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NEW ULM TELECOM INC - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion should be read in conjunction with our historical financial statements and the related notes contained elsewhere in this report. Overview NU Telecom offers a diverse array of communications products and services. Our ILEC and CLEC businesses provide local telephone service and network access to other telecommunications carriers for calls originated or terminated on our network. In addition, we provide long distance service, dial-up and broadband Internet access, and video services. On December 31, 2012 NU Telecom completed a spin-off agreement with HCC, continuing the expansion of our service area into the Minnesota communities and surrounding areas of Bellechester, Goodhue, Hanska, Mazzepa, Sleepy Eye and White Rock. In 2010, we acquired the assets of the CATV system located in and around Glencoe, Minnesota. We also sell and service other communications products. Our operations consist primarily of providing services to customers for a monthly charge. Because many of these services are recurring in nature, backlog orders and seasonality are not significant factors. Our working capital requirements include financing the construction of our networks, which consists of switches and cable, data, IP and digital TV. We also need capital to maintain our networks and infrastructure; fund the payroll costs of our highly skilled labor force; maintain inventory to service capital projects, our network and our telephone equipment customers; and to provide for the carrying value of trade accounts receivable, some of which may take several months to collect in the normal course of business. 18 -------------------------------------------------------------------------------- Table of Contents Executive Summary Highlights in 2012: • On December 31, 2012 NU Telecom completed a spin-off agreement with HCC. NU Telecom had originally acquired a one-third interest in HCC on November 3, 2006. HCC was equally owned by NU Telecom, Blue Earth Valley Communications, Inc. and Arvig Enterprises, Inc. Under the spin-off agreement, NU Telecom received all of the stock of SETC and other assets and investments of HCC and incurred $3.3 million of additional debt to finance the spin-off. Additional information pertaining to this acquisition is available in Note 3 - "Acquisitions and Dispositions" to the Consolidated Financial Statements of this Annual Report on Form 10-K. • Net income in 2012, totaled $3,174,914, which was a 56.6% increase compared to 2011. The HCC spin-off was structured as a tax-free reorganization under Section 355 of the Internal Revenue Code. NU Telecom had $1,778,309 of deferred book taxes associated with the HCC equity subsidiary that was reversed in 2012 due to the HCC spin-off. This reversal eliminated our income tax expense for 2012 and allowed us to record an income tax benefit of $365,477 for 2012. • Consolidated revenue for 2012 totaled $32,482,988, which was a $788,463 decrease compared to 2011. Network access revenue declined $1,071,332 or 9.0% in 2012 compared to 2011 largely due to lower minutes of use and the implementation of the FCC Intercarrier Compensation and the USF reform order in regards to state access pricing levels that took effect on July 3, 2012. This decrease was partially offset by increases in video and data revenue of $311,378 or 5.5% and $320,037 or 6.1%. • The HCC spin-off added approximately 4,700 access lines, 1,100 video customers, 2,900 broadband customers, 100 dial-up internet customers and 2,400 long distance customers to our customer base as of December 31, 2012. Business Trends Included below is synopsis of trends management believes will continue to affect our business in 2013. Voice and switched access revenues are expected to continue to be adversely impacted by future declines in access lines due to competition in the telecommunications industry from CATV providers, VoIP providers, wireless, other competitors and emerging technologies. As we experience access line losses, our switched access revenue will continue to decline consistent with industry-wide trends. A combination of changing minutes of use, carriers optimizing their network costs and lower demand for dedicated lines may affect our future voice and switched access revenues. Voice and switched access revenues may also be significantly affected by potential changes in rate regulation at the state and federal levels. We continue to monitor regulatory changes as we believe that rate regulation will continue to be scrutinized and may be subject to change. Access line increases totaled 3,659 or 13.8% in 2012 compared to 2011 due to the addition of SETC. Growth in broadband customer sales along with continued migration to higher connectivity speeds and the sales of Internet value-added services such as on-line data backup are expected to continue to offset some of the revenue declines from the unfavorable access line trends discussed above. 19 -------------------------------------------------------------------------------- Table of Contents To combat competitive pressures, we continue to emphasize the bundling of our products and services. Our customers can bundle local phone, high-speed Internet, long distance and video services. These bundles provide our customers with one convenient location to obtain all of their communications and entertainment needs, a convenient billing solution and bundle discounts. We believe that product bundles positively impact our customer retention, and the associated discounts provide our customers the best value for their communications and entertainment needs. We have built a state-of-the-art broadband network, along with the bundling of our voice, Internet and video services allows us to meet customer demands for products and services. We continue to focus on the research and deployment of advanced technological products that include broadband services, private line, VoIP, digital video, Internet Protocol Television (IPTV) and managed services. We continue to evaluate our operating structure to identify opportunities for increased operational efficiencies and effectiveness. Among other things, this involves evaluating opportunities for task automation, network efficiency and the balancing of our workforce based on the current needs of our customers. In November, 2011 the FCC released proposed rulemaking which comprehensively reforms and begins a new era in universal service and intercarrier compensation. This reform order impacts numerous support mechanisms and network access revenue streams that we have received in the past. While these rules may be altered based on ongoing petitions for reconsideration and are being challenged through appeals, we are evaluating them. We cannot predict the entire impact these regulatory changes will have on our revenue and costs, but do believe it will increase the historical decline in revenue and profitability of our company. 20 -------------------------------------------------------------------------------- Table of Contents Financial results for the Telecom Segment for the years ended December 31, 2012 and 2011 are included below: Telecom Segment 2012 2011 Increase (Decrease) Operating Revenues Local Service $ 5,782,218 $ 6,000,257 $ (218,039 ) -3.63 % Network Access 10,781,356 11,852,688 $ (1,071,332 ) -9.04 % Video 5,969,610 5,658,232 $ 311,378 5.50 % Data 5,568,000 5,247,963 $ 320,037 6.10 % Long Distance 607,902 649,404 $ (41,502 ) -6.39 % Other 3,773,902 3,862,907 $ (89,005 ) -2.30 % Total Operating Revenues 32,482,988 33,271,451 $ (788,463 ) -2.37 % Cost of Services, Excluding Depreciation and Amortization 14,310,030 13,456,756 $ 853,274 6.34 % Selling, General and Administrative 6,269,618 6,400,900 $ (131,282 ) -2.05 % Depreciation and Amortization Expenses 8,219,749 9,010,393 $ (790,644 ) -8.77 % Total Operating Expenses 28,799,397 28,868,049 $ (68,652 ) -0.24 % Operating Income $ 3,683,591 $ 4,403,402 $ (719,811 ) -16.35 % Net Income $ 3,174,914 $ 2,027,523 $ 1,147,391 56.59 % Capital Expenditures $ 7,014,135 $ 4,824,204 $ 2,189,931 45.39 % Key metrics Access Lines 30,252 26,593 3,659 13.76 % Video Customers 11,204 10,309 895 8.68 % Broadband Customers 13,652 10,465 3,187 30.45 % Dial Up Internet Customers 476 638 (162 ) -25.39 % Long Distance Customers 15,372 13,530 1,842 13.61 % Revenue Local Service - We receive recurring revenue for basic local services that enable end-user customers to make and receive telephone calls within a defined local calling area for a flat monthly fee. In addition to subscribing to basic local telephone services, our customers may choose from a variety of custom calling features such as call waiting, call forwarding, caller identification and voicemail. Local service revenue was $5,782,218, which is $218,039 or 3.6% lower in 2012 than in 2011. Local service revenue was lower in 2012 compared to 2011 primarily due to a decrease in access lines of 1,055 or 4.0%, prior to the addition of access lines associated with the spin-off of SETC on December 31, 2012. The decrease in revenues was partially offset by increases in local private line and other optional services. Our access lines are decreasing as customers are increasingly utilizing other technologies, such as wireless phones and IP services, as well as customers eliminating second phone lines when they move their Internet service from a dial-up platform to a broadband platform. 21 -------------------------------------------------------------------------------- Table of Contents The number of access lines we serve as an ILEC and CLEC have been decreasing, which is consistent with a general industry trend. To help offset declines in local service revenue, we implemented an overall strategy that continues to focus on selling a competitive bundle of services. Our focus on marketing competitive service bundles to our customers helps create value for the customer and aids in the retention of our voice lines. Network Access - We provide access services to other telecommunications carriers for the use of our facilities to terminate or originate long distance calls on our network. Additionally, we bill SLCs to substantially all of our end-user customers for access to the public switched network. These monthly SLCs are regulated and approved by the FCC. In addition, network access revenue is derived from several federally administered pooling arrangements designed to provide network support and distribute funding to ILECs. Network access revenue was $10,781,356, which is $1,071,332 or 9.0% lower in 2012 than in 2011 primarily due to lower minutes of use and the implementation of the FCC Intercarrier Compensation and the USF reform order in regards to state access pricing levels that took effect on July 3, 2012. Video- We provide a variety of enhanced data network services on a monthly recurring basis to our end-user customers. This includes the broadband access portion of traditional Telecom broadband service. We also receive monthly recurring revenue from our end-user subscribers for providing commercial TV programming in competition with local CATV, satellite dish TV and off-air TV service providers. We serve seventeen communities with our digital TV services and five communities with our CATV services. Video revenue was $5,969,610, which is $311,378 or 5.5% higher in 2012 than in 2011. A combination of rate increases introduced into several of our markets over the course of 2011 and 2012; and the launching of IPTV services in Courtland, Hutchinson, Litchfield, New Ulm, Redwood Falls, Sanborn and Springfield, Minnesota and Aurelia, Iowa resulted in the increased revenues. This new enhanced service offering provides our customers with desired features and options, such as digital video recording. We also recognize increased revenues from these additional features and options. Data- We provide Internet services, including dial-up and high speed Internet to business and residential customers. Our revenue is received in various flat rate packages based on the level of service, data speeds and features. We also provide e-mail and managed services, such as web hosting and design, on-line file back up and on-line file storage. Data revenue was $5,568,000, which is $320,037 or 6.1% higher in 2012 than in 2011. This increase was primarily due to an increase in broadband customers of 269 or 2.6%, partially offset by a loss of 243 dial-up customers or 38.1%, prior to the addition of data customers associated with the spin-off of SETC on December 31, 2012. Broadband customers have a higher profit margin than dial-up Internet customers. We expect future growth in this area will be driven by customer migration from dial-up Internet to broadband products, such as our broadband services, expansion of service areas and our aggressively packaging and selling service bundles. Long Distance - Our end-user customers are billed for toll or long-distance services on either a per call or flat-rate basis. This also includes the offering of directory assistance, operator service and long distance private lines. Long distance revenue was $607,902, which is $41,502 or 6.4% lower in 2012 than in 2011. Long distance revenue was lower in 2012 compared to 2011 primarily due to a decrease in long distance lines of 552 or 4.1%, prior to the addition of long distance lines associated with the spin-off of SETC on December 31, 2012, as customers continue to use other technologies such as wireless and IP services to satisfy their long distance communication needs. 22 -------------------------------------------------------------------------------- Table of Contents Other Revenue - We generate revenue from directory publishing, sales and service of CPE, bill processing and add/move/change services. Our directory publishing revenue from end-user subscribers for Yellow Page advertising in our telephone directories recurs monthly. We also provide the retail sales and service of cellular phones and accessories through Telespire, a national wireless provider. We resell these wireless services as TechTrends Wireless, our branded product. We receive both recurring revenue for the wireless product, as well as revenue collected for the sale of wireless phones and accessories. Other revenue was $3,773,902, which is $89,005 or 2.3% lower in 2012 than in 2011. This decrease was primarily due to a decrease in the sales of CPE revenues, partially offset by an increase in the sales of cellular phone and activation revenues. Cost of Services (Excluding Depreciation and Amortization) Cost of services (excluding depreciation and amortization) was $14,310,030, which is $853,274 or 6.3% higher in 2012 than in 2011. This increase was primarily due to higher programming cost from video content providers and higher costs associated with increased maintenance and support agreements on our equipment and software, partially offset by lower employee benefit costs. Selling, General and Administrative Expenses Selling, general and administrative expenses were $6,269,618, which is $131,282 or 2.1% lower in 2012 than in 2011. This decrease was primarily due to lower employee benefit costs, partially offset by increased expenses associated with complying with new SEC financial reporting requirements. Depreciation and Amortization Depreciation and amortization was $8,219,749, which is $790,644 or 8.8% lower in 2012 than in 2011. This decrease was primarily due to portions of our legacy telephone network becoming fully depreciated during 2012 and 2011 as we migrate to a new broadband network. Operating Income Operating income was $3,683,591, which is $719,811 or 16.3% lower in 2012 than in 2011. This decrease was primarily due to a decrease in revenue combined with an increase in cost of services, partially offset by a decrease in depreciation and amortization, and selling, general and administrative expenses, all of which are described above. Consolidated Results Other Income and Interest Expense HCC investment income increased $80,741 in 2012 compared to 2011. The increase reflects our equity portion of HCC net income prior to the spin-off of HCC on December 31, 2012. HCC net income increased in 2012 and 2011 primarily due to decreased interest expense associated with reduction of debt combined with lower interest rates on outstanding debt. Other income in 2012 and 2011 included a patronage credit earned with CoBank, ACB as a result of our debt agreements with them. The patronage credit allocated and received in 2012 amounted to $449,878, compared to $485,812 allocated and received in 2011. CoBank, ACB determines and pays the patronage credit annually, generally in the first quarter of the calendar year, based on its results from the prior year. We record these patronage credits as income when they are received. 23 -------------------------------------------------------------------------------- Table of Contents Interest income decreased $5,249 in 2012 compared to 2011. As a result of servicing our debt, excess cash available to purchase investments was lower. Interest expense decreased $188,995 in 2012 compared to 2011. This decrease was primarily due to lower outstanding debt balances and the maturing of several of our swap agreements with CoBank, ACB during 2011 as the variable rate we now pay on that debt portion is lower than the fixed rate we were previously paying, and the implementation of a cash management program with CoBank, ACB at the beginning of 2011. Other investment income decreased $95,785 in 2012 compared to 2011. Other investment income includes our equity ownerships in several partnerships and limited liability corporations. We recorded $158,582 of income from equity investments in 2012 and $228,168 of income in 2011 Income Taxes Income tax expense decreased by $1,869,394 as we recorded an income tax benefit of $365,477 in 2012 and income tax expense of $1,503,917 in 2011. The effective income tax rate was (13.0%) and 42.6% for 2012 and 2011. The effective income tax rate in 2012 was lower than 2011 primarily due to changes in deferred taxes as a result of the HCC spin-off, partially offset by the recognition of approximately $29,000 in net tax benefits in 2011. This amount was originally for the 2006 tax year, which was no longer open for examination by federal and state tax authorities. The difference between the effective tax rate and the federal statutory tax rate are reconciled in Note 7 - "Income Taxes" to the Consolidated Financial Statements of this Annual Report on Form 10-K. Inflation It is the opinion of our management that the effects of inflation on operating revenue and expenses over the past two years have been immaterial. Our management anticipates that this trend will continue in the near future. Off Balance Sheet Arrangements The Company has no significant Off Balance Sheet Arrangements (as defined in Item 303 (a)(4) of Regulation S-K). Liquidity and Capital Resources Capital Structure NU Telecom's total capital structure (long-term and short-term debt obligations, plus stockholders' equity) was $102,338,011 at December 31, 2012, reflecting 54.5% equity and 45.5% debt. This compares to a capital structure of $97,191,975 at December 31, 2011, reflecting 55.2% equity and 44.8% debt. In the telecommunications industry, debt financing is most often based on operating cash flows. Specifically, our current use of our credit facilities is in a ratio of approximately 3.15 times debt to EBITDA (earnings before interest, taxes, depreciation and amortization) as defined in our credit agreements, well within acceptable limits for our agreements and our industry. Our management believes adequate operating cash flows and other internal and external resources, such as our cash on hand and revolving credit facility, are available to finance ongoing operating requirements, including capital expenditures, business development, debt service and temporary financing of trade accounts receivable. 24 -------------------------------------------------------------------------------- Table of Contents Liquidity Outlook Our short-term and long-term liquidity needs arise primarily from (i) capital expenditures; (ii) working capital requirements needed to support the growth of our business; (iii) debt service; (iv) dividend payments on our common stock and (v) potential acquisitions. Our primary sources of liquidity for the year ended December 31, 2012 were proceeds from cash generated from operations and cash reserves held at the beginning of the period. At December 31, 2012 we had a working capital deficit of $4,947. However, at December 31, 2012 we also had approximately $3.8 million available under our revolving credit facility to fund any short-term working capital needs. We have not conducted a public equity offering. We operate with original equity capital, retained earnings and additions to indebtedness in the form of senior debt and bank lines of credit. Cash Flows We expect our liquidity needs to originate from capital expenditures, payment of interest and principal on our indebtedness, income taxes and dividends. We use our cash inflow to manage the temporary increases in cash demand and utilize our revolving credit facility to manage more significant fluctuations in liquidity caused by growth initiatives. While it is often difficult for us to predict the impact of general economic conditions on our business, we believe that we will be able to meet our current and long-term cash requirements primarily through our operating cash flows. We were in full compliance with our debt covenants as of December 31, 2012, and anticipate that we will be able to plan for and match future liquidity needs with future internal and available external resources. While we periodically seek to add growth initiatives by either expanding our network or our markets through organic/internal investments or through strategic acquisitions, we feel we can adjust the timing or the number of our initiatives according to any limitations which may be imposed by our capital structure or sources of financing. At this time, we do not anticipate our capital structure will limit our growth initiatives over the next twelve months. The following table summarizes our cash flow: For Year Ended December 31 2012 2011 Increase (Decrease) Net cash provided by (used in): Operating activities $ 10,450,013 $ 8,654,333 $ 1,795,680 20.75 % Investing activities (7,020,595 ) (4,866,204 ) (2,154,391 ) 44.27 % Financing activities (1,901,285 ) (4,961,115 ) 3,059,830 -61.68 % Increase (decrease) in cash $ 1,528,133 $ (1,172,986 ) $ 2,701,119 -230.28 % 25 -------------------------------------------------------------------------------- Table of Contents Cash Flows from Operating Activities Cash generated by operations for the year ended December 31, 2012 was $10,450,013, compared to cash generated by operations of $8,654,333 in 2011. The increase in cash flows from operating activities in 2012 was primarily due to an increase in net income, the timing of changes in receivables, partially offset by the change in deferred income tax. Cash generated by operations continues to be our primary source of funding for existing operations, capital expenditures, debt service and dividend payments to stockholders. Cash at December 31, 2012 was $2,749,850, compared to $1,221,717 at December 31, 2011. Cash Flows Used in Investing Activities We operate in a capital intensive business. We continue to upgrade our local networks for changes in technology in order to provide advanced services to our customers. Cash flows used in investing activities were $7,020,595 for the year ended December 31, 2012, compared to $4,866,204 used in investing activities in 2011. Capital expenditures relating to on-going operations were $7,014,135 in 2012 and $4,824,204 in 2011. Our investing expenditures have been financed with cash flows from our current operations and advances on our line of credit. We believe that our current operations will provide adequate cash flows to fund our plant additions for the upcoming year; however, funding from our revolving credit facility is available if the timing of our cash flows from operations does not match our cash flow requirements. We currently have approximately $3.8 million available under our existing credit facility to fund capital expenditures and other operating needs. Cash Flows Used In Financing Activities Cash used in financing activities for the year ended December 31, 2012 was $1,901,285. This included long-term debt repayments of $3,698,883 and the distribution of $1,692,329 of dividends to stockholders, offset by a $1,191,713 increase in debt due to the new loan associated with the HCC spin-off and a $2,298,214 increase in debt due to the use of our revolving credit facility. Cash used in financing activities for the year ended December 31, 2011 was $4,961,115. This included long-term debt repayments of $3,208,976, a $76,829 reduction in our revolving credit facility and the distribution of $1,675,310 of dividends to stockholders. Working Capital We had a working capital deficit (i.e. current assets minus current liabilities) of $4,947 as of December 31, 2012, with current assets of approximately $8.6 million and current liabilities of approximately $8.6 million, compared to a working capital deficit of $232,247 as of December 31, 2011. The ratio of current assets to current liabilities was 1.00 and 0.97 as of December 31, 2012 and 2011. In addition, if it becomes necessary, we will have sufficient availability under our revolving credit facility to fund any fluctuations in working capital and other cash needs. 26 -------------------------------------------------------------------------------- Table of Contents Long-Term Debt and Revolving Credit Facilities Our long-term debt obligations as of December 31, 2012, were $42,494,385, excluding current debt maturities of $4,113,000. Long-term debt obligations as of December 31, 2011, were $39,809,171, excluding current debt maturities of $3,698,883. We have a credit facility with CoBank, ACB. Under the credit facility, we entered into separate Master Loan Agreements (MLAs) and a series of supplements to the respective MLAs. Under the terms of the two MLAs and the supplements, we initially borrowed $59,700,000 and borrowed an additional $4,500,000 on December 19, 2012 and entered into promissory notes on the following terms: MLA RX0583 RX0583-T1 - $15,000,000 term note with interest payable monthly. Twelve quarterly principal payments of $125,000 are due commencing March 31, 2008 through December 31, 2010. Sixteen quarterly principal payments of $250,000 are due commencing March 31, 2011 through December 31, 2014. A final balloon payment of $9,500,000 is due at maturity of the note on December 31, 2014. RX0583-T2 - $10,000,000 revolving note with interest payable monthly. Final maturity date of the note is December 31, 2014. We currently have drawn $8,221,385 on this revolving note as of December 31, 2012. RX0583-T3 - $4,500,000 term note with interest payable monthly. Final maturity date of the note is December 31, 2014. Seven quarterly principal payments of $225,000 are due commencing June 30, 2013 through December 31, 2014. A final balloon payment of $2,925,000 is due at maturity of the note on December 31, 2014. RX0583-T1 and RX0583-T2 initially bear interest at a "LIBOR Margin" rate equal to 2.50 percent over the applicable LIBOR rate. RX0583-T3 initially bears interest at a "LIBOR Margin" rate equal to 3.00 percent over the applicable LIBOR rate. The LIBOR Margin decreases as our "Leverage Ratio" decreases. MLA RX0584 RX0584-T1 - $29,700,000 term note with interest payable monthly. Twenty quarterly principal payments of $609,500 are due commencing March 31, 2010 through December 31, 2014. A final balloon payment of $17,510,000 is due at maturity of the note on December 31, 2014. RX0584-T2 - $2,000,000 revolving note with interest payable monthly. Final maturity of the note is December 31, 2014. We currently have not drawn any funds on this revolving note as of December 31, 2012. RX0584-T3 - $3,000,000 term note with interest payable monthly. Final maturity of the note was April 3, 2008. This note has been fully paid. Each note above initially bears interest at a "LIBOR Margin" rate equal to 2.75 percent over the applicable LIBOR rate. The LIBOR Margin decreases as our "Leverage Ratio" decreases. 27 -------------------------------------------------------------------------------- Table of Contents NU Telecom and its respective subsidiaries also have entered into security agreements under which substantially all the assets of NU Telecom and its respective subsidiaries have been pledged to CoBank, ACB as collateral. In addition, NU Telecom and its respective subsidiaries have guaranteed all the obligations under the credit facility. Our credit facility requires us to comply with specified financial ratios and tests. These financial ratios and tests include total leverage ratio, debt service coverage ratio, equity to total assets ratio and maximum annual capital expenditures tests. At December 31, 2012 and 2011, we were in compliance with all financial ratios in the loan agreements. Our loan agreements include restrictions on our ability to pay cash dividends to our stockholders. However, we are allowed to pay dividends (a) (i) in an amount up to $2,050,000 in any year and (ii) in any amount if our "Total Leverage Ratio," that is, the ratio of our "Indebtedness" to "EBITDA" (in each case as defined in the loan documents) is equal to or less than 3.50 to 1.00, and (b) in either case if we are not in default or potential default under our loan agreements. As of September 30, 2012, our Total Leverage Ratio fell below the 3.50 to 1.00 ratio, thus eliminating any restrictions on our ability to pay cash dividends to our stockholders. Our credit facility contains restrictions that, among other things, limits or restricts our ability to enter into guarantees and contingent liabilities, incur additional debt, issue stock, transact asset sales, transfers or dispositions, and engage in mergers and acquisitions, without CoBank, ACB approval. See Note 5 - "Long-Term Debt" to the Consolidated Financial Statements of this Annual Report on Form 10-K for information pertaining to our long-term debt. Guarantees We have guaranteed the obligations of our New Ulm subsidiary joint venture investment in FiberComm, LC. See Note 12 - "Guarantees" to the Consolidated Financial Statements of this Annual Report on Form 10-K. Critical Accounting Policies and Estimates Management's discussion and analysis of financial condition and results of operations stated in this 2012 Annual Report on Form 10-K, are based upon NU Telecom's consolidated financial statements that have been prepared in accordance with GAAP and, where applicable, conform to the accounting principles as prescribed by federal and state telephone utility regulatory authorities. We presently give accounting recognition to the actions of regulators where appropriate. The preparation of our financial statements requires our 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. Our senior management has discussed the development and selection of accounting estimates and the related Management Discussion and Analysis disclosure with our Audit Committee. For a summary of our significant accounting policies, see Note 1 - "Summary of Significant Accounting Policies" to the Consolidated Financial Statements of this Annual Report on Form 10-K. There were no significant changes to these accounting policies during the year ended December 31, 2012. 28 -------------------------------------------------------------------------------- Table of Contents Revenue Recognition We recognize revenue when (i) persuasive evidence of an arrangement exists, (ii) delivery of the product has occurred or a service has been provided, (iii) the price is fixed or determinable and (iv) collectability is reasonably assured. Revenues are earned from our customers primarily through the connection to our local network, digital and commercial television programming, and Internet services (both dial-up and high-speed broadband). Revenues for these services are billed based on set rates for monthly service or based on the amount of time the customer is utilizing our facilities. The revenue for these services is recognized when the service is rendered. Revenues earned from IXCs accessing our network are based on the utilization of our network by these carriers as measured by minutes of use on the network by the individual carriers. Revenues are billed at tariffed access rates for both interstate and intrastate calls. Revenues for these services are recognized based on the period the access is provided. Interstate access rates are established by a nationwide pooling of companies known as NECA. The FCC established NECA in 1983 to develop and administer interstate access service rates, terms and conditions. Revenues are pooled and redistributed on the basis of a company's actual or average costs. New Ulm's and SETC's settlements from the pools are based on its actual costs to provide service, while the settlements for NU Telecom subsidiaries - WTC, PTC and HTC are based on nationwide average schedules. Access revenues for New Ulm and SETC include an estimate of a cost study each year that is trued-up subsequent to the end of any given year. Our management believes the estimates included in our preliminary cost study are reasonable. We cannot predict the future impact that industry or regulatory changes will have on interstate access revenues. Intrastate access rates are filed with state regulatory commissions in Minnesota and Iowa. We derive revenues from system sales and services through the sale, installation and servicing of communication systems. In accordance with GAAP, these deliverables are accounted for separately. We recognize revenue from customer contracts for sales and installations using the completed-contract method, which recognizes income when the contract is substantially complete. We recognize rental revenues over the rental period. Allowance for Doubtful Accounts We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. In making the determination of the appropriate allowance for doubtful accounts, we consider specific accounts, historical write-offs, changes in customer relationships, credit worthiness and concentrations of credit risk. Specific accounts receivable are written off once a determination is made that the account is uncollectible. Additional allowances may be required if the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments. Our allowance for doubtful accounts was $175,705 and $300,000 as of December 31, 2012 and 2011. 29 -------------------------------------------------------------------------------- Table of Contents Financial Derivative Instruments and Fair Value Measurements We have adopted the rules prescribed under GAAP for our financial assets and liabilities. GAAP includes a fair value hierarchy that is intended to increase consistency and comparability in fair value measurements and related disclosures. The fair value hierarchy is based on inputs to valuation techniques used to measure fair value that are either observable or unobservable. Observable inputs reflect assumptions market participants would use in pricing an asset or liability based on market data obtained from independent sources, while unobservable inputs reflect a reporting entity's pricing based upon its own market assumptions. The fair value hierarchy consists of the following three levels: Level 1: Inputs are quoted prices in active markets for identical assets or liabilities. Level 2: Inputs are quoted prices for similar assets or liabilities in an active market, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable, and market-corroborated inputs that are derived principally from or corroborated by observable market data. Level 3: Inputs are derived from valuation techniques where one or more significant inputs or value drivers are unobservable. We use financial derivative instruments to manage our overall cash flow exposure to fluctuations in interest rates. We account for derivative instruments in accordance with GAAP that requires derivative instruments to be recorded on the balance sheet at fair value. Changes in fair value of derivative instruments must be recognized in earnings unless specific hedge accounting criteria are met, in which case, the gains and losses are included in other comprehensive income rather than in earnings. We have entered into interest rate swaps with our lender CoBank, ACB to manage our cash flow exposure to fluctuations in interest rates. These instruments were designated as cash flow hedges and were effective at mitigating the risk of fluctuations on interest rates in the market place. Any gains or losses related to changes in the fair value of these derivatives are accounted for as a component of accumulated other comprehensive income (loss) for as long as the hedge remains effective. The fair value of our interest rate swap agreements is discussed in Note 6 - "Interest Rate Swaps" to the Consolidated Financial Statements of this Annual Report on Form 10-K. The fair value of our swap agreements were determined based on Level 2 inputs. Valuation of Goodwill We have goodwill on our books related to prior acquisitions of telephone properties. As discussed more fully in Note 4 - "Goodwill and Intangibles" to the Consolidated Financial Statements of this Annual Report on Form 10-K, and in accordance with GAAP, goodwill is reviewed for impairment annually or more frequently if an event occurs or circumstances change that would reduce the fair value below its carrying value. We perform our annual fair value evaluation in the fourth quarter of each year. The impairment test for goodwill involves a two-step process: step one consists of a comparison of the fair value of a reporting unit with its carrying amount, including the goodwill allocated to each reporting unit. If the carrying amount is in excess of the fair value, step two requires the comparison of the implied fair value of the reporting unit goodwill with the carrying amount of the reporting unit goodwill. Any excess of the carrying value of the reporting unit goodwill over the implied fair value of the reporting unit goodwill will be recorded as an impairment loss. 30 -------------------------------------------------------------------------------- Table of Contents In 2012 and 2011, we engaged an independent valuation firm to complete an annual impairment test for existing goodwill acquired. For 2012 and 2011, the testing resulted in no impairment to goodwill as the determined fair value was sufficient to pass the first step of the impairment test. Our independent valuation firm used a combination of Income (Discounted Cash Flow Method or DCF Method) and Market Approaches to estimate the fair value of the goodwill on our books related to prior acquisitions of telephone properties. The assumptions used in the estimates of fair value were based on projections provided by our management and a rate of return based on market information observed in debt and traded equity securities. Their Market Approaches considered market multiples observed in companies comparable to ours, traded on public exchange or over-the-counter, or transacted in a merger or acquisition transaction. Assumptions used in our 2012 DCF model include the following: • A 10.00% weighted average cost of capital based on an industry weighted average cost of capital; and • A 1.50% terminal growth rate. The most significant amount of goodwill recorded on our books was due to the acquisition of HTC and the addition of goodwill obtained through the HCC spin-off. The carrying value of that goodwill was $39,975,906 as of December 31, 2012 and $29,707,100 as of December 31, 2011. The increase of $10,268,806 in goodwill in 2012 compared to 2011 is due to the addition of goodwill obtained through the HCC spin-off on December 31, 2012. In 2012, we tested the HTC goodwill. Based on the DCF models, and income and market-based approaches we used, we determined the estimated enterprise fair value of our reporting unit exceeded the carrying amount of that reporting unit by approximately $5.9 million, which indicated that we had no impairment as of December 31, 2012. The market-based approaches used in our evaluations are subject to change as a result of changing economic and competitive conditions. Future negative changes relating to our financial operations could result in a potential impairment of goodwill. Income Taxes The provision for income taxes consists of an amount for taxes currently payable and a provision for tax consequences deferred to future periods. Deferred income taxes are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities, and their respective tax basis. Significant components of our deferred taxes arise from differences (i) in the basis of property, plant and equipment due to the use of accelerated depreciation methods for tax purposes, as well as (ii) in partnership investments and intangible assets due to the difference between book and tax basis. Our effective income tax rate is normally higher than the United States tax rate due to state income taxes and permanent differences. We account for income taxes in accordance with GAAP. As required by GAAP, we recognize the financial statement benefit of tax positions only after determining that the relevant tax authority would more-likely-than-not sustain the position following an audit. For tax positions meeting the more-likely-than-not threshold, the amount recognized in the financial statements is the largest benefit that has a greater than 50 percent likelihood of being realized upon ultimate settlement with the relevant tax authority. 31 -------------------------------------------------------------------------------- Table of Contents In accordance with GAAP, we record net unrecognized tax benefits that, if recognized, would affect the income tax provision when recorded. See Note 7 - "Income Taxes" to the Consolidated Financial Statements of this Annual Report Form 10-K. We are primarily subject to United States, Minnesota and Iowa income taxes. Tax years subsequent to 2008 remain open to examination by federal and state tax authorities. Our policy is to recognize interest and penalties related to income tax matters as income tax expense. Property, Plant and Equipment We record impairment losses on long-lived assets used in operations when events and circumstances indicate the assets might be impaired and the undiscounted cash flows estimated to be generated by those assets are less than the carrying amounts of those assets. In assessing the recoverability of long-lived assets, we compare the carrying value to the undiscounted future cash flows the assets are expected to generate. If the total of the undiscounted future cash flows is less than the carrying amount of the assets, we would write down those assets based on the excess of the carrying amount over the fair value of the assets. Fair value is generally determined by calculating the discounted future cash flows expected from those assets. Changes in these estimates could have a material adverse effect on the assessment of long-lived assets, thereby requiring a write-down of the assets. Write-downs of long-lived assets are recorded as impairment charges and are a component of operating expenses. We have reviewed our long-lived assets and concluded that no impairment charge on these long-lived assets is necessary. We use the group life method (mass asset accounting) to depreciate the assets of our telephone companies. Telephone plant acquired in a given year is grouped into similar categories and depreciated over the remaining estimated useful life of the group. When an asset is retired, both the asset and the accumulated depreciation associated with that asset are removed from the books. Due to rapid changes in technology, selecting the estimated economic life of telecommunications plant and equipment requires a significant amount of judgment. We periodically review data on expected utilization of new equipment, asset retirement activity and net salvage values to determine adjustments to our depreciation rates. We have not made any significant changes to the lives of assets in the two-year period ended December 31, 2012. Equity Method Investment We are an investor in several partnerships and limited liability corporations. Our percentages of ownership in these joint ventures range from 14.29% to 24.39%. We use the equity method of accounting for these investments, which reflects original cost and the recognition of our share of the net income or losses from the respective operations. Incentive Compensation We engaged an outside consultant in 2005 to advise us in our development of an Employee Incentive Plan for employees other than executive officers and a Management Incentive Plan for our executive officers. Both plans were implemented in 2006. Both of these plans are cash-based incentive plans. Payments on each plan are based on an achievement of objectives of measurable corporate performance, with financial and customer related targets. The financial targets are based on an achievement of specified operating revenues and net income, based on our budget, while the customer service targets are based on several factors, including (i) "uptime" (the amount of time that our phone, cable and Internet services are available to customers) and restoration time (our ability to restore service when an interruption occurs), (ii) customer retention and (iii) customer service (derived from customer service data). 32 -------------------------------------------------------------------------------- Table of Contents We accrue an estimated liability each year for these potential payouts and reverse that accrual if the incentive payout targets are not met and paid out. Incentive payouts, if earned, are typically paid in late March or early April of the year following the target year and after the filing of our Annual Report on Form 10-K. Recent Accounting Developments See Note 1 - "Summary of Significant Accounting Policies" to the Consolidated Financial Statements of this Annual Report on Form 10-K, for a discussion of recent accounting developments. |