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TMCNet:  HICKORY TECH CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

[November 09, 2012]

HICKORY TECH CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

(Edgar Glimpses Via Acquire Media NewsEdge) Forward Looking Statements The Private Securities Litigation Reform Act of 1995 contains certain safe harbor provisions regarding forward-looking statements. This Quarterly Report on Form 10-Q may include forward-looking statements. These statements may include, without limitation, statements with respect to anticipated future operating and financial performance, growth opportunities and growth rates, acquisition and divestiture opportunities, business strategies, business and competitive outlook, and other similar forecasts and statements of expectation. Words such as "expects," "anticipates," "intends," "plans," "believes," "seeks," "estimates," "targets," "projects," "will," "may," "continues," and "should," and variations of these words and similar expressions, are intended to identify these forward-looking statements. Such forward-looking statements are subject to risks and uncertainties that could cause our actual results to differ materially from such statements. Factors that might cause such a difference include, but are not limited to, those contained in Item 1A of Part II, "Risk Factors" of this quarterly report on Form 10-Q and Item 1A, "Risk Factors" of our Annual Report on Form 10-K for the year ended December 31, 2011, which is incorporated herein by reference.


Because of these risks, uncertainties, and assumptions and the fact that any forward-looking statements made by us and our management are based on estimates, projections, beliefs, and assumptions of management, they are not guarantees of future performance and you should not place undue reliance on them. In addition, forward-looking statements speak only as of the date they are made. With the exception of the requirements set forth in the federal securities laws or the rules and regulations of the Securities and Exchange Commission, we do not undertake any obligations to update any forward-looking information, whether as a result of new information, future events or otherwise.

Critical Accounting Policies The preparation of our financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and the related disclosure of contingent assets and liabilities. A description of the accounting policies that we consider particularly important for the portrayal of our results of operations and financial position, and which may require a higher level of judgment by our management, is contained under the caption, "Critical Accounting Policies," in the Management's Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2011 and Amendment No. 1 on Form 10-K/A other than the following.

Acquisition/Business Combinations We account for each business combination by applying the acquisition method, which requires (i) identifying the acquiree; (ii) determining the acquisition date; (iii) recognizing and measuring the identifiable assets acquired, the liabilities assumed, and any non-controlling interest we have in the acquiree at their acquisition date fair value; and (iv) recognizing and measuring goodwill.

To establish fair value we measure the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The measurement assumes the highest and best use of the asset by the market participants that would maximize the value of the asset or the group of assets within which the asset would be used at the measurement date, even if the intended use of the asset is different.

Goodwill is measured and recorded as the amount, by which the consideration transferred, generally at the acquisition date fair value, exceeds the acquisition date fair value of identifiable and intangible assets acquired, liabilities assumed, and any non-controlling interest we have in the acquiree.

We also estimate the value of amortizable intangible assets such as customer relationships. These estimates are based on acquiree historical data such as experience based sales and retention rate assumptions.

Acquisition costs are expensed as incurred.

Table of Contents 19 -------------------------------------------------------------------------------- Financial Derivative Instruments We enter into fixed interest rate swap agreements (financial derivative instruments) to manage exposure to interest rate fluctuations on a portion of our variable-interest rate debt. Our interest rate swaps increase or decrease the amount of cash paid for interest depending on the increase or decrease of interest required on our variable rate debt.

We account for our financial derivative instruments in accordance with ASC 815, "Derivatives and Hedging." ASC 815 requires that all derivative instruments be recorded on the balance sheet as either an asset or a liability measured at its fair value, and that changes in the derivatives' fair value be recognized in earnings unless specific hedge accounting criteria are met. The fair value estimate of our interest rate swaps represent the net present value of future cash flows based on projections of the three month LIBOR rate over the life of each swap. Our financial derivative instruments are not designated as hedges and therefore are not accounted for using hedge accounting. The difference between interest paid and interest received, which may change as market interest rates change, is accrued and recognized as a component of interest expense.

Results of Operations We conduct our operations in three business segments: (i) Fiber and Data, (ii) Equipment and (iii) Telecom. An overall description of our three business segments can be found in Note 15 to the Notes to the Consolidated Financial Statements.

Executive Summary Third quarter 2012 revenue of $45.8 million represents an increase of 1% compared to the same period in 2011. Revenue increased by $4.2 million or 36% in our Fiber and Data Segment driven both by organic growth and the addition of IdeaOne. This growth was largely offset by a decline of $1.4 million or 9% from customer contracts and project completion within our Equipment Segment combined with a decline of $2.1 million or 12% of revenue in the Telecom Segment. On a year-to-date basis revenue has grown by 10% led by a 31% increase in our Fiber and Data Segment services revenue and a 24% increase in equipment revenue.

Telecom services revenue has declined 9% year-to-date, a sharper decline than we have experienced in recent years due primarily to the impacts of FCC order 11-161, whose effects we felt on both a broad scale in its reform of intercarrier compensation and in a more direct way through the modification of a specific customer agreement. Telecom revenue has also been adversely impacted by the industry-wide trend of declining legacy telecommunication services.

Fiber and Data Segment revenue of $15.7M reflects growth of $4.2M or 36% in the third quarter of 2012 compared to 2011. We completed our acquisition of IdeaOne Telecom, a Fargo-based fiber and data service provider in March of 2012. IdeaOne contributed $3.3M or 78% of the revenue growth realized during the third quarter utilizing the deep metro-fiber network in Fargo, which also connects to our regional fiber network. In 2013, completion of our northern Minnesota broadband route, will add even more diversity between our networks and is expected to provide additional growth opportunities for our customers and continue sales momentum in wholesale transport and fiber-based special access services.

Equipment Segment revenue while recording a decline of $1.4M or 9% in revenue in the third quarter of 2012 compared to 2011 has realized revenue growth of $6.7M or 17% increase year-over-year. Driving this growth is sales of equipment, which has increased $7.5M in year-to-date 2012 compared to 2011 providing customers with solutions that fully integrate their information technology networks and provide cloud-based technology infrastructure components.

Telecom Segment revenue declined $2,115,000 or 12% in the third quarter of 2012 as compared to 2011 with the largest declines realized in revenue from network access, local service and bill processing. The network access decline of $835,000 or 15% in the third quarter and a portion of the local service decline of $410,000 or 12% have been impacted by the unique effects of the Federal Communication Commission's ("FCC") revision of Intercarrier Compensation and Federal Universal Service Support rules that significantly impact network access and reciprocal compensation revenue and required a modification of a contract with an external communications provider who aggregated high volume traffic on our network. Competition continues to intensify and has caused price compression in our Telecom markets. In response we began offering our customers new service combination bundles in July 2012, discounting rates for existing customers in an attempt to reduce churn and attract new customers.

Table of Contents 20 -------------------------------------------------------------------------------- Total costs and expenses increased 6% in the third quarter of 2012 as compared to 2011 due to continued investment in growing our Fiber and Data Segment offset by lower sales volumes in our Equipment Segment. Expenses include a full quarter of IdeaOne Telecom operations, which is incorporated into the Fiber and Data Segment. Depreciation and amortization increased $1.1 million in the third quarter of 2012 compared to 2011 and is directly related to our newly acquired IdeaOne plant and intangible assets. Interest expense decreased $1,255,000 in the third quarter of 2012 primarily due to the change in fair value on our interest rate swap agreements. Without the accounting for fair value changes on our interest rate swap agreements which increased interest expense by $131,000 in the third quarter of 2012 and $1,393,000 in the third quarter of 2011, interest expense would have shown an increase of $7,000 in the third quarter of 2012 compared to the third quarter of 2011. The third quarter of 2011 was impacted by an adjustment to record amortization expense of debt fees related to our previous credit facility which increased interest expense by $310,000.

Table of Contents 21 -------------------------------------------------------------------------------- Fiber and Data Segment The following table provides a breakdown of the Fiber and Data Segment operating results.

Fiber and Data Three Months Ended September 30 % Nine Months Ended September 30 %(Dollars in thousands) 2012 2011 Change 2012 2011 Change Operating revenue before intersegment eliminations: Services 15,528 11,368 37 % 43,924 33,296 32 % Intersegment 215 219 -2 % 601 566 6 % Total operating revenue $ 15,743 $ 11,587 36 % $ 44,525 $ 33,862 31 % Cost of services (excluding depreciation and amortization) 7,735 5,834 33 % 21,819 17,335 26 % Selling, general and administrative expenses 2,925 2,230 31 % 8,477 6,455 31 % Depreciation and amortization 2,638 1,597 65 % 7,155 4,739 51 % Total costs and expenses 13,298 9,661 38 % 37,451 28,529 31 % Operating income $ 2,445 $ 1,926 27 % $ 7,074 $ 5,333 33 % Net income $ 1,454 $ 1,146 27 % $ 4,208 $ 3,173 33 % Capital expenditures $ 6,390 $ 2,988 114 % $ 11,958 $ 7,211 66 % Revenue Fiber and Data. We serve wholesale, enterprise, and commercial business customers with high-speed communications products delivered through our extensive regional fiber network and community access rings supported by a 24x7x365 network operations center. This revenue stream is generally based on multi-year contracts with retail businesses, regional and national service providers, and wireless carriers, building a solid monthly recurring revenue base.

Fiber and Data services revenue increased $4,156,000 or 36% in the third quarter and grew by $10,663,000 or 31% in the year-to-date period as compared to the same periods in 2011. Organic growth in the third quarter and year-to-date period was $901,000 or 8% and $3,222,000 or 10%. IdeaOne contributed $3,255,000 and $7,441,000 to revenue in the third quarter and year-to-date periods of 2012, respectively. We continue to experience demand for our wholesale private line services and growth in our fiber-based special access services, including backhaul sales to wireless carriers. We are also focused on our commercial customer segment expanding our business product offerings to include a wide range of services including: data, internet, voice and VoIP, hosted services and equipment solutions. Our IdeaOne acquisition advances our strategy of growing our commercial and Enterprise business and broadband services, as approximately 85% of IdeaOne revenue comes from business services Throughout 2012, we have continued to expand our network. Our acquisition of IdeaOne was completed on March 1, 2012 adding 225 fiber route miles to our regional network and extending to 650 on-net fiber-lit buildings within the Fargo market. A 185 mile route from Minneapolis/St. Paul to Duluth/Superior was completed in the third quarter of 2012 as part of our Greater Minnesota Broadband Collaborative Project, while the western route continues to be built and will be completed by August 2013.

Total Cost and Expenses IdeaOne Telecom's operating results are reflected in our financial results of this segment beginning on March 1, 2012. The primary drivers of expense variances are noted below with the balance of the increases resulting from costs supporting IdeaOne operations, which is reported within the Fiber and Data Segment.

Table of Contents 22 --------------------------------------------------------------------------------Cost of Services (excluding Depreciation and Amortization) Fiber and Data Segment cost of services increased by $1,901,000 or 33% and $4,484,000 or 26% in the third quarter and year-to-date periods as compared to the same periods in 2011. The organic growth in cost of services excluding IdeaOne's operations was 9% for the quarter and 8% year-to-date, commensurate with the organic revenue growth cited above.

Aside from IdeaOne, the primary drivers of the increase in cost of services were: (1) an increase in volume-driven circuit costs of $131,000 for the quarter and $452,000 in the year-to-date period supporting increased revenue, (2) an increase of $139,000 for the quarter and $491,000 in the year-to-date period in wages and benefits supporting growth, and (3) an increase of $61,000 for the quarter and $144,000 in maintenance contract expense associated with the expansion of our network..

Selling, General and Administrative Expenses Fiber and Data Segment selling, general and administrative expenses increased $695,000 in the third quarter and $2,022,000 year-to-date equating to a 31% increase in both periods of 2012 as compared to the same periods in 2011. The organic growth in selling, general and administrative expenses excluding IdeaOne's operations was 8% for the quarter and 12% year-to-date. Aside from IdeaOne, the primary drivers of the higher cost was a $139,000 quarterly and $416,000 year-to-date increase in corporate overhead costs along with a year-to-date increase of $146,000 in commissions expense driven by sales and a $129,000 year-to-date increase in wages and benefits.

Depreciation and Amortization Fiber and Data Segment depreciation and amortization increased by $1,041,000 or 65% in the third quarter and $2,416,000 or 51% in year-to-date 2012 as compared to the same periods in 2011. This increase was primarily due to our IdeaOne Telecom acquisition which added $852,000 and $1,971,000 of depreciation and amortization to the third quarter and year-to-date 2012 periods. The balance of the increase in depreciation is driven by continued investments made to expand and enhance our fiber and broadband network. Amortization expense remained constant except for the addition of IdeaOne Telecom intangible assets.

Table of Contents 23 -------------------------------------------------------------------------------- Equipment Segment The following table provides a breakdown of the Equipment Segment operating results.

Equipment Three Months Ended September 30 % Nine Months Ended September 30 %(Dollars in thousands) 2012 2011 Change 2012 2011 Change Operating revenue before intersegment eliminations: Equipment $ 12,915 $ 14,269 -9 % $ 38,954 $ 31,499 24 % Services 2,086 2,147 -3 % 6,332 7,087 -11 % Total operating revenue $ 15,001 $ 16,416 -9 % $ 45,286 $ 38,586 17 % Cost of sales (excluding depreciation and amortization) 10,906 12,223 -11 % 33,664 27,146 24 % Cost of services (excluding depreciation and amortization) 1,802 1,634 10 % 5,141 5,008 3 % Selling, general and administrative expenses 1,332 1,235 8 % 4,159 3,765 10 % Depreciation and amortization 71 74 -4 % 213 213 0 % Total costs and expenses 14,111 15,166 -7 % 43,177 36,132 19 % Operating income $ 890 $ 1,250 -29 % $ 2,109 $ 2,454 -14 % Net income $ 529 $ 744 -29 % $ 1,254 $ 1,458 -14 % Capital expenditures $ (15 ) $ 213 -107 % $ 175 $ 306 -43 % Revenue Equipment. We are a Master Unified Communications and Gold Certified Cisco partner providing equipment solutions and support for a broad spectrum of business clients. Our equipment solutions team plans, designs and implements networks that utilize emerging technological advancements including TelePresence Video, Unified Communications, and data center solutions. Equipment sales are non-recurring in nature, making this revenue dependent upon new sales to existing and new customers, which makes it susceptible to fluctuations on a quarter-to-quarter basis based on customer spend, contracts and project completion.

Revenue from equipment sales decreased $1,354,000 or 9% in the third quarter of 2012 as compared to the same period in 2011; however year-to-date results provided overall growth of 24% as compared to the same period in 2011. The year-to-date increase is driven by the strong sales of advanced unified communication and data center equipment we experienced in the first quarter of 2012, exceeding $15,000,000 in revenue for that quarter. We continue to have success in selling advanced unified computing system products, data center equipment and Vblock technology, which includes complete infrastructure packages combing networking, computing, storage, security and management technologies.

Equipment Services. Services include network assessments, planning, design, implementation and training. Maintenance contracts ("Smartnet" contracts) are offered in conjunction with hardware solutions and are also classified as services revenue. Our total care support team provides a single-point-of-contact for the support of applications, systems and infrastructure. We also offer security solutions, combining leading network security products with our experience and expertise in integrated communications systems.

Table of Contents 24 -------------------------------------------------------------------------------- Equipment services revenue declined $61,000 or 3% and $755,000 or 11% in the third quarter and year-to-date periods of 2012 as compared to 2011. The main contributor to the decline was lower maintenance revenue of $313,000 or 31% in the third quarter and $859,000 or 27% year-to-date driven by the timing and number of large Smartnet maintenance renewals. Contract services revenue, which includes design, configuration, and installation of voice and data equipment, increased by $330,000 or 43% in the third quarter and declined slightly - by $12,000 or .5% year-to-date. This revenue is tied to large equipment installations and is also a product of timing.

Cost of Sales Cost of sales is composed of equipment material costs and is directly related to equipment sales. Equipment sales volume drove an 11% decline in the third quarter and a 24% year-to-date increase in cost of sales compared to the same periods in 2011. Labor associated with installation of the equipment is included in cost of services (excluding depreciation and amortization) described below.

Cost of Services (excluding Depreciation and Amortization) Cost of services increased $168,000 or 10% and $133,000 or 3% in the third quarter and year-to-date periods of 2012 as compared to the same periods in 2011. The increase is driven by a $214,000 quarterly and $413,000 year-to-date increase in wages and benefits. This increase was partially offset by declines of $39,000 quarterly and $158,000 year-to-date in contract labor and a $37,000 quarterly and $75,000 year-to-date decline in postage and freight.

Selling, General and Administrative Expenses Selling, general and administrative expenses increased $97,000 or 8% and $394,000 or 10% in the third quarter and year-to-date periods of 2012 compared to 2011. The increase is driven by growth in corporate overhead costs of $103,000 quarterly and $308,000 year-to-date.

Depreciation and Amortization Depreciation expense decreased $3,000 or 4% in the third quarter and remained constant in the year-to-date period of 2012 as compared to the same periods in 2011.

Table of Contents 25-------------------------------------------------------------------------------- Telecom Segment The following table provides a breakdown of the Telecom Segment operating results.

Telecom Three Months Ended September 30 % Nine Months Ended September 30 %(Dollars in thousands) 2012 2011 Change 2012 2011 Change Operating revenue before intersegment eliminations: Local Service $ 3,124 $ 3,534 -12 % $ 9,901 $ 10,822 -9 % Network Access 4,677 5,512 -15 % 14,329 17,088 -16 % Broadband 4,861 5,101 -5 % 14,840 15,245 -3 % Directory 764 845 -10 % 2,316 2,563 -10 % Long Distance 611 717 -15 % 1,895 2,173 -13 % Bill Processing 950 1,330 -29 % 3,190 2,917 9 % Intersegment 465 404 15 % 1,319 1,220 8 % Other 297 421 -29 % 933 1,284 -27 % Total Telecom operating revenue $ 15,749 $ 17,864 -12 % $ 48,723 $ 53,312 -9 % Total Telecom revenue before intersegment eliminations Unaffiliated customers $ 15,284 $ 17,460 $ 47,404 $ 52,092 Intersegment 465 404 1,319 1,220 15,749 17,864 48,723 53,312 Cost of services (excluding depreciation and amortization) 7,447 7,844 -5 % 22,373 23,540 -5 % Selling, general and administrative expenses 2,779 2,919 -5 % 8,429 9,035 -7 % Depreciation and amortization 4,146 4,101 1 % 12,364 12,137 2 % Total Telecom costs and expenses 14,372 14,864 -3 % 43,166 44,712 -3 % Operating Income $ 1,377 $ 3,000 -54 % $ 5,557 $ 8,600 -35 % Net income $ 816 $ 1,787 -54 % $ 3,301 $ 5,102 -35 % Capital expenditures $ 2,979 $ 2,440 22 % $ 6,777 $ 6,615 2 % Key metrics Business access lines 20,546 23,378 -12 % Residential access lines 22,715 25,329 -10 % Total access lines 43,261 48,707 -11 % Long distance customers 30,662 32,730 -6 % Digital Subscriber Line customers 19,751 19,749 0 % Digital TV customers 10,341 10,503 -2 % Total Telecom Revenue. Telecom services revenue has declined 9% year-to-date, a sharper decline than we experienced in recent years due primarily to the impacts of FCC order 11-161, whose effects we felt on both a broad scale in its reform of intercarrier compensation and in a more direct way through the modification of a specific customer agreement. Telecom revenue has also been adversely impacted by the industry-wide trend of declining legacy telecommunication services. We expect continued but more modest declines in telecom revenue as new access reform measures are more fully implemented and their effects stabilize.

Local Service. We receive monthly recurring revenue from customers primarily for providing local telephone services, enhanced calling features, miscellaneous local services and reciprocal compensation from wireless carriers.

Table of Contents 26 -------------------------------------------------------------------------------- Local service revenue declined $410,000 or 12% in the third quarter of 2012, extending the year-to-date decline to $921,000 or 9%. We have experienced residential line loss at a rate between 10%-11% over the past three years while experiencing business customer line losses of 3%-4%. Business customer line loss increased to 12% in 2012, driven by the impact of traffic stimulation provisions in FCC order 11-161 which required modification of a contract with an external communications provider, resulting in removing the majority of that customer's lines in early 2012. Business customers are also migrating toward alternative communication services including wireless, voice services provided by cable TV companies and VoIP services which are offered by our Fiber and Data Segment.

Local service revenue continues to be affected by ongoing changes within the regulatory environment, intense competition and ever-changing technological advances providing alternative communication options for our customers. In July 2012, we launched new service bundles which we believe to be highly competitive in the markets we serve in an effort to attract new customers and retain current customers.

Network Access. We receive a variety of fees and settlements to compensate us for the origination, transport, and termination of calls and traffic on our network. These include the fees assessed to interexchange carriers, subscriber line charges imposed on end-users, and settlements from nationally administered and jointly funded revenue pools.

Network access revenue declined $835,000 or 15% in third quarter and $2,759,000 or 16% year-to-date in 2012 as compared to the same periods in 2011. The decline is driven by multiple factors, including: the decrease in access lines as a result of intense competition from wireless carriers and cable TV providers causing lower minutes of use; changes in the regulatory environment; and carriers optimizing their own networks which lowers the demand of special access circuits. The 11% decline in access lines is the underlying driver of the decrease in both periods and was negatively impacted by the January 2012 modification of a contract with an external communications provider as a result of traffic stimulation provisions in FCC order 11-161. Traffic sensitive revenue, including minutes-of-use and tandem functions, accounted for $767,000 and $1,852,000 of the third quarter and year-to-date declines, respectively.

FCC order 11-161 contains comprehensive rules reforming all forms of intercarrier compensation and implements a new support mechanism for the deployment of broadband services. Generally, the intercarrier compensation reform outlines a path toward a "bill & keep" method where there is no compensation for termination of traffic received from another carrier. The transition to this method includes numerous steps depending on the type of traffic exchanged and the regulated status of the affected local exchange carrier. August 2012 marked the first month that support from the Connect America Fund ("CAF") was received, which is a mechanism to recover some of the carriers' lost revenue due to the reform.

Long Distance. We charge our end-user customers for toll or long distance service on either a per-call or flat-rate basis. Services include the provision of directory assistance, operator service, and long distance private lines.

Long distance revenue declined $106,000 or 15% and $278,000 or 13% in the third quarter and year-to-date periods of 2012 as compared to the same periods in 2011. The customer loss rate of 6% in the third quarter is consistent with the loss rates experienced the past couple of years. The increasing number of customers choosing unlimited long distant calling plans and reduced rates-per-minute charged to customers as a result of aggressive competition is driving the decrease in long distance revenue.

Broadband. We receive monthly recurring revenue for a variety of residential and business broadband data network services. Broadband services include: DSL, Internet, digital TV, and business Ethernet and other data services.

Broadband revenue declined $240,000 or 5% in the third quarter of 2012 and $405,000 or 3% year-to-date compared to the same periods in 2011. Intense competition in the markets we serve has resulted in a loss of 2% of our DTV customer base and no change in our DSL subscriber base year-to-date. Competitors are offering competing or alternative services forcing price compression on the products and services we offer. As previously mentioned, in July 2012 we launched new service bundles emphasizing our customer's desire for broadband services. These bundles have been well received in our marketplace to date. We will realize lower residential customer revenue due to customer savings on bundled services; however, we are optimistic that our new bundles will reduce churn and attract new customers.

Table of Contents 27 -------------------------------------------------------------------------------- Directory. We receive monthly recurring revenue from end-user subscribers for yellow page advertising in our telephone directories, which are distributed in south central Minnesota and northwest Iowa.

Directory revenue declined $81,000 and $247,000 in the third quarter and year-to date periods of 2012 equating to a 10% decrease in both periods compared to the same periods in 2011. The decline is driven by decreased demand for published advertising as businesses move toward online platforms. Declining directory revenue is expected to continue.

Bill Processing. We provide data processing and billing services to other communication service providers. We collect a combination of monthly recurring revenue, software license fees and integration services revenue from companies with whom we have established long-term data processing relationships.

Bill processing revenue decreased $380,000 or 29% in the third quarter from the same period a year ago but remains $273,000 or 9% higher year-to-date in 2012 as compared to the same periods in 2011. Revenue from this business is often driven by the timing of project completion. Competitive communications providers continue to be interested in SuiteSolution®, our billing and customer management software system. SuiteSolution® provides communications billing, customer management and operations support systems incorporating the latest in database and screen presentation technology. External customer growth has increased demand for contract and support services increasing revenue from this business.

Other Revenue. Other revenue consists primarily of sales of wholesale contract services, late fees applied to subscriber billings, and add, move, and change revenue on customer premise equipment.

Other revenue declined $124,000 or 29% and $351,000 or 27% in the third quarter and year-to-date 2012 as compared to the same periods in 2011. The decline in 2012 is primarily driven by a decrease in wholesale contract services and a decrease in revenue from a joint network arrangement.

Cost of Services (excluding Depreciation and Amortization) Cost of services (excluding depreciation and amortization) decreased by $397,000 or 5% and $1,167,000 or 5% in the third quarter and year-to-date period of 2012 compared to 2011. The decline is attributable to: (1) a decrease of $194,000 quarterly and $461,000 year-to-date in wage and benefit expense, (2) a decrease of $180,000 quarterly and $639,000 in conference bridge commission related to the loss of a large external communications provider and (3) a decrease of $110,000 quarterly and $215,000 year-to-date in access expense. The declines mentioned above were partially offset by an increase of $119,000 quarterly and $298,000 year-to-date in costs of content related to payments to programming providers for our DTV product.

Selling, General and Administrative Expenses Selling, general and administrative expenses decreased by $140,000 or 5% and $606,000 or 7% in the third quarter and year-to-date periods of 2012 compared to 2011. The decline is primarily driven by a decrease in corporate overhead costs of $254,000 quarterly and $763,000 year-to-date and a $147,000 quarterly and $209,000 year-to-date decline in property taxes. The two items mentioned above were partially offset by a $167,000 quarterly and $350,000 increase in wage and benefit expense.

Depreciation and Amortization Depreciation and amortization expense increased by $45,000 or 1% and $227,000 or 2% in the third quarter and year-to-date periods of 2012 as compared to the same periods in 2011. Continued investment in broadband infrastructure enhancements to our network is primary reason for this increase.

Table of Contents 28 -------------------------------------------------------------------------------- Consolidated Results Interest Expense Consolidated interest expense decreased $1,255,000 or 44% and $564,000 or 11% in the third quarter and year-to-date periods in 2012 compared to the same periods in 2011. These declines are driven by the change in our financial derivative instrument fair value which is recognized in interest expense. The change in the fair value drove an increase in interest expense of $131,000 and $295,000 in the third quarter and year-to-date periods of 2012 compared to an increase of $1,393,000 and $1,629,000 in the same periods of 2011. Interest associated primarily with our senior credit facility increased year-over-year driven by higher interest rates associated with our debt refinancing which took place in the third quarter of 2011 and higher debt levels. The outstanding balance of our debt obligations (long-term and current portion) has increased $16,550,000 from $120,605,000 at September 30, 2011 to $137,155,000 as of September 30, 2012. The September 30, 2012 debt balance is $16,920,000 higher than the December 31, 2011 balance of $120,235,000. The higher debt balance is associated with the $22,000,000 incremental debt we borrowed to fund the IdeaOne acquisition. Our effective interest rate for the first nine months of 2012 was approximately 4.2% on an annualized basis compared to a 4.1% 2011 annualized rate.

Income Taxes Our effective income tax rate for the third quarter of 2012 and 2011 was 40.7% and 38.9%, respectively. The effective tax rate in 2011 was impacted by the releases of income tax reserves and associated interest of $343,000. Without the release of income tax reserves and associated interest the effective tax rate would have been 41.2% in 2011. The effective tax rate from operations differs from the federal statutory rate primarily due to state income taxes.

Liquidity and Capital Resources Working Capital Working capital (i.e. current assets minus current liabilities) was $16,048,000 as of September 30, 2012 compared to working capital of $23,079,000 as of December 31, 2011. The ratio of current assets to current liabilities was 1.5 as of September 30, 2012 and 1.8 as of December 31, 2011.

Capital Structure The total capital structure (long-term and current maturities of long-term debt obligations plus shareholders' equity) was $181,113,000 at September 30, 2012, reflecting 24% equity and 76% debt. This compares to a total capital structure of $163,432,000 at December 31, 2011, reflecting 26% equity and 74% debt. In the communications industry, the capacity for debt financing is most often based on multiples of operating cash flows. Specifically, our current use of the senior credit facility is in a ratio of approximately 2.96 times debt to Earnings before Interest, Tax, Depreciation and Amortization, ("EBITDA") as defined in our credit agreement; well within the acceptable limit for our agreement of 3.5 times debt to EBITDA and well within the limits for our industry.

We employ an extended term payable financing arrangement for the equipment provisioning portion of our Equipment Segment and view this arrangement as a structured accounts payable that is paid within 60 days with no separate interest charge. As such, the extended term payable financing amount of $14,008,000 and $6,920,000 as of September 30, 2012 and December 31, 2011, respectively, is not considered to be part of our capital structure and has been excluded from the references above regarding debt and total capital (see Note 8 to the Notes to the Consolidated Financial Statements).

Internal operations of our business continue to be our primary source of liquidity. We have invested in capital expenditures, paid interest, taxes, dividends and debt obligations. We have not changed our equity capitalization and new equity was not a source of liquidity during this period. Cash and cash equivalents at September 30, 2012 of $10,051,000 decreased $3,006,000 compared to $13,057,000 at December 31, 2011. In September 2012 we made a $4,000,000 voluntary debt pay-down and in March 2012 used approximately $6,000,000 to fund the acquisition of IdeaOne Telecom.

Table of Contents 29 --------------------------------------------------------------------------------Cash Flows Management believes we will have the ability to meet our current and long-term liquidity and capital requirements through operating cash flows, borrowings available under our credit facility and other internal and available external resources. For temporary increases in cash demand we use our cash inflow and utilize our senior credit facility for more significant fluctuations in liquidity driven by growth initiatives. These sources coupled with our access to a $30,000,000 revolving credit facility (presently unused) provide further assurance against interruption in our business plans due to financing. Our expected primary uses of cash include ongoing operating requirements, capital expenditures, scheduled principal and interest payments on our credit facility, temporary financing of trade accounts receivable and the payment of dividends as they are declared.

While it is difficult for us to predict the impact general economic conditions may have on our business, we believe that we will be able to meet our current and long-term cash requirements through our operating cash flows. We are in full compliance with our debt covenants and anticipate that we will be able to plan for and match future liquidity needs with future internal and available external resources. Our senior debt agreement will be the sole external source of financing for the foreseeable future.

We feel we can adjust the timing or the number of strategic and growth initiatives according to any limitation we may face or be imposed by our capital structure or sources of financing. We do not anticipate our capital structure will limit future growth initiatives over the next 12 months.

Cash generated from operations represents the amount of cash generated by our daily operations after the payment of operating obligations. This continues to be our primary source of funds. Cash generated from operations in the first nine months of 2012 was $25,297,000 an increase of $499,000 compared to the first nine months of 2011. In both years cash generated from operations was primarily attributable to net income plus non-cash expenses including depreciation and amortization. The change in operating assets and liabilities of $112,000 from 2012 to 2011 is primarily driven by change in our receivables balance which is primarily driven by the timing and volume of equipment orders associated with our Equipment Segment. Offsetting this is lower routine income tax refunds received in 2012 compared to 2011.

Cash used for investing activities was $46,999,000 up $32,987,000 compared to year-to-date period of 2011. Approximately 85% of the increase is driven by our acquisition of IdeaOne Telecom for an adjusted purchase price of $28,180,000 which was funded partially with cash reserves and the remainder with additional term loan debt. Capital expenditures increased 33% when comparing 2012 to 2011 after netting out the $2,941,000 and $666,000 we received from the National Telecommunications Information Administration (NTIA) Broadband Technology Opportunities Program (BTOP) grant.

Capital spending continues to be our primary recurring investing activity and allows us to expand and enhance our network, remain competitive and enhance and expand our service offerings. We continue to focus on strategic investments in success-based and network expansion projects, such as builds to customer premises, fiber connections to cellular towers and expansion in key strategic locations, along with required spend to maintain our network. Investment in business services will continue to support growth and customer demand in backhaul transport services optimizing long-term revenue opportunities. We expect our 2012 capital spending to range between $27,000,000 and $31,000,000 with approximately $8,000,000 to $12,000,000 in the fourth quarter of 2012 (net of government grant).

In 2012, construction continues on our Greater Minnesota Broadband Collaborative project which is being funded in part by the NTIA BTOP grant. The project will extend our fiber-optic network across greater Minnesota to provide governmental, educational and healthcare organizations with a high-capacity broadband network.

As of September 30, 2012 approximately 75% of the route has been completed and project costs expended. The project is required to be complete by August 2013.

Table of Contents 30 -------------------------------------------------------------------------------- Financing activities primarily consist of borrowings and payments on our credit facility and the payment of dividends to our shareholders. Cash provided by financing activities was $18,696,000 in 2012 compared to $457,000 in 2011. In the first quarter of 2012, to fund the purchase of IdeaOne Telecom, we entered into an Incremental Term credit facility of $22,000,000 as an extension of our senior credit facility. Due to the timing and high volume of equipment orders in the third quarter of 2012 there was a $7,089,000 increase in our extended term payable compared to an increase of $4,377,000 in 2011. In the first nine months of 2012 and 2011, we used $5,658,000 and $5,407,000 in cash to make dividend payments to our shareholders, respectively. At the end of September, our Board of Directors declared a fourth quarter dividend of $.145 per share, representing a 3.5% increase from the previous dividend. We expect to pay similar dividends in the future; however, this will be dependent upon many factors, such as: operating results, capital requirements, debt compliance and other factors which are taken into account by the Board of Directors.

Our long-term obligations, including current maturities of debt and capital leases as of September 30, 2012 and December 31, 2011 were $137,155,000 and $120,235,000, respectively. Our credit facility requires us to comply with specified financial ratios and tests. The financial ratios required by our credit facility are not calculated in accordance with accounting principles generally accepted in the United States ("non-GAAP financial measures"). These calculations allow for the inclusion of historical EBITDA results for IdeaOne Telecom, our acquisition which closed on March 1, 2012. The non-GAAP financial measures are presented below for the purpose of demonstrating compliance with our debt covenants: (Dollars in thousands) September Leverage Ratio: 30, 2012 (A) Total debt (including outstanding letters of credit) $ 137,190 (B) EBITDA per our credit agreement Three Months Ended 9-30-12 11,429 Three Months Ended 6-30-12 11,233 Three Months Ended 3-31-12 11,466 Three Months Ended 12-31-11 10,069 IdeaOne Telecom Historical EBITDA (reflects five months) 2,138 Total EBITDA per our credit agreement $ 46,335 Total Leverage Ratio (A)/(B) 2.96 Maximum leverage ratio allowed 3.5 September Debt Service Coverage Ratio: 30, 2012 (A) EBITDA per our credit agreement, minus $ 46,335 Income Taxes (5,172 ) $ 41,163 the sum of (i) all scheduled principal payments to be made on debt (B) and (ii) interest expense 7,298 Debt Service Coverage Ratio (A)/(B) 5.6 Minimum debt service ratio allowed 2.5 New Accounting Pronouncements The financial statement impact relating to new accounting standards that have not yet been adopted by us can be found under Note 1. Basis of Presentation and Consolidation - "Recent Accounting Developments." Table of Contents 31 --------------------------------------------------------------------------------Reconciliation of non-GAAP financial measures In addition to the results reported in accordance with US GAAP, we also use certain non-GAAP measures including EBITDA (as defined in our credit agreement) to evaluate operating performance and to facilitate the comparison of our historical results and trends. These non-GAAP measures are also used to manage and evaluate the operating performance of our reportable segments. These financial measures should not be considered in isolation or as a substitute for net income (loss) as a measure of performance and net cash provided by operating activities as a measure of liquidity. Reconciliations to the most directly comparable GAAP measure are provided below.

Three Months Ended September 30 Nine Months Ended September 30 2012 2011 2012 2011 (Dollars in thousands) (Restated) (Restated) Net Income $ 1,741 $ 2,133 $ 5,773 $ 6,827 Add: Depreciation and Amortization 6,869 5,794 19,795 17,155 Interest expense 1,625 2,880 4,635 5,199 Income taxes 1,194 1,355 3,925 4,034 EBITDA $ 11,429 $ 12,162 $ 34,128 $ 33,215

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