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SECURITIES & EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
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(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended June 30, 2005
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or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OF 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ____________ to ________________
Commission File No. 1-15097
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LYNCH INTERACTIVE CORPORATION
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(Exact name of Registrant as specified in its charter)
Delaware 06-1458056
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State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
401 Theodore Fremd Avenue, Rye, New York 10580
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(Address of principal executive offices) (Zip Code)
(914) 921-8821
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Registrant's telephone number, including area code
Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes /X/ No / /
Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act).Yes / / No /X/
Indicate the number of shares outstanding of each of the Registrant's classes of
Common Stock, as of the latest practical date.
Class Outstanding at July 31, 2005
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Common Stock, $.0001 par value 2,752,251
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INDEX
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LYNCH INTERACTIVE CORPORATION AND SUBSIDIARIES
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PART I. FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited)
Condensed Consolidated Balance Sheets:
- June 30, 2005
- December 31, 2004
- June 30, 2004
Condensed Consolidated Statements of Operations:
- Three and six months ended June 30, 2005 and 2004
Consolidated Statements of Shareholders' Equity
Condensed Consolidated Statements of Cash Flows:
- Six months ended June 30, 2005 and 2004
Notes to Condensed Consolidated Financial Statements
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
Item 3. Quantitative and Qualitative Disclosure About Market Risk
Item 4. Controls and Procedures
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Item 6. Exhibits and Reports on Form 8-K
SIGNATURE
CERTIFICATIONS
1
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
LYNCH INTERACTIVE CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except share amounts)
JUNE 30, DECEMBER 31, JUNE 30,
2005 2004 2004
----------- ----------- --------------
(Unaudited) (Audited) (Unaudited)
ASSETS
Current assets:
Cash and cash equivalents $ 27,741 $ 27,214 $ 25,932
Receivables, less allowances of $245, $260 and $291,
respectively 8,340 8,225 8,456
Material and supplies 2,647 2,314 3,240
Prepaid expenses and other current assets 993 1,685 3,011
---------------------------------------
Total current assets 39,721 39,438 40,639
Property, plant and equipment:
Land 983 983 1,111
Buildings and improvements 17,757 17,640 17,555
Machinery and equipment 221,692 216,429 214,409
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240,432 235,052 233,075
Accumulated depreciation (123,098) (114,724) (111,672)
---------------------------------------
117,334 120,328 121,403
Excess of cost over fair value of net assets
acquired, net (goodwill) 60,501 60,042 60,580
Other intangibles 10,690 10,026 10,953
Investments in and advances to affiliated entities 11,003 12,340 10,523
Other assets 15,518 14,906 13,427
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Total assets $ 254,767 $ 257,080 $ 257,525
=======================================
See accompanying Notes to Condensed Consolidated Financial Statements.
2
LYNCH INTERACTIVE CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share amounts)
June 30, December 31, June 30,
2005 2004 2004
------------------------------------------
(Unaudited) (Audited) (Unaudited)
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Notes payable to banks $ 8,419 $ 4,793 $ 6,450
Trade accounts payable 2,874 4,326 3,606
Accrued interest payable 847 825 757
Accrued liabilities 12,968 11,238 9,952
Current maturities of long-term debt 25,068 14,364 13,959
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Total current liabilities 50,176 35,546 34,724
Long-term debt 138,660 154,602 160,721
Deferred income taxes 15,872 17,549 15,930
Other liabilities 3,463 3,268 2,962
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Total liabilities 208,171 210,965 214,337
Minority interests 11,250 11,543 10,784
Commitments and contingencies
Shareholders' equity
Common stock, $0.0001 par value-10,000,000
shares authorized; 2,824,766 issued;
2,752,251, 2,757,951 and 2,771,751 outstanding -- -- --
Additional paid-in capital 21,406 21,406 21,406
Retained earnings 14,643 13,735 11,256
Accumulated other comprehensive income 1,633 1,588 1,453
Treasury stock, 72,515, 66,815 and 53,015
shares, at cost (2,336) (2,157) (1,711)
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35,346 34,572 32,404
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Total liabilities and shareholders' equity $ 254,767 $ 257,080 $ 257,525
=======================================
See accompanying Notes to Condensed Consolidated Financial Statements.
3
LYNCH INTERACTIVE CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(in thousands, except per share data)
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
--------------------------------------------------
2005 2004 2005 2004
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Revenues $ 22,471 $ 21,087 $ 44,089 $ 42,511
Costs and expenses:
Cost of revenue, excluding depreciation 8,095 7,407 15,746 14,610
General and administrative costs at operations 3,343 3,253 6,766 6,392
Corporate office expenses 2,742 2,273 4,834 3,246
Depreciation and amortization 5,346 4,927 10,541 10,148
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Total Expense 19,526 17,860 37,887 34,396
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Operating profit 2,945 3,227 6,202 8,115
Other income (expense):
Investment income 191 82 984 810
Interest expense (2,950) (2,851) (5,772) (5,670)
Equity in earnings of affiliated companies 841 886 1,552 1,598
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(1,918) (1,883) (3,236) (3,262)
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Income before income taxes and minority interests 1,027 1,344 2,966 4,853
Provision for income taxes (330) (473) (1,097) (1,922)
Minority interests (484) (487) (961) (944)
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Net income $ 213 $ 384 $ 908 $ 1,987
===================================================
Basic and diluted weighted average shares outstanding 2,752 2,774 2,753 2,775
Basic and diluted earnings per share $ 0.08 $ 0.14 $ 0.33 $ 0.72
See accompanying Notes to Condensed Consolidated Financial Statements.
4
LYNCH INTERACTIVE CORPORATION AND SUBSIDIAIRES
CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
(Unaudited)
(in thousands, except share data)
SHARES OF ACCUMULATED
COMMON ADDITIONAL OTHER
STOCK OUT- COMMON PAID-IN RETAINED COMPREHENSIVE TREASURY
STANDING STOCK CAPITAL EARNINGS INCOME STOCK TOTAL
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Balance at December 31, 2004 2,757,951 $ 0 $ 21,406 $13,735 $ 1,588 $ (2,157) $34,572
Net income for the period -- -- -- 908 -- -- 908
Unrealized loss on available
for sale securities, net -- -- -- -- 45 -- 45
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Comprehensive income 953
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Purchase of Treasury Stock (5,700) -- -- -- -- (179) (179)
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Balance at June 30, 2005
2,752,251 $ 0 $ 21,406 $14,643 $ 1,633 $ (2,336) $35,346
=========================================================================================
See accompanying Notes to Condensed Consolidated Financial Statements.
5
LYNCH INTERACTIVE CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited) (in thousands)
SIX MONTHS ENDED
JUNE 30,
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2005 2004
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OPERATING ACTIVITIES:
Net Income $ 908 $ 1,987
Adjustments to reconcile net income to net cash provided
by operating activities:
Depreciation and amortization 10,541 10,148
Equity in earnings of affiliated companies (1,552) (1,598)
Distributions received from affiliated companies 2,973 879
Minority interests 961 944
Changes in operating assets and liabilities:
Receivables 5 (226)
Accounts payable and accrued liabilities (1,835) (368)
Other (286) (2,112)
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Net cash provided by operating activities 11,715 9,654
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INVESTING ACTIVITIES:
Capital expenditures (4,205) (6,307)
Acquisition of business (3,594) (4,877)
Acquisition of spectrum (500) --
Investment in and advances to affiliated entities (62) (63)
Other 217 (367)
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Net cash used in investing activities (8,144) (11,614)
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FINANCING ACTIVITIES:
Issuance of long term debt 2,412 5,599
Repayments of long term debt (7,650) (6,702)
Net proceeds on lines of credit 3,626 2,994
Purchase of treasury stock (179) (237)
Distributions to partners (1,253) (318)
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Net cash provided by (used in) financing activities (3,044) 1,336
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Net increase (decrease) in cash and cash equivalents 527 (624)
Cash and cash equivalents at beginning of period 27,214 26,556
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Cash and cash equivalents at end of period $ 27,741 $ 25,932
======================
Cash paid for:
Interest expense $ 5,669 $ 5,509
======================
Income taxes $ 1,353 $ 1,703
======================
See accompanying Notes to Condensed Consolidated Financial Statements.
6
LYNCH INTERACTIVE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
A. BASIS OF PRESENTATION
Lynch Interactive Corporation ("Interactive" or the "Company") consolidates the
operating results of its subsidiaries (81%-100% owned at June 30, 2005, December
31, 2004 and June 30, 2004). All material intercompany transactions and balances
have been eliminated. Investments in affiliates in which the Company does not
have a majority voting control, but has the ability to significantly influence
management decisions, are accounted for in accordance with the equity method.
The Company accounts for the following affiliated companies on the equity basis
of accounting: Coronet Communications Company (20% owned at June 30, 2005,
December 31, 2004 and June 30, 2004), Capital Communications Company, Inc. (49%
owned at June 30, 2005, December 31, 2004 and June 30, 2004; in addition,
Interactive owns a convertible preferred stock which, if converted, would
increase its ownership in Capital Communications to 50%), two cellular
partnership operations in New Mexico (both 33% owned at June 30, 2005, December
31, 2004 and June 30, 2004), KMG Holdings Group (37% owned since May 2004) and
telecommunications operations in North Dakota, Iowa and New York (5% to 14%
owned).
The accompanying unaudited condensed consolidated financial statements have been
prepared in accordance with accounting principles generally accepted in the
United States of America for interim financial information and with the
instructions to Form 10-Q and Articles 10 and 11 of Regulation S-X. Accordingly,
they are not audited and do not include all of the information and footnotes
required for complete financial statements. The consolidated financial
statements and footnotes included in this Form 10-Q should be read in
conjunction with the consolidated financial statements and notes thereto
included in the Company's annual report on Form 10-K for the year ended December
31, 2004. In the opinion of management, all adjustments (consisting of normal
recurring accruals) considered necessary for a fair presentation have been
included. Operating results for the six month period ended June 30, 2005 are not
necessarily indicative of the results that may be expected for the year ending
December 31, 2005. The preparation of consolidated financial statements in
conformity with accounting principles generally accepted in the United States
requires management to make estimates and assumptions that affect the amounts
reported in the financial statements and accompanying notes. Actual results
could differ from those estimates. Certain prior period amounts in the
accompanying consolidated financial statements have been reclassified to conform
to current period presentation.
B. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In June 2004, the Emerging Issues Task Force ("EITF") issued EITF No. 03-01,
"The Meaning Of Other-Than-Temporary Impairment And Its Application To Certain
Investments". EITF 03-01 includes new guidance for evaluating and recording
impairment losses on debt and equity investments, as well as new disclosure
requirements for investments that are deemed to be temporarily impaired. The
provisions of EITF 03-01 were initially effective for reporting periods
beginning after June 15, 2004, while the disclosure requirements for debt and
equity securities accounted for under SFAS 115, "Accounting For Certain
Investments In Debt And Equity Securities", are effective for annual periods
ending after December 15, 2003. In September 2004, the FASB delayed the
effective date for the measurement and recognition guidance of EITF 03-01. The
Company will evaluate the effect of adopting the recognition and measurement
guidance when the final consensus is reached.
In May 2005, the FASB issued SFAS 154, "Accounting Changes and Error
Corrections". SFAS 154 eliminates the requirement in APB Opinion No. 20,
"Accounting Changes", to include the cumulative effect of changes in accounting
principle in the income statement in the period of change. Instead, to enhance
the comparability of prior period financial statements, SFAS 154 requires that
changes in accounting principle be retrospectively applied. Under the
retrospective application, the new accounting principle is applied as of the
beginning of the first period presented as if that principle had always been
used. Adoption of SFAS 154 is required for accounting changes and corrections of
errors made in the fiscal year beginning after December 15, 2005.
In December 2004, the FASB issued SFAS No.153, "Exchanges of Nonmonetary
Assets", which eliminates the exception for nonmonetary exchanges of similar
productive assets and replaces it with a general exception for exchanges of
nonmonetary assets that do not have commercial substance. SFAS No.153 will be
effective for nonmonetary asset exchanges occurring in fiscal periods beginning
after June 15, 2005. The Company does not believe the adoption of SFAS No.153
will have a material impact on its consolidated financial statements.
7
In December 2004, the FASB issued SFAS No.123(R), "Share-Based Payment", which
establishes standards for transactions in which an entity exchanges its equity
instruments for goods or services. This standard requires a public entity to
measure the cost of employee services received in exchange for an award of
equity instruments based on the grant-date fair value of the award. This
eliminates the exception to account for such awards using the intrinsic method
previously allowable under APB Opinion No.25. SFAS No.123(R) will be effective
in the first quarter of 2006. The Company does not believe that the adoption of
SFAS No.123(R) will have a material impact on its consolidated financial
statements.
In March 2005, the FASB issued Interpretation No. 47, "Accounting for
Conditional Asset Retirement Obligations" ("FIN 47"), which clarifies that
conditional asset retirement obligations are within the scope of SFAS No. 143,
"Accounting for Asset Retirement Obligations." FIN 47 requires the Company to
recognize a liability for the fair value of conditional asset retirement
obligations if the fair value of the liability can be reasonably estimated. The
Company does not believe that the adoption of FIN 47 will have a material impact
on its financial statements.
C. ACQUISITIONS AND DISPOSITIONS
In March 2004, the Company signed an agreement to acquire California-Oregon
Telecommunications Company ("Cal-Ore") located in Dorris, California. Cal-Ore's
subsidiary Cal-Ore Telephone Company is the incumbent service provider for a
rural area of about 850 square miles along the Northern California border with
Oregon with approximately 2,500 access lines. Cal-Ore's other businesses include
an Internet service provider, a Competitive Local Exchange Carrier("CLEC") that
is planning to provide services in the surrounding area and interests in certain
cellular partnerships. The acquisition price is $21.2 million, subject to
certain closing adjustments. On May 5, 2005, the California Public Utilities
Commission approved the transaction subject to various conditions. The Company
expects the acquisition to close in the third quarter of 2005.
In February 2005, Lynch 3G participated in Auction 58 for PCS Spectrum and was
high bidder for two licenses, Marquette, MI and Klamath Falls, OR, for a total
cost of $0.5 million.
On March 18, 2005, a subsidiary of the Company, Central Telcom Services, LLC,
closed on an agreement with Precis Communications, LLC, to acquire its cable
television assets for a purchase price of $3.5 million. The system has 2,411
cable subscribers located in Sanpete and Sevier Counties, Utah. The preliminary
allocation of the purchase price included $0.4 million of goodwill and $0.4
million for subscriber lists and other intangible assets.
On July 29, 2005, a subsidiary of the Company closed on the sale of
approximately 62% of the Company's security business accounts to an investment
group for approximately $2.75 million, net of holdbacks and fees. The proceeds
will be used to retire debt.
D. INVESTMENTS IN AFFILIATED COMPANIES
Interactive has equity investments in both broadcasting and telecommunications
companies.
Summarized financial information for broadcasting companies accounted for by the
equity method as of and for the three and six months ended June 30, 2005 and
2004 and as of December 31, 2004, is as follows:
BROADCASTING COMBINED
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JUNE 30, DECEMBER 31, JUNE 30,
2005 2004 2004
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(in thousands)
Current assets $ 4,183 $ 6,896 $ 5,163
Property, plant & equipment, intangibles & other 10,463 9,558 8,749
------------------------------------
Total Assets $ 14,646 $ 16,454 $ 13,912
====================================
8
Current liabilities $ 2,256 $ 3,383 $ 2,400
Long term liabilities 16,231 16,751 15,756
Equity (3,841) (3,680) (4,244)
------------------------------------
Total liabilities & equity $ 14,646 $ 16,454 $ 13,912
====================================
THREE MONTHS ENDED
Revenues $ 2,972 $ 3,204
Gross profit 807 1,062
Net income (loss) (72) 328
SIX MONTHS ENDED
Revenues $ 6,028 $ 6,694
Gross profit 1,557 2,318
Net income (loss) (171) 682
A wholly owned subsidiary of the Company has a 20% investment in Coronet
Communications Company ("Coronet"), which operates television station WHBF-TV, a
CBS affiliate in Rock Island, Illinois. A second wholly owned subsidiary of the
Company has a 49% investment in Capital Communications Company, Inc.
("Capital"), which operates television station WOI-TV, an ABC affiliate in Des
Moines, Iowa. At June 30, 2005, December 31, 2004 and June 30, 2004, the
investment in Coronet was carried at a negative $0.6 million, $0.6 million and
$0.7 million, respectively, due to the subsidiary's guarantee of $3.8 million of
Coronet's third party debt. The guarantee is in effect for the duration of the
loan which expires on December 31, 2005 and would be payable if the equity
investee fails to make such payment in accordance with the terms of the loan.
Long-term debt of Coronet, at June 30, 2005, totaled $9.2 million payable
quarterly through December 31, 2005 to a third party lender.
At June 30, 2005, December 31, 2004 and June 30, 2004, the investment in Capital
is carried at zero as its share of net losses recognized to date have exceeded
its net investment and the Company has no further commitment to Capital. The
Company's shares in Capital have been pledged as security for Capital's long
term debt.
Summarized financial information for telecommunications companies which includes
the cellular telephone providers, spectrum license holders, and other
telecommunication operations accounted for by the equity method as of and for
the three and six months ended June 30, 2005 and 2004 and as of December 31,
2004 is as follows (in thousands):
TELECOMMUNICATIONS COMBINED
--------------------------------
JUNE 30, DECEMBER 31, JUNE 30,
2005 2004 2004
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(in thousands)
Current assets $33,256 $36,080 $31,064
Property, plant & equipment, intangibles & other 34,900 33,087 26,350
-------------------------------
Total Assets $68,156 $69,167 $57,414
===============================
Current liabilities $22,941 $22,745 $22,107
Long term liabilities 6,002 5,900 8,223
Equity 39,213 40,522 27,084
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Total liabilities & equity $68,156 $69,167 $57,414
===============================
THREE MONTHS ENDED
Revenues $15,229 $14,443
Gross profit 6,920 6,567
Net income 4,005 4,357
9
SIX MONTHS ENDED
Revenues $29,998 $26,749
Gross profit 13,406 12,042
Net income 7,645 7,652
Interactive owns a one-third interest in two cellular telephone providers in New
Mexico: New Mexico RSA 3 and RSA 5. The Company's net investment in these
partnerships was $4.9 million, $6.5 million and $5.5 million at June 30, 2005,
December 31, 2004 and June 30, 2004, respectively and included in Investment in
and advances to affiliated entities.
E. INDEBTEDNESS
In June 2005, Interactive closed on a new $10 million unsecured revolving credit
facility, at 1.5% over prime, expiring in 2008, replacing the previous
short-term line of credit facility. Borrowings under this and the previous
facility, included in Notes payable to banks, were $4.3 million, $1.1 million
and $2.6 million at June 30, 2005, December 31, 2004 and June 30, 2004,
respectively.
Long-term debt consists of (all interest rates are at June 30, 2005) (in
thousands):
JUNE 30, DECEMBER 31, JUNE 30,
2005 2004 2004
--------------------------------------------
Rural Electrification Administration ("REA") and
Rural Telephone Bank ("RTB")notes payable due
quarterly through 2027 at fixed interest rates ranging
from 2% to 7.5%. (5.1% weighted average, secured
by assets of the telephone companies with a net book $55,211 $ 57,129 $ 58,787
value of $150 million)
Bank Credit facilities utilized by certain telephone
and telephone holding companies due from 2005 to
2016, $8.3 million at fixed interest rates averaging
8.3% and $60.0 million at variable interest rates 68,347 70,402 74,548
averaging 5.3%.
Unsecured notes issued in connection with
acquisitions through 2008, at fixed interest rates 38,419 38,983 38,889
averaging 9.5%
Other 1,751 2,452 2,456
------------------------------------------
163,728 168,966 174,680
Current maturities (25,068) (14,364) (13,959)
------------------------------------------
$ 138,660 $154,602 $160,721
==========================================
In March 2005, in conjunction with the acquisition of cable assets in Utah, a
subsidiary of the Company borrowed $2.2 million from a bank at variable interest
rates included in Bank Credit facilities above.
In general, the long-term debt facilities are secured by substantially all of
the Company's property, plant and equipment, receivables and common stock of
certain subsidiaries and contain certain covenants restricting distributions to
Lynch Interactive. At June 30, 2005, the Company is in compliance with all
covenants. At June 30, 2005, December 31, 2004 and June 30, 2004, substantially
all the subsidiaries' net assets are restricted from distribution to Lynch
Interactive.
10
F. COMPREHENSIVE INCOME
Other comprehensive income, net of tax, which consists of unrealized gains
(losses) on available for sale securities, as of June 30, 2005 and 2004 are as
follows (in thousands):
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
----------------------------------------------
2005 2004 2005 2004
----------------------------------------------
Net income $ 213 $ 384 $ 908 $ 1,987
Unrealized gains 209 305 69 1,166
Tax effect (71) (104) (24) (399)
----------------------------------------------
Net other comprehensive income 138 201 45 767
----------------------------------------------
Comprehensive income $ 351 $ 585 $ 953 $ 2,754
==============================================
G. TREASURY STOCK PURCHASES
In January 2005, the Company purchased 5,700 shares of its common stock for
treasury at an average investment of $31.53 per share. The Company has made no
additional share repurchases since January.
H. LITIGATION
TAYLOR LITIGATION.
Interactive and several other parties, including Interactive's CEO, and Fortunet
Communications, L.P., which was Sunshine PCS Corporation's
predecessor-in-interest, have been named as defendants in a lawsuit originally
brought by Rufus C. Taylor, III ("Taylor" or the " relator") under the so-called
qui tam provisions of the federal False Claims Act in the United States District
Court for the District of Columbia. The complaint was filed under seal with the
court in February 2001. At the initiative of one of the defendants, the seal was
lifted in January 2002. Under the False Claims Act, a private plaintiff called a
relator may file a civil action on the U.S. government's behalf against another
party for violation of the statute. In return, the relator receives a statutory
bounty from the government's litigation proceeds if he is successful.
The main allegation in the case is that the defendants participated in the
creation of "sham" bidding entities that allegedly defrauded the federal
Treasury by improperly participating in certain Federal Communications
Commission ("FCC") spectrum auctions restricted to small businesses, as well as
obtaining bidding credits in other spectrum auctions allocated to "small" and
"very small" businesses. While the complaint seeks to recover an unspecified
amount of damages, which would be subject to mandatory trebling under the
statute, a report prepared for the relator in February 2005 alleges damages of
approximately $91 million in respect of bidding credits, approximately $70
million in respect of government loans and approximately $206 million in respect
of subsequent sales of licenses, in each case prior to trebling.
Interactive strongly believes that this lawsuit is completely without merit and
that relator's damage computations are without basis, and intends to defend the
suit vigorously. The U.S. Department of Justice has notified the court that it
has declined to intervene in the case. Nevertheless, we cannot predict the
ultimate outcome of the litigation, nor can we predict the effect that the
lawsuit or its outcome will have on our business or plan of operation.
Interactive does not have any insurance to cover its cost of defending this
lawsuit, which costs will be material. Interactive does have a directors and
officers liability policy but the insurer has reserved its rights under the
policy and, as a result, any coverage to be provided to any director or officer
of Interactive in connection with a judgment rendered in this action is unclear
at this time.
Interactive was formally served with the complaint in July 2002. In September
2002, the defendants filed two motions with the United States District Court for
the District of Columbia: a motion to dismiss the lawsuit and a motion to
11
transfer the action to the Southern District of New York. In September 2003, the
Court granted our motion to transfer the action. A scheduling conference was
held in February 2004, at which time the judge approved a scheduling order and
discovery commenced. In July 2004, the judge denied in part and granted in part
our motion to dismiss. Interactive and its subsidiaries remain parties to the
litigation.
In December 2004, the defendants filed a motion in the United States District
Court for the District of Columbia to compel the FCC to provide certain
information subpoenaed by defendants in order to enable them to conduct their
defense. This motion was denied in May 2005 and defendants have filed a notice
of appeal with the U. S. Court of Appeals for the D.C. Circuit. Discovery is
substantially complete and the preparation and filing of dispositive motions has
begun. See "History of Lynch's "C" Block Activities" below.
HISTORY OF LYNCH'S "C" BLOCK ACTIVITIES.
As part of the Omnibus Budget Resolution of 1993, Congress authorized the FCC to
employ competitive bidding procedures to select among mutually exclusive
applicants for certain spectrum licenses. Initially the FCC had an initiative to
include, among others, African Americans, Native Americans, Asian Americans and
women. As a result of this, the FCC conducted auctions beginning in 1995 to
allocate spectrum in a competitive manner. Interactive was a participating
investor and/or service provider to various entities in this "C-Block" auction.
By December 18, 1995, Interactive (through its predecessor Lynch Corporation)
had investments in five entities that participated in the FCC auction for
broadband PCS "C" block spectrum (Auction 5). When the auction closed, on May 6,
1996, these five entities, on a combined basis, were the higher bidders for
thirty-one 30 MHz licenses at a gross cost of $288.2 million. These entities
were initially put together under the FCC's initiative to include, among others,
women, African Americans, Native Americans and Asian Americans. As a result of
changes in these initiatives, these same individuals were qualified as small
businesses and remained eligible as bidders. These entities received $72 million
of bidding credits, and accordingly the net cost was $216.2 million. The federal
government provided financing for 90% of the cost of these licenses, or $194.6
million. Interactive's investments in these entities totaled $21 million.
Events during and subsequent to Auction 5, made financing these licenses through
the capital markets much more difficult than originally anticipated. On April
18, 1997, among other reasons, in order to obtain some economies of scale, such
as financing, the five entities merged into Fortunet Communications, Inc. The
FCC, in partial response to actions by Nextwave and others, promoted a plan for
refinancing the "C" block licenses. In 1997, many of the license holders from
Auction 5, including Fortunet, petitioned the FCC for relief in order to afford
these small businesses the opportunity to more realistically restructure and
build out their systems. The President of Fortunet, Karen Johnson, participated
in an FCC sponsored forum on this issue on June 30, 1997. The response from the
FCC, which was announced on September 26, 1997 and modified on March 24, 1998,
afforded license holders four options. One of these options was the resumption
of current debt payments, which had been suspended earlier in 1997 for all such
license holders. Another option, amnesty, was to return all licenses and forgo
any amounts deposited in exchange for forgiveness of the FCC debt. Other options
included: disaggregation, splitting a 30 MHz license into two 15 MHz licenses
and forgoing 50% of the amount deposited; and prepayment, return of certain
licenses and utilizing 70% of the amount deposited to acquire other licenses,
with the other 30% of the deposits to be forfeited.
On June 8, 1998, Fortunet elected to apply its eligible credits relating to its
original down payment to the purchase of three licenses for 15 MHz of PCS
spectrum in Tallahassee, Panama City and Ocala, Florida. Consistent with an FCC
promulgated disaggregation alternative, Fortunet surrendered all the remaining
licenses and forfeited 30% of its original down payment in full satisfaction of
its government obligations, including forgiveness of all accrued interest.
Accordingly, Fortunet retained 15 MHz of spectrum in the three Florida markets
covering a population of approximately 962,000 at a net auction cost of $15.8
million. As a result of this FCC process, disaggregation resulted in a reduction
of the bidding credits to $5.3 million. Fortunet also lost $6.0 million of its
down payment. As a result of this decision, during 1997, Interactive recorded a
12
$7.0 million write down of its investment in Fortunet. As a lawyer who worked on
many applications for FCC licenses, Taylor (the relator in this case) is
doubtless aware of the details of these FCC initiated alternatives for the "C"
Block, as presumably are his law firms.
On April 15, 1999, the FCC completed a reauction of all the C-Block licenses
that were surrendered, including the 15 MHz of spectrum that Fortunet returned
to the FCC on June 8, 1998 in respect of the Tallahassee, Panama City and Ocala,
Florida markets. In that reauction, the successful bidders paid a total of $2.7
million for those three 15 MHz licenses returned by Fortunet versus the $15.8
million paid by Fortunet. As a result of this auction, Interactive recorded a
further write down of its investment of $15.4 million, including capitalized
costs, to reflect the amount bid for the similar licenses in the reauction.
In February 2000, Fortunet merged with Sunshine PCS Corporation, which by way of
a spin-off from Lynch Interactive became a public company. It traded under the
symbol SUNPA.
On December 31, 2003, Sunshine, after appropriate corporate and regulatory
steps, sold its three 15 MHz licenses to Cingular Wireless for $13.75 million.
Interactive received $7.6 million as part of the sale transaction versus its
cash investment of $21.9 million initially invested in the original five
entities in 1992.
OTHER LITIGATION.
In addition to the litigation described above, Interactive is a party to routine
litigation incidental to its business. Based on information currently available,
Interactive believes that none of this ordinary routine litigation, either
individually or in the aggregate, will have a material effect on its financial
condition and results of operations.
I. MCI/WORLDCOM RECOVERY
During 2002, the Company wrote off substantially all receivables associated with
MCI/WorldCom ("MCI"), which had filed for protection under bankruptcy laws. In
the second quarter of 2005, certain of the Company's subsidiaries received cash
and stock in MCI, Inc. valued at less than $0.1 million which has been recorded
in income as a reduction to General and Administrative Costs at Operations. In
addition, the Company expects to receive $0.2 million in cash and stock that
will be recorded in income when such cash and stock is received.
J. RELATED PARTY TRANSACTIONS
Expenditures for fees that the Company is incurring with regard to the False
Claims Act litigation are based on allocations among defendants, and are subject
to negotiation. It is expected that the final allocation may be adjusted subject
to final conclusion of the litigation.
At June 30, 2005, December 31, 2004, and June 30, 2004, assets of $20.8 million,
$15.2 million and $14.1 million, which are classified as cash and cash
equivalents, are invested in United States Treasury money market funds for which
affiliates of the Company's CEO serve as investment managers to the respective
funds.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
This discussion should be read together with the Consolidated Financial
Statements of Interactive and the notes thereto included elsewhere in this
Quarterly Report.
13
RESULTS OF OPERATIONS
OVERVIEW
Interactive has grown primarily through the selective acquisition of rural local
exchange carriers ("RLECs") and by offering additional services such as Internet
service, alarm services, long distance service and competitive local exchange
carrier ("CLEC") service. From 1989 through the current reporting period,
Interactive (and its predecessor corporation) acquired fourteen telephone
companies, four of which have indirect minority ownership of 2% to 19%, whose
operations range in size from approximately 800 to over 10,000 access lines. The
Company's telephone operations are located in Iowa, Kansas, Michigan, New
Hampshire, New Mexico, New York, North Dakota, Utah and Wisconsin.
The telecommunications industry in general and the RLECs that comprise
Interactive's business face a number of economic or industry-wide issues and
challenges.
o REGULATORY- The Telecommunications Act of 1996 and other federal
and state legislation and regulations have a significant impact on
the industry and on rural carriers in particular. Interactive's
telephone companies are all RLECs serving very high cost areas with
a significant portion of their revenues being derived from federal
or state support mechanisms, which are referred to as Universal
Service Funds ("USF"). The revenues and margins of our RLEC
subsidiaries are largely dependent on the continuation of such
support mechanisms.
o COMPETITION- The effects of competition from CLECs, wireless
service, high speed cable, Voice over Internet Protocol ("VoIP")
and other internet providers is an industry-wide issue that is felt
to varying degrees by our rural telephone companies.
o THE ECONOMY- Unemployment, building starts, business bankruptcies
and the overall health of the economy have a significant effect on
demand for our services.
o TELECOMMUNICATION BANKRUPTCIES- Interactive's telephone companies
have significant, normal course of business receivables from
interexchange carriers, such as MCI or Global Crossings who filed
for bankruptcy and, as a result, have been written-off. Additional
bankruptcies could have a significant effect on our financial
condition. The Company has recovered settlements from MCI of less
than $0.1 million through June 30, 2005 and expects to recover an
additional $0.2 million in the third quarter of 2005.
o MARKET CHALLENGES- Our phone companies are required to comply with
industry-wide initiatives such as local number portability and the
requirements of the Communications Assistance for Law Enforcement
Acto ("CALEA") that are expensive to implement and that in some
cases have limited demand in our markets.
Interactive generates cash and earns telecommunications revenues primarily from
local network access, intrastate and interstate access revenue and from state
and federal USF support mechanisms. Due to the nature of the Company's regulated
telephone operations, revenues and operating expenses are relatively stable
period to period.
o Local Revenues - The number of access lines is the primary driver
of local network access revenues. In addition, the ratio of
business to residential lines, as well as the number of features
subscribed to by customers are secondary drivers.
o Intrastate access revenues - Customer usage, primarily based on
minutes of use, and the number of access lines are the primary
drivers of intrastate access revenues since the Company's RLECs are
on a "bill-and-keep" basis.
o All of our RLECs participate in the National Exchange Carrier
Association ("NECA") access pools. Interstate access revenues
depend upon whether the RLEC has elected to be "cost-based" or has
remained an "average schedule" carrier. The revenues of our nine
14
cost-based carriers directly correlate to the rate-of-return on
regulated net investment earned by the NECA access pools plus the
amount of regulated operating expenses including taxes. The
revenues of the Company's five average schedule subsidiaries
correlate to usage based measurements such as access lines,
interstate minutes-of-use, and the number and mileage of different
types of circuits. The average schedule formulas are intended to be
a proxy for cost-based recovery.
o USF subsidies are primarily driven by investments in specific types
of infrastructure, as well as certain operating expenses and taxes
of the Company. Interstate and intrastate USF subsidies are included
in the respective interstate and intrastate access revenue captions
in the breakdown of revenue and operating expenses which follows.
o Other business revenue: Interactive's companies also provide
non-regulated telecommunications related services, including
Internet access service, wireless and long distance resale service,
in certain of its telephone service and adjacent areas. Interactive
also provides and intends to provide more local telephone and other
telecommunications service outside certain of its franchise areas by
establishing CLEC operations in selected nearby areas. In addition,
certain of Interactive's companies have expanded into cable and
security businesses in the areas in which they operate.
o Long Distance revenues are only retained by the Company if it is
providing the long distance service to the end user customer as the
toll provider. For unaffiliated Interexchange Carriers ("IXCs") who
contract with Interactive for billing services, the Company provides
billing services and receives an administrative handling fee.
The following are material opportunities, challenges and risks that
Interactive's executives are currently focused on, as well as actions that
are being taken to address the concerns:
o Universal Service Reform: Efforts to modify universal service
mechanisms are currently underway at the FCC. In June 2004, the
FCC asked the Federal-State Joint Board on Universal Service
("Joint Board") to review the rules relating to the high-cost
universal service support mechanisms for rural carriers and to
determine the appropriate rural mechanism to succeed the
five-year plan adopted in the Rural Task Force Order. In
particular, the FCC asked the Joint Board to make
recommendations on a long-term universal service plan that
ensures that support is specific, predictable, and sufficient to
preserve and advance universal service. The FCC asked the Joint
Board to ensure that its recommendations are consistent with the
goal of ensuring that consumers in rural, insular, and high-cost
areas have access to telecommunications and information services
at rates that are affordable and reasonably comparable to rates
charged for similar services in urban areas. The FCC also asked
the Joint Board to consider how support can be effectively
targeted to rural telephone companies serving the highest cost
areas, while protecting against excessive fund growth. In
conducting its review, the Joint Board is supposed to take into
account the significant distinctions among rural carriers, and
between rural and non-rural carriers and consider all options
for determining appropriate universal service support. The
Company participated with the RLEC industry in comments to the
FCC regarding the potential impact to customers and RLECs in
rural America. Total USF support payments are material to the
Company's financial results.
o Intercarrier Compensation and Access Charge Reform: The Company
is actively participating in the RLEC industry's efforts to
determine how intercarrier compensation and access charges
should be modified without sustaining revenue losses for RLECs.
o Loss of Access Revenues from VoIP and wireless usage: The
Company is experiencing revenue losses as usage transfers from
landline service provided by the Company's subsidiaries to
either VoIP or wireless services. VoIP traffic currently does
not pay access charges or contribute to universal service. The
FCC has several proceedings underway to determine whether VoIP
traffic should contribute for the use of the network and
contribute to USF. The Company is participating in the RLEC
industry efforts to have VoIP traffic contribute for use of the
underlying network on which the VoIP call travels. To offset
15
revenue losses from traditional voice services, Interactive is
installing more broadband services and is exploring how to best
incorporate VoIP into its business model.
o Intrastate revenue and operating income at our Michigan
telephone company will be substantially reduced in the future
due to a state requirement to expand the local calling area. The
Company has filed with the state commission to recover a portion
of the revenue deficiency by increasing local access rates,
however, there is no assurance that it will be successful.
SECOND QUARTER ENDED JUNE 30, 2005 COMPARED TO 2004
The following is a breakdown of revenues and operating costs and expenses (in
thousands):
Three months ended June 30, Increase
2005 2004 (Decrease)
---------------------------------------
(Unaudited)
Revenues:
Local access $ 2,986 $ 3,058 $ (72)
Interstate access 10,237 9,272 965
Intrastate access 3,478 3,693 (215)
Other business 5,770 5,064 706
---------------------------------------
Total 22,471 21,087 1,384
---------------------------------------
Operating Cost and Expense:
Cost of revenue, excluding depreciation 8,095 7,407 688
General and administrative costs at
operations 3,343 3,253 90
Corporate office expenses 2,742 2,273 469
Depreciation and amortization 5,346 4,927 419
---------------------------------------
Total 19,526 17,860 1,666
---------------------------------------
Operating profit $ 2,945 $ 3,227 $ (282)
=======================================
Total revenues in the 2005 second quarter increased $1.4 million, 6.6%, to $22.5
million compared to $21.1 million in 2004. Local access revenue decreased by
$72 resulting from a 3.6% decrease in access lines partially offset by the
sale of additional features. The decrease in access lines is due to the increase
in cell phone usage and reduction in second lines as customers switch from
dial-up internet service to DSL. Interstate access revenue increased $1.0
million in 2005 primarily due to infrastructure development undertaken in 2002
and 2003, which entitled the Company to increased network access and USF support
primarily at the Haviland Telephone Company in Kansas, and to a lesser extent,
the effects of 2005 investments resulted in increased network access revenue at
our Michigan telephone company. Intrastate network access revenue decreased $0.2
million due to a loss of toll revenue for dial-up access to the internet at our
Michigan telephone company, the gradual phase-out of a New York pool for small
carriers, and a reduction of minutes of use at several of our companies. Other
business revenues increased $0.7 million due to increased DSL penetration, and
revenues from a small cable company in Utah that the Company acquired in
February 2004 as well as a larger acquisition of cable television assets that
was completed in March 2005.
Total costs and expenses increased by $1.7 million to $19.5 million in the
second quarter of 2005. Costs of revenue increased $0.7 million, or 9.3%, due to
additional operating costs related to the infrastructure development in Haviland
and costs generated by the cable television operations acquired in February 2004
and March 2005. General and administrative costs incurred at the operations
increased $0.1 million primarily due to increased property taxes due to the
Haviland infrastructure development. Corporate office expenses increased $0.5
million resulting from $1.6 million of legal costs incurred defending the False
Claims Act litigation in 2005 compared to $0.8 million in 2004. In addition, in
16
2005 the Company incurred legal and consulting costs in conjunction with a
shareholder proposal to deregister as a public company. Depreciation and
amortization increased $0.4 million primarily due to a 2004 regulatory
adjustment.
As a result of the above, operating profit in the second quarter of 2005
decreased by $0.3 million to $2.9 million compared to 2004.
ADJUSTED OPERATING PROFIT
Adjusted operating profit is used by our management as a supplemental financial
measure to evaluate the operating performance of our business that, when viewed
with our GAAP results and the accompanying reconciliations, we believe provides
a more complete understanding of factors and trends affecting our business than
the GAAP results alone. We also regularly communicate our adjusted operating
profit to the public through our earnings releases because it is the financial
measure commonly used by analysts that cover the telecommunications industry and
our investor base to evaluate our operating performance. In addition, we
routinely use adjusted operating profit as a metric for valuing potential
acquisitions. We understand that analysts and investors regularly rely on
non-GAAP financial measures, such as adjusted operating profit, to provide a
financial measure by which to compare a company's assessment of its operating
performance against that of other companies in the same industry. This non-GAAP
financial measure is helpful in more clearly reflecting the sales of our
products and services, as well as highlighting trends in our core business that
may not otherwise be apparent when relying solely on GAAP financial measures,
because this non-GAAP financial measure eliminates from earnings financial items
that have less bearing on our performance.
Interactive's management believes strongly in growing intrinsic value as a
long-term prescription for managing an enterprises health. Our local management
teams run their respective businesses as stand-alone, entrepreneurial units. We
believe that adjusted operating profit is the clearest indicator of the cash
flow generating ability and long-term health of such units. We value potential
acquisitions on the same basis.
The term "adjusted operating profit" as used in this Form 10-Q refers to, for
any period, net income (loss) before all components of "Other income (expense)"
(consisting of investment income, interest expense, equity in earnings of
affiliates, gains and losses on disposition of or impairment of assets), income
taxes, depreciation, amortization, minority interests and income or loss from
discontinued operations.
Set forth below are descriptions of the financial items that have been excluded
from net income (loss) to calculate adjusted operating profit and the material
limitations associated with using this non-GAAP financial measure as compared to
the use of the most directly comparable GAAP financial measure:
o The amount of interest expense we incur is significant and reduces
the amount of funds otherwise available to use in our business and,
therefore, is important for investors to consider. However,
management does not consider the amount of interest expense when
evaluating our core operating performance.
o Investment income is considered to be similar to interest expense.
Although it is important for investors to consider, management does
not consider the amount of investment income when evaluating our
core operating performance.
o Management does not consider income tax expense when considering the
profitability of our core operations. Nevertheless, the amount of
taxes we are required to pay reduces the amount of funds otherwise
available for use in our business and thus may be useful for an
investor to consider.
o Depreciation and amortization are important for investors to
consider, even though they are non-cash charges, because they
represent generally the wear and tear on our property, plant and
equipment, which produce our revenue. We do not believe these
charges are indicative of our core operating performance.
17
o Income from equity investments relates to our proportionate share of
income or loss from the entities in which we hold minority
interests. We do not control these entities and, as such, do not
believe the income we receive from such entities is indicative of
our core operating performance.
o Minority interest in (income) loss of subsidiaries relates to our
minority investors' proportionate share of income or losses in our
non-wholly owned subsidiaries, which generated non-cash charges to
our operating results. Operating results attributable to these
minority investors' investments do not necessarily result in any
actual benefit or detriment to us and, therefore, we believe it
would be more helpful for an investor to exclude such items as being
more reflective of our core operating performance.
o Gain or losses on the disposition of assets or impairment of
investments may increase or decrease the cash available to us and
thus may be important for an investor to consider. We are not in the
business of acquiring or disposing of assets and, therefore, the
effect of the dispositions of assets may not be comparable from
year-to-year. We believe such gains or losses recorded on the
disposition of an asset do not reflect the core operating
performance of our business.
o Management compensates for the above-described limitations of using
a non-GAAP financial measure by using this non-GAAP financial
measure only to supplement our GAAP results to provide a more
complete understanding of the factors and trends affecting our
business. Adjusted operating profit should not be considered to be a
substitute for net income or (loss) as an indicator of the Company's
operating performance.
The following table provides the components of Adjusted Operating Profit and
reconciles it to net income (in thousands):
Three months ended June 30, Increase
2005 2004 (Decrease)
---------------------------------------
(Unaudited)
Adjusted operating profit from:
Operating units $ 11,033 $ 10,427 $ 606
Corporate expense:
Taylor litigation 1,607 778 829
Other 1,135 1,495 (360)
--------------------------------------
Total corporate expenses 2,742 2,273 469
--------------------------------------
Adjusted operating profit $ 8,291 $ 8,154 $ 137
======================================
Reconciliation to net income:
Adjusted operating profit $ 8,291 $ 8,154 $ 137
Depreciation and amortization (5,346) (4,927) (419)
Investment income 191 82 109
Interest expense (2,950) (2,851) (99)
Equity in income of affiliates 841 886 (45)
Income tax (330) (473) 143
Minority Interests (484) (487) 3
--------------------------------------
Net income $ 213 $ 384 $ (171)
======================================
18
OTHER INCOME (EXPENSE)
In 2005, investment income increased by $0.1 million primarily due to an
increase in interest rates.
Interest expense decreased $0.1 million due primarily to lower average
outstanding borrowings partially offset by higher interest rates.
Equity in earnings of affiliates was $0.8 million in 2005 and $0.9 million in
2004 reflecting consistent earnings of the Company's New Mexico cellular
investments (RSA 3 and 5) in both periods.
INCOME TAX PROVISION
The income tax provision includes federal, as well as state and local taxes. The
tax provision for the second quarter of 2005 and 2004, represent effective tax
rates of 45.1% and 44.4% respectively. The difference between these effective
rates and the federal statutory rate is principally due to state income taxes,
including the effect of earnings attributable to different state jurisdictions.
MINORITY INTERESTS
Minority interests decreased earnings by $0.5 million in both 2005 and 2004
reflecting the consistent earnings of the Company's New Mexico cellular
investments.
NET INCOME
Net income in 2005 was $0.2 million, or $0.08 per share (basic and diluted),
compared to a net income last year of $0.4 million, or $0.14 per share (basic
and diluted). The Company has no dilutive instruments outstanding.
SIX MONTHS ENDED JUNE 30, 2005 COMPARED TO 2004
The following is a breakdown of revenues and operating costs and expenses (in
thousands):
Six months ended June 30, Increase
2005 2004 (Decrease)
--------------------------------------
(Unaudited)
Revenues:
Local access $ 5,844 $ 5,947 $ (103)
Interstate access 19,932 18,610 1,322
Intrastate access 7,175 7,814 (639)
Other business 11,138 10,140 998
-------------------------------------
Total 44,089 42,511 1,578
-------------------------------------
Operating Cost and Expense:
Cost of revenue, excluding depreciation 15,746 14,610 1,136
General and administrative costs at
operations 6,766 6,392 374
Corporate office expenses 4,834 3,246 1,588
Depreciation and amortization 10,541 10,148 393
-------------------------------------
Total 37,887 34,396 3,491
-------------------------------------
Operating profit $ 6,202 $ 8,115 $(1,913)
=====================================
Total revenues in the first six months of 2005 increased $1.6 million, or 3.7%,
to $44.1 million compared to $42.5 million in 2004. Local access revenue
decreased by $0.1 million resulting from a 3.6% decrease in access lines
19
partially offset by the sale of additional features. The decrease in access
lines is due to the increase in cell phone usage and reduction in second lines
as customers switch from dial-up internet service to DSL. Interstate access
revenue increased $1.3 million in 2005 primarily due to infrastructure
development undertaken in 2002 and 2003, which entitled the Company to increased
network access and USF support primarily at the Haviland Telephone Company in
Kansas, and to a lesser extent, the effects of 2005 investments resulted in
increased network access revenue at our Michigan telephone company. Intrastate
network access revenue decreased $0.6 million due to a loss of toll revenue for
dial-up access to the internet at our Michigan telephone company, the gradual
phase-out of a New York pool for small carriers, and a reduction of minutes of
use at several of our companies. Other business revenues increased $1.0 million
due to increased DSL penetration, and revenues from a small cable company in
Utah that the Company acquired in February 2004 as well as a larger acquisition
of cable television assets that was completed in March 2005.
Total costs and expenses increased by $3.5 million to $37.9 million in the first
six months of 2005. Costs of revenue increased $1.1 million, or 7.8%, due to
additional operating costs related to the infrastructure development in Haviland
and costs generated by the cable television operations acquired in February 2004
and March 2005. General and administrative costs incurred at the operations
increased $0.4 million primarily due to professional fees with regard to local
area calling in Michigan and increased audit and Sarbanes - Oxley implementation
fees. Corporate office expenses increased $1.6 million resulting from $2.8
million of legal costs incurred defending the False Claims Act litigation in
2005 compared to $1.2 million in 2004. In addition, the Company incurred legal
and consulting costs in conjunction with a shareholder proposal to deregister as
a public company. Depreciation and amortization increased $0.4 million primarily
due to a 2004 regulatory adjustment.
As a result of the above, operating profit in 2005 decreased by $1.9 million to
$6.2 million compared to 2004.
ADJUSTED OPERATING PROFIT
The following table provides the components of Adjusted Operating Profit and
reconciles it to net income (in thousands):
Six months ended June 30, Increase
2005 2004 (Decrease)
--------------------------------------
(Unaudited)
Adjusted operating profit from:
Operating units $ 21,577 $ 21,509 $ 68
Corporate expense:
Taylor litigation 2,808 1,150 1,658
Other 2,026 2,096 (70)
--------------------------------------
Total corporate expenses 4,834 3,246 1,588
--------------------------------------
Adjusted operating profit $ 16,743 $ 18,263 $ (1,520)
======================================
Reconciliation to net income:
Adjusted operating profit $ 16,743 $ 18,263 $ (1,520)
Depreciation and amortization (10,541) (10,148) (393)
Investment income 984 810 174
Interest expense (5,772) (5,670) (102)
Equity in income of affiliates 1,552 1,598 (46)
Income tax (1,097) (1,922) 825
Minority Interests (961) (944) (17)
--------------------------------------
Net income $ 908 $ 1,987 $ (1,079)
======================================
20
OTHER INCOME (EXPENSE)
In 2005, investment income increased by $0.2 million primarily due to an
increase in CoBank patronage refunds and a $0.1 million retroactive dividend
from Iowa Network Services. Such increases were offset by a $0.2 million gain on
the sale of an investment in the 2004 period.
Interest expense decreased $0.1 million due primarily to lower average
outstanding borrowings partially offset by higher interest rates.
Equity in earnings of affiliates decreased slightly in 2005 reflecting
consistent earnings of the Company's New Mexico cellular investments (RSA 3 and
5) in both periods.
INCOME TAX PROVISION
The income tax provision includes federal, as well as state and local taxes. The
tax provision for the first six months of 2005 and 2004, represent effective tax
rates of 45.5% and 44.5%, respectively. The difference between these effective
rates and the federal statutory rate is principally due to state income taxes,
including the effect of earnings attributable to different state jurisdictions.
MINORITY INTERESTS
Minority interests decreased earnings by similar amounts in both 2005 and 2004
reflecting the consistent earnings of the Company's New Mexico cellular
investments.
NET INCOME
Net income in 2005 was $0.9 million, or $0.33 per share (basic and diluted),
compared to a net income last year of $2.0 million, or $0.72 per share (basic
and diluted). The Company has no dilutive instruments outstanding.
LIQUIDITY AND CAPITAL RESOURCES
LIQUIDITY
The debt at each of Interactive's subsidiary companies contains restrictions on
the amount of funds that can be transferred to their respective parent
companies. The Interactive parent company ("Parent Company") needs cash
primarily to pay corporate expenses, federal income taxes and to invest in new
opportunities, including spectrum licenses. The Parent Company receives cash to
meet its obligations primarily through management fees charged to its
subsidiaries, a tax sharing agreement with its subsidiaries, usage of a line of
credit facility, and has obtained additional liquidity by refinancing certain
subsidiary debt. In addition, the Parent Company considers various alternative
long-term financing sources: debt, equity, or sale of investments and other
assets.
In June 2005, Interactive closed on a new $10 million unsecured revolving
credit facility of which $5.7 million was available at June 30, 2005, at 1.5%
over prime, expiring in 2008, replacing the previous short-term line of credit
facility. The Company continues to have a need for additional credit facilities,
but management believes that it has various alternative means to obtain adequate
resources to fund operations over the next twelve months.
The Company's RLECs and other businesses need cash to fund their current
operations, as well as future long-term growth initiatives. Each RLEC and other
business finances its cash needs with cash generated from operations, by
utilizing existing borrowing capacity or by entering into new long-term debt
agreements. New business acquisitions are generally financed with a combination
of new long-term debt, secured by the acquired assets, as well as cash from the
Parent. While management expects that both Parent and the operating subsidiaries
will be able to obtain adequate financing resources to enable the Company to
meet its obligations, there is no assurance that such can be readily obtained or
at reasonable costs. The Company is obligated under long-term debt provisions
21
and lease agreements to make certain cash payments over the term of the
agreements. The following table summarizes, as of June 30, 2005 for the periods
shown, these contractual obligations and certain other financing commitments
from banks and other financial institutions that provide liquidity:
Payments Due by Period
(In thousands)
Less than After 5
Total 1 year 1 - 3 years 4 - 5 years years
-------------------------------------------------------------
Long-term debt (a) $163,728 $ 25,068 $ 54,087 $ 35,582 $ 48,991
Operating leases 1,271 286 455 230 300
Notes payable to banks 8,419 8,419 -- -- --
Guarantees 3,750 3,750 -- -- --
-------- -------- -------- -------- --------
Total contractual cash obligations
and commitments $177,168 $ 37,523 $ 54,542 $ 35,812 $ 49,291
======== ======== ======== ======== ========
(a) Does not include interest payments on debt
A subsidiary of the Company has guaranteed $3.8 million of an equity investees'
total debt of $9.2 million. The guarantee is in effect for the duration of the
loan which expires on December 31, 2005 and would be payable if the equity
investee fails to make such payment in accordance with the terms of the loan.
At June 30, 2005, total debt (including notes payable to banks) was $172.1
million, a decrease of $1.7 million from December 31, 2004. At June 30, 2005,
there was $102.6 million of fixed interest rate debt outstanding averaging 7.0%
and $69.6 million of variable interest rate debt averaging 6.3%. The debt at
fixed interest rates includes $38.1 million of subordinated notes at interest
rates averaging 9.5% issued to sellers as part of acquisitions. The long-term
debt facilities at certain subsidiaries are secured by substantially all of such
subsidiaries assets, while at other subsidiaries it is secured by the common
stock of such subsidiaries. In addition, the debt facilities contain certain
covenants restricting distribution to Lynch Interactive. At June 30, 2005,
December 31, 2004 and June 30, 2004, substantially all of the subsidiaries' net
assets are restricted.
Interactive has a high degree of financial leverage. As of June 30, 2005, the
ratio of total debt to equity was 4.9 to 1. Certain subsidiaries also have high
debt to equity ratios. Management believes that it is currently more beneficial
to hold excess cash at certain of our subsidiaries rather than utilizing the
cash to pay-down existing credit facilities.
As of June 30, 2005, Interactive had current assets of $39.7 million and current
liabilities of $50.2 million resulting in a working capital deficiency of $10.5
million, compared to a surplus of $3.9 million at December 31, 2004. The
reduction in working capital was primarily due to the reclassification of $11.9
million of long-term debt to current maturities, which will become due prior to
June 30, 2006. The Company expects to re-finance such debt prior to their
maturity dates.
SOURCES AND USES OF CASH
Cash at June 30, 2005, was $27.7 million, an increase of $0.5 million compared
to December 31, 2004. The majority of the cash is restricted by debt covenant to
the subsidiary that generated it and is generally not available for transfer to
the Parent Company. In 2005, net cash provided by operations of $11.7 million
was used to invest in plant and equipment and to repay debt. The acquisition of
cable assets in March 2005 was funded in part by $2.2 million of new borrowings.
Capital expenditures were $4.2 million in the 2005 six month period, compared to
$6.3 million in 2004 which is predominantly spent at the RLECs and will be
22
included in their rate bases for rate setting purposes. Capital expenditures in
2005 are expected to be approximately $11 million, most of which will be added
to the RLEC rate bases.
On March 18, 2005, a subsidiary of the Company, Central Telcom Services, LLC,
closed on an agreement with Precis Communications, LLC, to acquire a cable
television assets for a purchase price of $3.5 million of which $2.2 million was
financed with secured bank debt.
On July 29, 2005, a subsidiary of the Company closed on the sale of
approximately 62% of the company's security accounts to an investment group for
approximately $2.75 million, net of holdbacks and fees. The proceeds will be
used to retire debt. The Company will continue to monitor such accounts and
provide billing and collection services for the new owner.
The Company has initiated an effort to monetize certain of its assets, including
selling a portion or all of its investment in certain of its operating entities
and equity investments. These initiatives may include the sale of certain
telephone operations where growth opportunities are not readily apparent. There
is no assurance that all or any part of this program can be effectuated on
acceptable terms.
Subsequent to the spin-off by Lynch Corporation, the Board of Directors of Lynch
Interactive Corporation authorized the purchase of up to 100,000 shares of
common stock. Through June 30, 2005, 72,700 shares had been purchased at an
average cost of $32.26 per share.
President Bush's proposed Budget for Fiscal Year 2006 establishes the process
and terms to implement the dissolution of the Rural Telephone Bank ("RTB").
Under RTB's By-Laws, on dissolution, the holders of its Class B and Class C
stock would be paid the par value of their stock. As of December 31, 2004, the
total par value of RTB Class B and Class C stock at the Company's subsidiaries
was $11.3 million. The net book value and tax basis of this stock, at that date,
was $1.1 million. The dissolution of the RTB and payments to the stockholders is
subject to numerous approvals and actions, including Congressional approval of
President Bush's proposed Budget for Fiscal Year 2006 and actions by RTB's Board
of Directors. Therefore, the Company cannot predict whether, or when, such
payments will actually be made to the Company's subsidiaries.
Lynch Corporation, the Company's predecessor, has not paid any cash dividends on
its common stock since 1989. The Company has not paid any cash dividends since
its inception in 1999 and does not expect to pay cash dividends on its common
stock in the foreseeable future. Interactive currently intends to retain its
earnings, if any, for use in its business. Further financing may limit or
prohibit the payment of dividends.
CONTINGENCIES
TAYLOR LITIGATION.
Interactive and several other parties, including Interactive's CEO, and Fortunet
Communications, L.P., which was Sunshine PCS Corporation's
predecessor-in-interest, have been named as defendants in a lawsuit brought by
Taylor under the so-called qui tam provisions of the federal False Claims Act in
the United States District Court for the District of Columbia. The complaint was
filed under seal with the court in February 2001. At the initiative of one of
the defendants, the seal was lifted in January 2002. Under the False Claims Act,
a private plaintiff called a relator may file a civil action on the U.S.
government's behalf against another party for violation of the statute. In
return, the relator receives a statutory bounty from the government's litigation
proceeds if he is successful.
The main allegation in the case is that the defendants participated in the
creation of "sham" bidding entities that allegedly defrauded the federal
Treasury by improperly participating in certain FCC spectrum auctions restricted
to small businesses, as well as obtaining bidding credits in other spectrum
auctions allocated to "small" and "very small" businesses. While the complaint
seeks to recover an unspecified amount of damages, which would be subject to
mandatory trebling under the statute, a report prepared for the relator in
February 2005 alleges damages of approximately $91 million in respect of bidding
credits, approximately $70 million in respect of government loans and
approximately $206 million in respect of subsequent sales of licenses, in each
case prior to trebling.
23
Interactive strongly believes that this lawsuit is completely without merit and
that relator's initial damage computations are without basis, and intends to
defend the suit vigorously. The U.S. Department of Justice has notified the
court that it has declined to intervene in the case. Nevertheless, we cannot
predict the ultimate outcome of the litigation, nor can we predict the effect
that the lawsuit or its outcome will have on our business or plan of operation.
Interactive does not have any insurance to cover its cost of defending this
lawsuit, which costs will be material. Interactive does have a directors and
officers liability policy but the insurer has reserved its rights under the
policy and, as a result, any coverage to be provided to any director or officer
of Interactive in connection with a judgment rendered in this action is unclear
at this time.
Interactive was formally served with the complaint in July 2002. In September
2002, the defendants filed two motions with the United States District Court for
the District of Columbia: a motion to dismiss the lawsuit and a motion to
transfer the action to the Southern District of New York. In September 2003, the
Court granted our motion to transfer the action. A scheduling conference was
held in February 2004, at which time the judge approved a scheduling order and
discovery commenced. In July 2004, the judge denied in part and granted in part
our motion to dismiss. Interactive and its subsidiaries remain parties to the
litigation.
In December 2004, the defendants filed a motion in the United States District
Court for the District of Columbia to compel the FCC to provide certain
information subpoenaed by defendants in order to enable them to conduct their
defense. This motion was denied in May 2005 and defendants have filed a notice
of appeal with the U.S. Court of Appeals for the D.C. Circuit. Discovery is
substantially complete and the preparation and filing of dispositive motions has
begun.
See also "H. Litigation - History of Lynch's C-Block Activities" above for a
history of our involvement in Auction 5.
OTHER LITIGATION.
In addition to the litigation described above, Interactive is a party to routine
litigation incidental to its business. Based on information currently available,
Interactive believes that none of this ordinary routine litigation, either
individually or in the aggregate, will have a material effect on its financial
condition and results of operations.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The preparation of consolidated financial statements requires Interactive's
management to make estimates and judgments that affect the reported amounts of
assets, liabilities, revenues and expenses, and related disclosure of contingent
assets and liabilities. On an ongoing basis, Interactive evaluates its
estimates, including those related to revenue recognition, carrying value of its
investments in spectrum entities and long-lived assets, purchase price
allocations, and contingencies and litigation. Interactive bases its estimates
on historical experience and on various other assumptions that are believed to
be reasonable under the circumstances, the results of which form the basis for
making judgments about the carrying values of assets and liabilities that are
not readily apparent from other sources. Actual results may differ from these
estimates under different assumptions or conditions. Interactive believes the
following critical accounting policies affect its more significant judgments and
estimates used in the preparation of its consolidated financial statements.
We believe that revenue from interstate access for our "cost-based" companies is
based on critical accounting estimates and judgment. Such revenue is derived
from settlements with the National Exchange Carrier Association ("NECA"). NECA
was created by the FCC to administer interstate access rates and revenue pooling
on behalf of small local exchange carriers who elect to participate in a pooling
environment. Interstate settlements for cost-based companies are determined
based on the various subsidiaries' cost of providing interstate
telecommunications service. Interactive recognizes interstate access revenue as
services are provided based on an estimate of the current year cost of providing
service. Estimated revenue is adjusted to actual upon the completion of cost
24
studies in the subsequent period. In addition, an accounting estimate is
required of the potential liability that may be required for NECA pool
over-earnings.
Interactive's business development strategy is to expand its existing operations
through internal growth and acquisition. From 1989 through 2001, the Company has
acquired fourteen telephone companies. Significant judgments and estimates are
required to allocate the purchase price of acquisitions to the fair value of
tangible assets acquired and identifiable intangible assets and liabilities
assumed. Any excess purchase price over the above fair values is allocated to
goodwill. Additional judgments and estimates are required to determine if
identified intangible assets have finite or indefinite lives.
Annually, the Company tests goodwill and other intangible assets with indefinite
lives for impairment. The Company screens for potential impairment by
determining fair value for each reporting unit. We estimate the fair value of
each reporting unit based on a number of subjective factors, including: (a)
appropriate weighting of valuation approaches (income approach, market approach
and comparable public company approach), (b) estimates of our future cost
structure, (c) discount rates for our estimated cash flows, (d) selection of
peer group companies for the public company approach, (e) required level of
working capital, (f) assumed terminal value and (g) time horizon of cash flow
forecasts.
We consider the estimate of fair value to be a critical accounting estimate
because (a) a potential goodwill impairment could have a material impact on our
financial position and results of operations and (b) the estimate is based on a
number of highly subjective judgments and assumptions, the most critical of
which is that the regulatory environment will continue in its current form.
Interactive tests its investments and other long-term non-regulated assets
annually whenever events or changes in circumstances indicate that the carrying
value of such assets may not be recoverable. Significant judgment is required to
determine if an impairment has occurred and whether such impairment is "other
than temporary."
The calculation of depreciation and amortization expense is based on the
estimated economic useful lives of the underlying property, plant and equipment
and intangible assets. Although Interactive believes it is unlikely that any
significant changes to the useful lives of its tangible or intangible assets
will occur in the near term, rapid changes in technology, the discontinuance of
accounting under SFAS No. 71 by the Company's wireline subsidiaries, or changes
in market conditions could result in revisions to such estimates that could
materially affect the carrying value of these assets and the Company's future
consolidated operating results.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In June 2004, the Emerging Issues Task Force ("EITF") issued EITF No. 03-01,
"The Meaning Of Other-Than-Temporary Impairment And Its Application To Certain
Investments". EITF 03-01 includes new guidance for evaluating and recording
impairment losses on debt and equity investments, as well as new disclosure
requirements for investments that are deemed to be temporarily impaired. The
provisions of EITF 03-01 were initially effective for reporting periods
beginning after June 15, 2004, while the disclosure requirements for debt and
equity securities accounted for under SFAS 115, "Accounting For Certain
Investments In Debt And Equity Securities", are effective for annual periods
ending after December 15, 2003. In September 2004, the FASB delayed the
effective date for the measurement and recognition guidance of EITF 03-01. The
Company will evaluate the effect of adopting the recognition and measurement
guidance when the final consensus is reached.
In May 2005, the FASB issued SFAS 154, "Accounting Changes and Error
Corrections". SFAS 154 eliminates the requirement in APB Opinion No. 20,
"Accounting Changes", to include the cumulative effect of changes in accounting
principle in the income statement in the period of change. Instead, to enhance
the comparability of prior period financial statements, SFAS 154 requires that
changes in accounting principle be retrospectively applied. Under the
retrospective application, the new accounting principle is applied as of the
beginning of the first period presented as if that principle had always been
used. Adoption of SFAS 154 is required for accounting changes and corrections of
errors made in the fiscal year beginning after December 15, 2005.
In December 2004, the FASB issued SFAS No.153, "Exchanges of Nonmonetary
Assets", which eliminates the exception for nonmonetary exchanges of similar
productive assets and replaces it with a general exception for exchanges of
nonmonetary assets that do not have commercial substance. SFAS No.153 will be
effective for nonmonetary asset exchanges occurring in fiscal periods beginning
after June 15, 2005. The Company does not believe the adoption of SFAS No.153
will have a material impact on its consolidated financial statements.
25
In December 2004, the FASB issued SFAS No.123(R), "Share-Based Payment", which
establishes standards for transactions in which an entity exchanges its equity
instruments for goods or services. This standard requires a public entity to
measure the cost of employee services received in exchange for an award of
equity instruments based on the grant-date fair value of the award. This
eliminates the exception to account for such awards using the intrinsic method
previously allowable under APB Opinion No.25. SFAS No.123(R) will be effective
in the first quarter of 2006. The Company does not believe that the adoption of
SFAS No.123(R) will have a material impact on its consolidated financial
statements.
In March 2005, the FASB issued Interpretation No. 47, "Accounting for
Conditional Asset Retirement Obligations" ("FIN 47"), which clarifies that
conditional asset retirement obligations are within the scope of SFAS No. 143,
"Accounting for Asset Retirement Obligations." FIN 47 requires the Company to
recognize a liability for the fair value of conditional asset retirement
obligations if the fair value of the liability can be reasonably estimated. The
Company does not believe that the adoption of FIN 47 will have a material impact
on its financial statements.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
The Company is exposed to market risks relating to changes in the general level
of U.S. interest rates. Changes in interest rates affect the amount of interest
earned on the Company's cash equivalents and short-term investments
(approximately $27.7 million at June 30, 2005 and $27.2 million at December 31,
2004). The majority of the Company's debt is fixed rate and the Company
generally finances the acquisition of long-term assets by borrowing on a fixed
long-term basis. The Company does not use derivative financial instruments for
trading or speculative purposes. Management does not foresee any significant
changes in the strategies used to manage interest rate risk in the near future,
although the strategies may be reevaluated as market conditions dictate. As of
June 30, 2005, the fair value of debt was approximately equal to its carrying
value.
At June 30, 2005 and December 31, 2004, approximately $69.6 million and $67.2
million, respectively, or 40% and 39% of Interactive's long-term debt and notes
payable bears interest at variable rates. Accordingly, the Company's earnings
and cash flows are affected by changes in interest rates. Assuming the current
level of borrowings for variable rate debt and assuming a one percentage point
change in the 2005 average interest rate under these borrowings, it is estimated
that Interactive's interest expense in the six months of 2005 would have changed
by approximately $0.3 million. In the event of an adverse change in interest
rates, management would likely take actions to further mitigate its exposure.
However, due to the uncertainty of the actions that would be taken and their
possible effects, no such actions are assumed. As of June 30, 2005, if the
Company were to convert a significant portion of its variable interest rate debt
into fixed interest rates, such conversion could have increased interest expense
for the six month period by $0.9 million assuming that variable rates remain
constant. Further, such analysis does not consider the effects of the change in
the level of overall economic activity that could exist in such an environment.
ITEM 4. CONTROLS AND PROCEDURES
Our Chief Executive Officer and Chief Financial Officer have evaluated the
effectiveness of the Company's disclosure controls and procedures (as defined in
Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934 (the
"Act")) as of the end of the period covered by this report. Based on that
evaluation, the Chief Executive Officer and Chief Financial Officer have
concluded that the Company's disclosure controls and procedures as of the end of
the period covered by this report were designed and were functioning effectively
to provide reasonable assurance that the information required to be disclosed by
the Company in reports filed under the Act is recorded, processed, summarized
and reported within the time periods specified in the SEC's rules and forms. The
Company believes that a controls system, no matter how well designed and
operated, cannot provide absolute assurance that the objectives of the controls
system are met, and no evaluation of controls can provide absolute assurance
that all control issues and instances of fraud, if any, within a company have
been detected.
26
During the period covered by this report, there have been no changes in our
internal control over financial reporting that have materially affected, or is
reasonably likely to materially affect, our financial statements.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
TAYLOR LITIGATION.
Interactive and several other parties, including Interactive's CEO, and Fortunet
Communications, L.P., which was Sunshine PCS Corporation's
predecessor-in-interest, have been named as defendants in a lawsuit originally
brought by Taylor under the so-called qui tam provisions of the federal False
Claims Act in the United States District Court for the District of Columbia. The
complaint was filed under seal with the court in February 2001. At the
initiative of one of the defendants, the seal was lifted in January 2002. Under
the False Claims Act, a private plaintiff called a relator may file a civil
action on the U.S. government's behalf against another party for violation of
the statute. In return, the relator receives a statutory bounty from the
government's litigation proceeds if he is successful.
The main allegation in the case is that the defendants participated in the
creation of "sham" bidding entities that allegedly defrauded the federal
Treasury by improperly participating in certain FCC spectrum auctions restricted
to small businesses, as well as obtaining bidding credits in other spectrum
auctions allocated to "small" and "very small" businesses. While the complaint
seeks to recover an unspecified amount of damages, which would be subject to
mandatory trebling under the statute, a report prepared for the relator in
February 2005 alleges damages of approximately $91 million in respect of bidding
credits, approximately $70 million in respect of government loans and
approximately $206 million in respect of subsequent sales of licenses, in each
case prior to trebling.
Interactive strongly believes that this lawsuit is completely without merit and
that relator's damage computations are without basis, and intends to defend the
suit vigorously. The U.S. Department of Justice has notified the court that it
has declined to intervene in the case. Nevertheless, we cannot predict the
ultimate outcome of the litigation, nor can we predict the effect that the
lawsuit or its outcome will have on our business or plan of operation.
Interactive does not have any insurance to cover its cost of defending this
lawsuit, which costs will be material. Interactive does have a directors and
officers liability policy but the insurer has reserved its rights under the
policy and, as a result, any coverage to be provided to any director or officer
of Interactive in connection with a judgment rendered in this action is unclear
at this time.
Interactive was formally served with the complaint in July 2002. In September
2002, the defendants filed two motions with the United States District Court for
the District of Columbia: a motion to dismiss the lawsuit and a motion to
transfer the action to the Southern District of New York. In September 2003, the
Court granted our motion to transfer the action. A scheduling conference was
held in February 2004, at which time the judge approved a scheduling order and
discovery commenced. In July 2004, the judge denied in part and granted in part
our motion to dismiss. Interactive and its subsidiaries remain parties to the
litigation.
In December 2004, the defendants filed a motion in the United States District
Court for the District of Columbia to compel the FCC to provide certain
information subpoenaed by defendants in order to enable them to conduct their
defense. This motion was denied in May 2005 and defendants are considering
appropriate responses. Discovery is substantially complete and the preparation
and filing of dispositive motions has begun. See "History of Lynch's "C" Block
Activities" below.
HISTORY OF LYNCH'S "C" BLOCK ACTIVITIES.
As part of the Omnibus Budget Resolution of 1993, Congress authorized the FCC to
employ competitive bidding procedures to select among mutually exclusive
applicants for certain spectrum licenses. Initially the FCC had an initiative to
include, among others, African Americans, Native Americans, Asian Americans and
27
women. As a result of this, the FCC conducted auctions beginning in 1995 to
allocate spectrum in a competitive manner. Interactive was a participating
investor and/or service provider to various entities in this "C-Block" auction.
By December 18, 1995, Interactive (through its predecessor Lynch Corporation)
had investments in five entities that participated in the FCC auction for
broadband PCS "C" block spectrum (Auction 5). When the auction closed, on May 6,
1996, these five entities, on a combined basis, were the higher bidders for
thirty-one 30 MHz licenses at a gross cost of $288.2 million. These entities
were initially put together under the FCC's initiative to include, among others,
women, African Americans, Native Americans and Asian Americans. As a result of
changes in these initiatives, these same individuals were qualified as small
businesses and remained eligible as bidders. These entities received $72 million
of bidding credits, and accordingly the net cost was $216.2 million. The federal
government provided financing for 90% of the cost of these licenses, or $194.6
million. Interactive's investments in these entities totaled $21 million.
Events during and subsequent to Auction 5, made financing these licenses through
the capital markets much more difficult than originally anticipated. On April
18, 1997, among other reasons, in order to obtain some economies of scale, such
as financing, the five entities merged into Fortunet Communications, Inc. The
FCC, in partial response to actions by Nextwave and others, promoted a plan for
refinancing the "C" block licenses. In 1997, many of the license holders from
Auction 5, including Fortunet, petitioned the FCC for relief in order to afford
these small businesses the opportunity to more realistically restructure and
build out their systems. The President of Fortunet, Karen Johnson, participated
in an FCC sponsored forum on this issue on June 30, 1997. The response from the
FCC, which was announced on September 26, 1997 and modified on March 24, 1998,
afforded license holders four options. One of these options was the resumption
of current debt payments, which had been suspended earlier in 1997 for all such
license holders. Another option, amnesty, was to return all licenses and forgo
any amounts deposited in exchange for forgiveness of the FCC debt. Other options
included: disaggregation, splitting a 30 MHz license into two 15 MHz licenses
and forgoing 50% of the amount deposited; and prepayment, return of certain
licenses and utilizing 70% of the amount deposited to acquire other licenses,
with the other 30% of the deposits to be forfeited.
On June 8, 1998, Fortunet elected to apply its eligible credits relating to its
original down payment to the purchase of three licenses for 15 MHz of PCS
spectrum in Tallahassee, Panama City and Ocala, Florida. Consistent with an FCC
promulgated disaggregation alternative, Fortunet surrendered all the remaining
licenses and forfeited 30% of its original down payment in full satisfaction of
its government obligations, including forgiveness of all accrued interest.
Accordingly, Fortunet retained 15 MHz of spectrum in the three Florida markets
covering a population of approximately 962,000 at a net auction cost of $15.8
million. As a result of this FCC process, disaggregation resulted in a reduction
of the bidding credits to $5.3 million. Fortunet also lost $6.0 million of its
down payment. As a result of this decision, during 1997, Interactive recorded a
$7.0 million write down of its investment in Fortunet. A lawyer who worked on
many applications for FCC licenses, Taylor (the relator in this case) is
doubtless aware of the details of these FCC initiated alternatives for the "C"
Block, as presumably are his law firms.
On April 15, 1999, the FCC completed a reauction of all the C-Block licenses
that were surrendered, including the 15 MHz of spectrum that Fortunet returned
to the FCC on June 8, 1998 in respect of the Tallahassee, Panama City and Ocala,
Florida markets. In that reauction, the successful bidders paid a total of $2.7
million for those three 15 MHz licenses returned by Fortunet versus the $15.8
million paid by Fortunet. As a result of this auction, Interactive recorded a
further write down of its investment of $15.4 million, including capitalized
costs, to reflect the amount bid for the similar licenses in the reauction.
In February 2000, Fortunet merged with Sunshine PCS Corporation, which by way of
a spin-off from Lynch Interactive became a public company. It traded under the
symbol SUNPA.
On December 31, 2003, Sunshine, after appropriate corporate and regulatory
steps, sold its three 15 MHz licenses to Cingular Wireless for $13.75 million.
Interactive received $7.6 million as part of the sale transaction versus its
cash investment of $21.9 million initially invested in the original five
entities in 1992.
28
OTHER LITIGATION.
In addition to the litigation described above, Interactive is a party to routine
litigation incidental to its business. Based on information currently available,
Interactive believes that none of this ordinary routine litigation, either
individually or in the aggregate, will have a material effect on its financial
condition and results of operations.
ITEM 2. ISSUER PURCHASES OF EQUITY SECURITIES
MAXIMUM NUMBER
OF (OR APPROXIMATE
TOTAL NUMBER OF DOLLAR VALUE) OF
TOTAL NUMBER SHARES PURCHASED SHARES THAT MAY YET
OF SHARES (OR AVERAGE PRICE AS PART OF PUBLICLY BE PURCHASED UNDER
UNITS) PAID PER SHARE ANNOUNCED PLANS THE PLANS OR
PERIOD PURCHASED (OR UNIT) OR PROGRAMS(1) PROGRAMS(1)
------ --------- --------- -------------- -----------
4/1/05 to 4/30/05 -- -- -- 27,300
5/1/05 to 5/31/05 -- -- -- 27,300
6/1/05 to 6/30/05 -- -- -- 27,300
------------------------------------------------------
Total -- -- --
======================================================
(1) In September 1999, the Board of Interactive approved a stock
repurchase program providing for the purchase of up to 100,000
shares of Common Stock in such manner, at such times and at such
prices as the Chief Executive Officer or his designee determines.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
Exhibit 31.1 - Chief Executive Officer Section 302
Certification.
Exhibit 31.2 - Chief Financial Officer Section 302
Certification.
Exhibit 32.1 - Chief Executive Officer Section 906
Certification.
Exhibit 32.2 - Chief Financial Officer Section 906
Certification.
(b) Reports on Form 8-K during the quarter reported on: - Current
Report on Form 8-K filed April 4, 2005, under Items
7 and 12 reporting the issuance of a press release regarding
the Company's operating results for the quarter and year
ended December 31, 2004.
- Current Report on Form 8-K filed May 16, 2005, under Items 7
and 12 reporting the issuance of a press release regarding
the company's first quarter 2005 operating results.
- Current Report on Form 8-K filed June 15, 2005 under Item 1
and Item 9 reporting on the closing of the Company's three
year $10 million revolving credit line with Webster Bank,
N.A.
29
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934,
the Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
LYNCH INTERACTIVE CORPORATION
(Registrant)
/s/ Robert E. Dolan
-------------------
Robert E. Dolan
Chief Financial Officer
August 15, 2005
30