TELEPHONE & DATA SYSTEMS INC quarterly report, Q3 FY2011

Business Context and Reporting Period

Telephone and Data Systems, Inc. (TDS) filed an unaudited Form 10-Q for the quarter and nine months ended September 30, 2011. TDS operates primarily through 84%-owned U.S. Cellular, which provides wireless services, and wholly owned TDS Telecom, which provides ILEC and CLEC wireline, broadband, video, hosted and managed services. TDS served approximately 5.9 million wireless customers and 1.1 million wireline equivalent access lines at quarter-end.

Financial Performance and Position

Metric	Q3 2011	Q3 2010	Nine months 2011	Nine months 2010
Operating revenues	$1.325 billion	$1.266 billion	$3.864 billion	$3.721 billion
Operating income	$126.9 million	$84.7 million	$343.2 million	$276.1 million
Net income	$88.2 million	$53.5 million	$252.3 million	$170.1 million
Net income available to common shareholders	$71.3 million	$41.4 million	$206.7 million	$131.7 million
Diluted EPS	$0.68	$0.39	$1.98	$1.24
Adjusted OIBDA	$307.6 million	$276.5 million	$912.1 million	$851.2 million

Consolidated operating revenue increased 5% in the quarter and 4% year to date. Operating income increased 50% in the quarter and 24% year to date. Approximate operating margins were 9.6% versus 6.7% in Q3 2010 and 8.9% versus 7.4% for the nine-month periods. Net income attributable to common shareholders increased 72% in the quarter and 57% year to date.

U.S. Cellular nine-month revenue increased 4% to $3.244 billion and operating income increased 29% to $264.5 million. Service revenue increased 4%, led by 37% growth in inbound roaming revenue and 17% growth in other revenue. Equipment revenue increased 14%.
TDS Telecom nine-month revenue increased 2% to $608.6 million and operating income increased 11% to $83.3 million. Growth in hosted and managed services, data customers and the OneNeck acquisition offset declines in voice, physical access lines and CLEC revenue.
Nine-month cash flow from operating activities was $973.3 million, compared with $764.8 million in 2010. Capital expenditures were $643.4 million, compared with $486.1 million, producing reported free cash flow of $329.9 million versus $278.6 million.
Cash and cash equivalents were $599.5 million at September 30, 2011, compared with $368.1 million at December 31, 2010. Short-term and long-term investments totaled approximately $335.5 million.
Total assets were $8.163 billion and total equity was $4.629 billion at September 30, 2011. Current liabilities were $868.7 million; long-term debt was $1.528 billion and the current portion of long-term debt was $3.6 million.
TDS and U.S. Cellular had aggregate revolving credit capacity of $700 million, with no borrowings outstanding and approximately $699.6 million available after letters of credit.

Material Changes Versus the Prior Comparable Period

Wireless customer trends weakened: U.S. Cellular reported 112,000 net retail customer losses in the first nine months of 2011 versus 6,000 net additions in 2010. Total customers declined to 5.932 million from 6.103 million, although postpaid churn improved to 1.4% from 1.5%.
Wireless smartphone penetration increased to 26.2% from 12.1%, and smartphones represented 40.6% of devices sold versus 18.8%. Higher data usage and roaming supported revenue growth but increased network and equipment costs.
TDS Telecom equivalent access lines declined 2% to 1.085 million. ILEC data revenue increased 30% year to date, while ILEC voice revenue decreased 5% and CLEC revenue decreased 4%.
Capital expenditures increased 32% year to date, primarily for wireless network expansion, capacity, LTE deployment and systems development.
TDS issued $300 million of 7% senior notes and redeemed its $282.5 million of 7.6% Series A notes. U.S. Cellular issued $342 million of 6.95% senior notes and redeemed its $330 million of 7.5% senior notes. The weighted-average interest rate on long-term debt declined to 6.8% from 7.1% at December 31, 2010.
Equity in earnings of unconsolidated entities declined 15% to $64.0 million year to date, while interest expense increased 9% to $94.2 million, partly because $15.4 million of previously capitalized debt issuance costs were expensed upon debt redemptions.

Guidance, Outlook, Risks and Unusual Items

U.S. Cellular maintained its 2011 service revenue estimate of $4.0 billion to $4.1 billion, depreciation, amortization and accretion plus asset disposal expense of approximately $590 million, and capital expenditure estimate of $750 million to $800 million. It raised estimated operating income to $230 million to $305 million from $210 million to $285 million and adjusted OIBDA to $820 million to $895 million from $800 million to $875 million.

TDS Telecom maintained 2011 ILEC/CLEC revenue guidance of $800 million to $830 million, operating income of $85 million to $115 million, adjusted OIBDA of $270 million to $300 million and capital expenditures of $175 million to $200 million. The capital expenditure estimate excludes $105.1 million of broadband stimulus grants.

Significant transactions included the $95.9 million OneNeck acquisition, acquisition of 63% of Airadigm, purchase of a previously noncontrolling wireless interest, and an exchange of spectrum licenses. The transactions generated a $26.1 million year-to-date gain on investment and a $4.97 million net gain on asset disposals and exchanges.
A U.S. Cellular business acquired in May was classified as held for sale, with $60.8 million of assets and $0.9 million of liabilities classified accordingly.
A triggering event from deteriorating macroeconomic and financial-market conditions and a sustained decrease in TDS's stock price required interim impairment testing. No goodwill or license impairment was recorded, but $945.1 million of licenses were in units whose fair value exceeded carrying value by less than 10%.
U.S. Cellular's B/OSS project is expected to continue through 2013, with estimated Amdocs payments of approximately $122 million; $22.8 million had been paid by September 30, 2011.
TDS disclosed a revision of prior-period amounts for immaterial asset-retirement-obligation and other errors. The company concluded amendments were not required, but the cumulative revisions increased December 31, 2010 retained earnings by $4.0 million.
Risks include intense wireless and wireline competition, customer losses, device subsidies, dependence on roaming and universal-service funding, FCC regulatory changes, LTE and systems implementation risks, potential impairment of licenses and goodwill, economic weakness, supply-chain disruption and access to capital.
TDS had accrued $4.4 million for legal proceedings and unasserted claims at September 30, 2011. The company stated that possible excess losses were not expected to be material, but ultimate outcomes could differ from accrued amounts.
The FCC adopted the Connect America Fund and intercarrier compensation reform order after quarter-end, and TDS received an FCC Office of Inspector General subpoena requesting information regarding federal universal-service support. The ultimate impact was not determinable.

Most Important Facts to Verify

Whether U.S. Cellular can reverse customer losses while sustaining smartphone, data and roaming revenue growth.
Actual full-year operating income, adjusted OIBDA and capital expenditures relative to the segment guidance ranges.
Cash generation after substantially higher wireless and wireline capital expenditures and the remaining B/OSS commitments.
Future impairment sensitivity for the license portfolio, particularly the $945.1 million of licenses with less than 10% fair-value cushion.
The financial and operational consequences of FCC universal-service and intercarrier-compensation reforms and the FCC subpoena.
Final effects of the Airadigm acquisition, the business classified as held for sale, the OneNeck integration and pending charter amendments.
Whether the disclosed prior-period accounting revisions or other control and reporting matters require further adjustment; management reported disclosure controls were effective as of September 30, 2011.