitors who are expanding their network coverage and pricing and promoting to gain market share; and (v) the effects of network transition as we move from our legacy CDMA to more advanced LTE/HSPA+/GSM networks. Over the same period, our prepaid wireless connections increased to 15,684 from 12,346 year over year. The success of prepaid offerings was attributable to the launch of significant prepaid offerings in 2012 and expansion of our indirect sales channel.

Churn on wireless connections of 2.4% in the second quarter of 2013 increased from 2.0% in the second quarter of 2012 due to several of the factors we have previously identified.

Due to special promotional offers, which included three-year contract terms, associated with our initial roll out of the iPhone in the second quarter of 2012, our wireless equipment subsidy decreased 52.7%, to $3.5 million in the second quarter of 2013 from $7.3 million in the second quarter of 2012. We sold 15,885 and 22,973 devices in the second quarter of 2013 and 2012, respectively. Our subsidy per device decreased to $224.00 in the second quarter of 2013 from the $327.00 in the second quarter of 2012.


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The table below provides certain key operating metrics as of or for the periods indicated. ARPU is defined as average monthly revenue per user.

                                                            June 30,
                                                      2013           2012

        Voice:
        At quarter end:
        Consumer access lines                          52,438         59,480
        Business access lines                          80,517         82,083
        Quarter:
        ARPU - consumer                             $   27.25      $   26.73
        ARPU - business                             $   23.93      $   24.49
        Year-to-date:
        ARPU - consumer                             $   26.72      $   26.67
        ARPU - business                             $   23.77      $   24.41

        Broadband:
        At quarter end:
        Consumer connections                           39,559         38,583
        Business connections                           19,539         19,069
        Quarter:
        ARPU - consumer                             $   47.37      $   39.01
        ARPU - business                             $  171.29      $  147.25
        Year-to-date:
        ARPU - consumer                             $   46.10      $   38.25
        ARPU - business                             $  167.66      $  144.39

        Wholesale lines at quarter end                 18,595         21,278

        Wireless:
. . .
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