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LMOS > SEC Filings for LMOS > Form 10-K on 7-Mar-2014All Recent SEC Filings

Show all filings for LUMOS NETWORKS CORP.

Form 10-K for LUMOS NETWORKS CORP.


7-Mar-2014

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.

You should read the following discussion of our financial condition in conjunction with our consolidated financial statements and the related notes included herein (Item 8). This discussion contains forward looking statements that involve risks and uncertainties. For additional information regarding some of these risks and uncertainties that affect our business and the industry in which we operate, please see "Risk Factors" and "Forward-Looking Statements" elsewhere in this report.

Overview

Lumos Networks is a fiber-based bandwidth infrastructure and service provider in the Mid-Atlantic region. We provide services to carrier and enterprise customers, including healthcare providers, local government agencies, financial institutions, educational institutions, and other enterprises over our approximately 7,400 route-mile fiber network. Our principal products and services include Multiprotocol Label Switching ("MPLS") based Ethernet, Metro Ethernet ("Metro E"), Fiber to the Cell site ("FTTC") wireless backhaul and data transport services, wavelength transport services and IP services.

Our primary objective is to leverage and expand our fiber assets to capture the growing demand for data and mobility services among our carrier and enterprise customers in our marketplace. Our overall strategy is to (i) leverage our fiber network to expand to new fiber to the cell site opportunities; (ii) monetize our approximately 7,400 route-mile fiber optic network by selling bandwidth infrastructure services to new and existing carrier and enterprise customers while maintaining a ratio of approximately 70% to 80% of our strategic data revenue from on-net traffic; (iii) proactively manage our churn by upgrading existing customers from legacy technologies to carrier Ethernet services; (iv) continue to provide high quality customer service and a compelling value proposition; (v) renew focus on managing resources from the declining legacy voice products into our faster growing and more profitable strategic data products; (vi) use our "edge-out" strategy to expand into new adjacent geographic markets to expand our addressable market; and (vii) execute our success-based investment strategy to improve capital efficiency and expand margins.

Our strategic data segment, which provided approximately 59% of our total revenue in 2013 represents the main growth opportunity and the key focal point of our strategy and currently includes our enterprise data, data transport, FTTC and IP services product lines. Given our focus on on-net customers, our strategic data services typically carry higher gross margins than many of our other services. A significant majority of our capital expenditures and sales force are dedicated to increasing revenue and profit from our strategic data segment. We believe that a balanced split between enterprise and carrier revenue results in the most effective capital allocation and resulting profitability.

The remaining 41% of our total revenue in 2013 was generated from our legacy voice and access segments. These legacy businesses, in the aggregate, require limited incremental capital to maintain the underlying assets and deliver reasonably predictable cash flows. It is our belief that revenue from these legacy businesses, in the aggregate, will continue to decline at an annual rate of approximately 10% to 15%. This decline is the expected result of regulatory actions taken to reduce intra-state tariffs, access line loss resulting from residential wireless substitution, technology changes and product replacement of voice service offerings from cable operators in our markets. Despite the declining revenues, we expect the cash flows from these legacy businesses to continue to significantly contribute to funding the capital investment in our growing strategic data segment.

Business Separation

On October 14, 2011, NTELOS announced a distribution date of October 31, 2011 for the spin-off of all of the then issued and outstanding shares of common stock of Lumos Networks, which operated NTELOS's wireline operations. We have been publicly traded on NASDAQ under the ticker symbol "LMOS" since November 1, 2011.

Financial data included in this Form 10-K reflects Lumos Networks as a standalone public company. Revenue for 2011 includes services sold to the NTELOS wireless segment that was previously eliminated, which amounted to $6.6 million for the period January 1, 2011 through October 31, 2011. Expenses include items previously unallocated by NTELOS, inclusive of legal and professional fees, equity-based compensation expense and certain expenses related to acquisitions. These additional expenses for the period January 1, 2011 through October 31, 2011 totaled $2.6 million.

Business Segments

Our operating segments closely align with our product and service offerings, which coincides with the way that our chief operating decision makers measured performance and allocated resources during 2013. Our reportable operating segments are strategic data, legacy voice and access.

Our strategic data segment provided approximately 58.5%, 52.7% and 45.1% of our total revenue for the years ended December 31, 2013, 2012 and 2011, respectively. Revenue for our strategic data segment increased 11.3% for the year ended December 31, 2013, as compared to 2012. This segment, which includes our enterprise data, data transport, FTTC and IP services product groups, represents the main growth opportunity and the key focal point of our strategy. We market and sell these services primarily to carrier and enterprise customers, including healthcare providers, local government agencies, financial institutions and educational institutions. These businesses, in the aggregate, typically carry higher gross margins than many of our other product lines. A majority of our


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capital expenditures and the focus of our sales force are dedicated to expanding revenue and profit from our strategic data products. We believe that a balanced split between carrier and enterprise revenue results in the most effective capital allocation and resulting profitability. Our ability to successfully implement our strategy and thereby sustain our revenue growth in our strategic data segment depends on our ability to effectively allocate capital and implement our "edge out" expansion plans in a timely manner, attract new customers, manage our churn by upgrading existing customers from legacy technologies to carrier Ethernet services and respond to competition from other data service providers in existing and new markets.

The 11.3% growth in our strategic data segment revenues in 2013 was achieved primarily through increases in customer bandwidth demand, as reflected in the addition of 238 fiber to the cell sites, and an approximate 12% increase in the number of on-net buildings. Our sales force is focused on taking advantage of increased carrier bandwidth demand, particularly for long-term fiber to the cell site contracts from wireless carriers that are deploying LTE data services, selling into the "edge out" markets, and improving penetration in existing markets. We had fiber deployed to 370 cell towers at December 31, 2012 and we added 238 cell towers in 2013 for a total of 608 fiber to the cell sites as of December 31, 2013. Although all of our strategic data product groups (enterprise data, carrier data and IP services) contributed to the year-over-year growth in revenues, the revenue growth from both our enterprise data and transport products, within our carrier data group, was negatively impacted by network grooming as existing customers redesign their networks and upgrade to newer products to improve efficiency. As we make further progress with implementing our "edge out" strategy in 2014, which includes extending and upgrading our fiber optic network in the Richmond, VA and Western PA markets, we believe that the effect of churn on these product lines will begin to be more than offset by revenue from new enterprise customers, FTTC contracts and inter-carrier connectivity.

The remainder of our total revenue was generated by our legacy voice and access segments. Our legacy voice segment provided 27.2%, 31.0% and 36.5% of revenue for the years ended December 31, 2013, 2012 and 2011, respectively. Our access segment provided 14.3%, 16.3% and 18.4% of revenue for the years ended December 31, 2013, 2012 and 2011, respectively. These businesses, in the aggregate, require limited incremental capital to maintain the underlying assets, and deliver reasonably predictable cash flows. Revenue declined 12.0% for both our legacy voice and access segments in 2013 as compared to 2012 and declined 15.2% and 11.8%, respectively, in 2012 as compared to 2011. This decline is the expected result of regulatory actions taken to reduce intra-state tariffs, access line loss resulting from residential wireless substitution, technology changes and product replacement by competitive voice service offerings from cable operators in our markets. We currently expect aggregate revenue from these businesses will continue to decline at an annual rate of approximately 10% to 15%. Despite the declining revenues, we expect the cash flows from these legacy businesses to continue to significantly contribute to funding the capital expenditures for our growing strategic data segment.

We anticipate further access revenue declines as a result of certain actions taken by applicable regulatory authorities, principally the FCC and the SCC. In 2011, the FCC released an order comprehensively reforming its Universal Service Fund ("USF") and intercarrier compensation systems. In the order, the FCC determined that interstate and intrastate access charges, as well as local reciprocal compensation, should be eliminated entirely over time. These FCC pricing reductions commenced on July 1, 2012 and continue through July 1, 2020. However, a portion of the access revenue previously received from carriers is being recovered through payments from the FCC's "Connect America Fund" ("CAF") and from increases in charges to end user subscribers in the form of rate increases and the FCC's "Access Recovery Charge". These new payments and revenues were also effective July 1, 2012. These actions directly impact the access rates charged by our RLECs, which provide service to the rural Virginia cities of Waynesboro and Covington, and portions of the Virginia counties of Alleghany, Augusta and Botetourt. Our total revenues from RLEC access services were $26.0 million, $27.3 million and $30.2 million for the years ended December 31, 2013, 2012 and 2011, respectively. Of these amounts, $16.6 million, $9.8 million and $7.7 million, respectively, were derived from cost recovery mechanisms including the USF and the CAF.

Our operating income margins were 22.1%, 19.9% and 24.1% for the years ended December 31, 2013, 2012 and 2011, respectively, excluding the asset impairment charge recognized in 2011. Our Adjusted EBITDA margins, as defined below, were 46.4%, 43.0% and 46.7% for the years ended December 31, 2013, 2012 and 2011, respectively. The increase in our Adjusted EBITDA margin for 2013 is due to a shift towards higher margin product lines combined with decreases in network access costs and selling, general and administrative expenses. We took certain cost reduction measures at the end of 2012, which were intended to increase our ability to fund our capital investment in our strategic data segment, and consisted of a reduction of approximately 10% of our workforce (primarily in our legacy businesses), consolidation of certain facilities and freezing the accumulation of benefits under certain postretirement benefit plans. The overall decrease in selling, general and administration expenses in 2013 is partially attributable to reduced salaries, wages and benefits and rental expense as a direct result of these initiatives (see "Results of Operations" below for further discussion). The decrease in our Adjusted EBITDA margin from 2011 to 2012 was primarily as a result of increased corporate expenses from the Company having been an independent, public company a full year for the first time in 2012.


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Operating Revenues

Our revenues are generated from the following segments:

Strategic data, which includes the following products: enterprise data (dedicated internet, metro Ethernet, and private line), carrier data (wholesale transport and fiber to the cell site) and IP services (integrated access, DSL, broadband XL, VoIP, and IP-based video);

Legacy voice, which includes the following products: local lines, PRI, long distance, and toll and directory services; and

Access, which primarily includes switched access services and revenue derived from programs funded by regulatory agencies for recovery of lost revenues resulting from intercarrier compensation reform.

Operating Expenses

Our operating expenses are incurred from the following categories:

Network access costs, including usage-based access charges, long distance and other direct costs incurred in accessing other telecommunications providers' networks in order to provide telecommunication services to our end-user customers and leased facility expenses for connection to other carriers;

Selling, general and administrative expenses, including network operating costs (which includes salaries, wages and benefits of network operations personnel, customer care, engineering, marketing, sales and other indirect network costs, but excludes network access costs), billing, publication of regional telephone directories, directory services, bad debt expenses, taxes other than income taxes, executive services, accounting, legal, purchasing, information technology, human resources and other general and administrative expenses, including earned bonuses and equity-based compensation expense related to shares of restricted stock and stock option instruments granted to employees and non-employee directors and amortization of actuarial losses related to retirement plans;

Depreciation and amortization, including depreciable long-lived property, plant and equipment and amortization of intangible assets where applicable;

Accretion of asset retirement obligations;

Asset impairment charges;

Gain on settlements, net; and

Restructuring charges.

Adjusted EBITDA

Adjusted EBITDA, as defined by us, is net income attributable to Lumos Networks Corp. before interest, income taxes, depreciation and amortization, accretion of asset retirement obligations, net income attributable to noncontrolling interests, other income or expenses, equity-based compensation charges, acquisition-related charges, amortization of actuarial gains or losses on retirement plans, employee separation charges, restructuring-related charges, gain or loss on settlements and gain or loss on interest rate swap derivatives.
Adjusted EBITDA margin is calculated as the ratio of Adjusted EBITDA, as defined above, to operating revenues.

Adjusted EBITDA is a non-GAAP financial performance measure. It should not be considered in isolation, as an alternative to, or more meaningful than measures of financial performance determined in accordance with GAAP. Management believes that Adjusted EBITDA is a standard measure of operating performance and liquidity that is commonly reported in the telecommunications and high- speed data transport industry and provides relevant and useful information to investors for comparing performance period to period and for comparing financial performance of similar companies. Management utilizes Adjusted EBITDA internally to assess its ability to meet future capital expenditure and working capital requirements, to incur indebtedness if necessary, and to fund continued growth. Management also uses Adjusted EBITDA to evaluate the performance of its business for budget planning purposes and as a factor in the Company's employee compensation programs.

Note 4 - Disclosures About Segments of an Enterprise and Related Information, of
the Notes to Consolidated Financial Statements provides a reconciliation of Adjusted EBITDA to Operating Income on a consolidated basis.

Other Income (Expenses)

Our other income (expenses) are generated (incurred) from interest expense on debt instruments and capital lease obligations, including amortization of debt issuance costs, gains or losses on interest rate swap derivatives and other income or expense, which


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includes interest income and fees, expenses related to our senior secured credit facility and, as appropriate under the circumstances, secondary public offering and stock registration costs and write-off of unamortized debt issuance costs.

Income Taxes

Our income tax expense and effective tax rate increases or decreases based upon changes in a number of factors, including primarily the amount of our pre-tax income or loss, state minimum tax assessments and non-deductible expenses.

Noncontrolling Interests in Losses (Earnings) of Subsidiaries

We have partnership through our RLEC with a 46.3% noncontrolling interest that owns certain signaling equipment and provides services to a number of small RLECs and to TNS (an inter-operability solution provider).

Results of Operations

Year ended December 31, 2013 compared to year ended December 31, 2012

Operating revenues increased $0.6 million, or 0.3%, from 2012 to 2013 resulting from an increase in strategic data segment revenues of $12.3 million, largely offset by an aggregate decrease in legacy voice and access segment revenues of $11.7 million. The growth in strategic data segment revenues was primarily driven by an increase in carrier data revenue of $8.9 million and increases in enterprise data and IP services revenues of $3.0 million and $0.5 million, respectively, from 2012 to 2013. The $11.7 million decline in legacy voice and access segment revenues is due primarily to line loss, access rate reductions resulting from regulatory actions, access reconfigurations and network grooming by carriers. For further details regarding these revenue fluctuations, see "Operating Revenues" below.

Operating income increased $4.6 million from $41.2 million in 2012 to $45.8 million in 2013 due to a $5.0 million increase in gross margin (operating revenues less network access costs) and a $2.4 million decrease in selling, general and administrative expenses. These favorable results were partially offset by an increase in depreciation and amortization costs of $3.4 million due to capital investment primarily in our fiber network assets. Variances in the individual line items on the consolidated statements of operations are described in the operating expenses section below.

Adjusted EBITDA was $96.3 million in 2013 compared to Adjusted EBITDA of $88.9 million in 2012. The increase in Adjusted EBITDA is directly attributable to the decrease in operating expenses, as described above and in further detail below.

Net income attributable to Lumos Networks increased $1.4 million from 2012 to 2013 primarily due to a $4.6 million increase in operating income, partially offset by an increase in income taxes of $1.0 million and an increase in interest expense of $2.3 million due to our debt refinancing in 2013.

OPERATING REVENUES

The following table identifies our operating revenues by major product group for
the years ended December 31, 2013 and 2012:




                             Year Ended December 31,
(Dollars in thousands)         2013            2012       $  Variance    %  Variance
Operating Revenues:
Strategic data:
Enterprise data            $     40,377     $  37,416    $      2,961          7.9  %
Carrier data                     61,884        52,978           8,906         16.8  %
IP services                      19,072        18,616             456          2.4  %
Total strategic data            121,333       109,010          12,323         11.3  %
Legacy voice                     56,466        64,146          (7,680)       (12.0) %
Access                           29,676        33,715          (4,039)       (12.0) %
Total operating revenues   $    207,475     $ 206,871    $        604          0.3  %

Strategic Data. Our strategic data segment consists of the enterprise data, carrier data (which includes FTTC) and IP services product groups. Changes in revenue by product group are as follows:


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Enterprise Data. Enterprise data revenues increased $3.0 million, or 7.9%, in 2013, primarily driven by growth in customer bandwidth demand and a 12.4% increase in on-net buildings, from 1,196 as of December 31, 2012 to 1,344 as of December 31, 2013. Revenue from our metro Ethernet product was the largest contributor to our enterprise data growth in 2013, increasing $4.0 million, or 25.8%, from the prior year. The growth in metro Ethernet product revenues was partially offset by declines in private line and other enterprise data products as a result of network grooming and technological product upgrades by existing customers.

Carrier Data. The 16.8% increase in carrier data revenue was primarily attributable to growth in FTTC revenue as a result of a 64% increase in our fiber connections to wireless cell sites, from 370 as of December 31, 2012 to 608 as of December 31, 2013 and increases in carrier transport product revenues due to growth in carrier demand and fiber network expansion.

IP Services. The 2.4% increase in IP services revenue was primarily driven by increases in high speed fiber to the premises Internet and video services and other Voice over IP ("VoIP") services partially offset by declines in the legacy DSL products.

Legacy Voice. Revenue from legacy voice products declined 12.0% in 2013 as compared to 2012. These declines were primarily due to the continuing churn from the commoditization of these products, the increasing use of wireless devices and our shift in focus to VoIP services (which is included in IP services revenue). As of December 31, 2013, we operated approximately 28,900 RLEC telephone access lines and 95,700 competitive voice lines, compared to approximately 31,200 and 110,000, respectively, as of December 31, 2012. This represents a 7.4% year-over-year decline in RLEC telephone access lines and a 13.0% year-over-year decline in competitive voice lines primarily due to competition from cable operators in our markets and wireless substitution.

Access. The 12.0% decline in access revenues is primarily due to a net 11.8% year-over-year decrease in access lines and rate reductions beginning in July 2012 based on rate actions from regulatory authorities, partially offset by the impact of certain cost recovery programs, as described in the overview section above.

OPERATING EXPENSES

The following table identifies our operating expenses for the years ended
December 31, 2013 and 2012:




                                    Year Ended December 31,
(Dollars in thousands)                2013            2012       $ Variance     %Variance
Consolidated Operating
Expenses:
Network access costs              $     42,417     $  46,845    $    (4,428)      (9.5) %
Selling, general and
administrative expenses                 76,749        79,176         (2,427)      (3.1) %
Depreciation and amortization           42,320        38,884          3,436        8.8  %
Accretion of asset retirement
obligations                                104           124            (20)     (16.1) %
Restructuring charges (1)                   50         2,981         (2,931)     (98.3) %
Gain on settlements, net (2)                  -       (2,335)         2,335     (100.0) %
Total operating expenses          $    161,640     $ 165,675    $    (4,035)      (2.4) %

(1) In 2012, the Company completed a cost reduction plan involving an employee reduction-in-force, the consolidation of certain facilities and freezing of the accumulation of benefits under certain postretirement plans. Restructuring charges of $3.0 million were recognized in 2012 and less than $0.1 million were recognized in 2013 in connection with this plan (see Note 12 in Part II, Item 8. Financial Statements).

(2) We recognized a net pre-tax gain of approximately $2.3 million in 2012 in connection with the settlement of outstanding matters related to a prior acquisition and the settlement of an outstanding lawsuit.

Network Access Costs. Network access costs decreased $4.4 million, or 9.5%, from the prior year primarily due to network grooming and the overall decrease in voice access lines.

Selling, General and Administrative Expenses. Selling, general and administrative expenses decreased $2.4 million, or 3.1%, in 2013 as compared to 2012. The decrease is primarily attributable to a non-recurring charge for employee separation benefits of $2.3 million in 2012, a $1.9 million net decrease in salaries, wages and benefits, a $0.5 million decrease in rent and a $0.5 million decrease in amortization of actuarial losses, partially offset by a $2.9 million increase in non-cash compensation expense. The decreases in employee benefits and rent expense are primarily attributable to the restructuring plan that was completed in December 2012, which included an employee reduction-in-force, consolidation of certain facilities and freezing certain retirement benefits. The increase in non-cash compensation expense is related to stock-based awards granted in 2013 under employee compensation plans and the accelerated vesting of certain performance-based awards upon attainment of the stock price target in accordance with the terms of the awards.


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Depreciation and Amortization. Depreciation and amortization increased $3.4 million, or 8.8%, over 2012. This net increase is attributable to a $4.8 million increase in depreciation expense partially offset by a $1.3 million decrease in amortization expense related to customer intangibles for which amortization expense is escalated in the early years of the asset lives based on these assets' estimated pattern of benefit. The increase in depreciation expense is a result of the year-over-year increase in our depreciable base of assets primarily from capital investment in our network including fiber to the cell site installations.

The following table identifies our operating expenses by segment for the years ended December 31, 2013 and 2012 and provides a reconciliation from total segment operating expenses to consolidated operating expenses for each period.

                                    Year Ended December 31,
(Dollars in thousands)                2013            2012      $ Variance     %Variance
Segment Operating Expenses:
Strategic data                    $     67,604     $  58,118    $    9,486       16.3  %
Legacy voice                            36,214        49,296       (13,082)     (26.5) %
Access                                   7,333        10,568        (3,235)     (30.6) %
Total segment operating
expenses                          $    111,151     $ 117,982    $   (6,831)      (5.8) %

Reconciliation of Segment
Operating Expenses to
Consolidated Operating
Expenses:
Total segment operating
expenses                          $    111,151     $ 117,982    $   (6,831)      (5.8) %
Depreciation and amortization
and
accretion of asset retirement
obligations                             42,424        39,008         3,416        8.8  %
. . .
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