UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

x                              QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended March 31, 2007

 

OR

 

o                                 TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                                                    to                                                  

 

Commission File Number 001-14157

 

TELEPHONE AND DATA SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

Delaware

36-2669023

(State or other jurisdiction of incorporation or organization)

(I.R.S. Employer Identification No.)

 

 

30 North LaSalle Street, Chicago, Illinois 60602

(Address of principal executive offices) (Zip Code)

 

Registrant’s telephone number, including area code: (312) 630-1900

 

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   o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer   x

Accelerated filer   o

Non-accelerated filer   o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes   o      No   x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Class

 

Outstanding at April 30, 2007

Common Shares, $.01 par value

 

51,937,620 Shares

Special Common Shares, $.01 par value

 

58,402,073 Shares

Series A Common Shares, $.01 par value

 

6,444,364 Shares

 

 




Telephone and Data Systems, Inc. and Subsidiaries

Quarterly Report on Form 10-Q
For the Period Ended March 31, 2007

Index

 

 

 

 

 

Page No.

 

 

 

 

 

 

 

 

 

Part I.

 

Financial Information

 

 

 

 

 

 

 

 

 

 

 

 

 

Item 1.

 

Financial Statements (Unaudited)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Consolidated Statements of Operations Three Months Ended March 31, 2007 and 2006

 

3

 

 

 

 

 

 

 

 

 

 

 

 

 

Consolidated Statements of Cash Flows Three Months Ended March 31, 2007 and 2006

 

4

 

 

 

 

 

 

 

 

 

 

 

 

 

Consolidated Balance Sheets March 31, 2007 and December 31, 2006

 

5

 

 

 

 

 

 

 

 

 

 

 

 

 

Notes to Consolidated Financial Statements

 

7

 

 

 

 

 

 

 

 

 

 

 

Item 2.

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

24

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended March 31, 2007 and 2006

 

 

 

 

 

 

 

U.S. Cellular Operations

 

28

 

 

 

 

 

TDS Telecom Operations

 

36

 

 

 

 

 

Recent Accounting Pronouncements

 

39

 

 

 

 

 

Financial Resources

 

39

 

 

 

 

 

Liquidity and Capital Resources

 

41

 

 

 

 

 

Application of Critical Accounting Policies and Estimates

 

47

 

 

 

 

 

Certain Relationships and Related Transactions

 

48

 

 

 

 

 

Safe Harbor Cautionary Statement

 

49

 

 

 

 

 

 

 

 

 

 

 

Item 3.

 

Quantitative and Qualitative Disclosures About Market Risk

 

51

 

 

 

 

 

 

 

 

 

 

 

Item 4.

 

Controls and Procedures

 

53

 

 

 

 

 

 

 

 

 

Part II.

 

Other Information

 

 

 

 

 

 

 

 

 

 

 

 

 

Item 1.

 

Legal Proceedings

 

56

 

 

 

 

 

 

 

 

 

 

 

Item 1A.

 

Risk Factors

 

56

 

 

 

 

 

 

 

 

 

 

 

Item 2.

 

Unregistered Sales of Equity Securities and Use of Proceeds

 

56

 

 

 

 

 

 

 

 

 

 

 

Item 5.

 

Other Information

 

57

 

 

 

 

 

 

 

 

 

 

 

Item 6.

 

Exhibits

 

58

 

 

 

 

 

 

 

 

 

Signatures

 

 

 

 




Part I. Financial Information

Item 1. Financial Statements

Telephone and Data Systems, Inc. and Subsidiaries

Consolidated Statements of Operations

Unaudited

 

 

Three Months Ended
March 31,

 

 

 

2007

 

2006

 

 

 

(Dollars in thousands,
except per share amounts)

 

 

 

 

 

 

 

Operating Revenues

 

$

1,156,557

 

$

1,059,077

 

 

 

 

 

 

 

Operating Expenses

 

 

 

 

 

Cost of services and products (exclusive of depreciation, amortization and accretion expense shown below)

 

405,968

 

376,306

 

Selling, general and administrative expense

 

416,482

 

392,621

 

Depreciation, amortization and accretion expense

 

191,310

 

182,966

 

Total Operating Expenses

 

1,013,760

 

951,893

 

 

 

 

 

 

 

Operating Income

 

142,797

 

107,184

 

 

 

 

 

 

 

Investment and Other Income (Expense)

 

 

 

 

 

Equity in earnings of unconsolidated entities

 

23,696

 

19,805

 

Interest and dividend income

 

16,196

 

11,483

 

Interest expense

 

(57,801

)

(58,532

)

Fair value adjustment of derivative instruments

 

255,870

 

30

 

Other expense

 

(2,224

)

(927

)

Total Investment and Other Income (Expense)

 

235,737

 

(28,141

)

 

 

 

 

 

 

Income Before Income Taxes and Minority Interest

 

378,534

 

79,043

 

Income tax expense

 

141,238

 

32,342

 

Income Before Minority Interest

 

237,296

 

46,701

 

Minority share of income

 

(17,971

)

(10,704

)

Net Income

 

219,325

 

35,997

 

Preferred dividend requirement

 

(13

)

(51

)

Net Income Available To Common

 

$

219,312

 

$

35,946

 

 

 

 

 

 

 

Basic Weighted Average Shares Outstanding (000s)

 

116,837

 

115,741

 

Basic Earnings Per Share (Note 6)

 

$

1.88

 

$

0.31

 

 

 

 

 

 

 

Diluted Weighted Average Shares Outstanding (000s)

 

118,383

 

116,327

 

Diluted Earnings Per Share (Note 6)

 

$

1.85

 

$

0.31

 

 

 

 

 

 

 

Dividends Per Share

 

$

0.0975

 

$

0.0925

 

 

The accompanying notes are an integral part of these consolidated financial statements.

3




Telephone and Data Systems, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

Unaudited

 

 

Three Months Ended
March 31,

 

 

 

2007

 

2006

 

 

 

(Dollars in thousands)

 

Cash Flows from Operating Activities

 

 

 

 

 

Net income

 

$

219,325

 

$

35,997

 

Add (Deduct) adjustments to reconcile net income to net cash provided by operating activities

 

 

 

 

 

Depreciation, amortization and accretion

 

191,310

 

182,966

 

Bad debts expense

 

12,255

 

9,075

 

Stock-based compensation expense

 

4,651

 

8,638

 

Fair value adjustment of derivative instruments

 

(255,870

)

(30

)

Deferred income taxes

 

81,841

 

(15,228

)

Equity earnings of unconsolidated entities

 

(23,696

)

(19,805

)

Distributions from unconsolidated entities

 

2,321

 

5,676

 

Minority share of income

 

17,971

 

10,704

 

Noncash interest expense

 

5,378

 

5,480

 

Other noncash expense

 

336

 

1,504

 

Changes in assets and liabilities

 

 

 

 

 

Change in accounts receivable

 

20,262

 

9,164

 

Change in materials and supplies

 

15,698

 

7,546

 

Change in accounts payable

 

(27,048

)

(53,405

)

Change in customer deposits and deferred revenues

 

12,648

 

5,209

 

Change in accrued taxes

 

54,241

 

47,703

 

Change in accrued interest

 

5,403

 

4,567

 

Change in other assets and liabilities

 

(49,901

)

(32,525

)

 

 

287,125

 

213,236

 

 

 

 

 

 

 

Cash Flows from Investing Activities

 

 

 

 

 

Additions to property, plant and equipment

 

(130,966

)

(143,776

)

Cash paid for acquisitions

 

(18,237

)

 

Cash received from divestitures

 

279

 

 

Other investing activities

 

2,246

 

(1,467

)

 

 

(146,678

)

(145,243

)

 

 

 

 

 

 

Cash Flows from Financing Activities

 

 

 

 

 

Issuance of notes payable

 

25,000

 

55,000

 

Issuance of long-term debt

 

454

 

560

 

Repayment of notes payable

 

 

(105,000

)

Repayment of long-term debt

 

(848

)

(748

)

Repayment of medium-term notes

 

 

(35,000

)

TDS Common Shares and Special Common Shares issued for benefit plans

 

7,040

 

3,080

 

U.S. Cellular Common Shares issued for benefit plans

 

5,558

 

3,858

 

Distributions to minority partners

 

(2,519

)

(4,146

)

Dividends paid

 

(11,399

)

(10,749

)

Other financing activities

 

(655

)

1,207

 

 

 

22,631

 

(91,938

)

 

 

 

 

 

 

Net Increase (Decrease) in Cash and Cash Equivalents

 

163,078

 

(23,945

)

 

 

 

 

 

 

Cash and Cash Equivalents -

 

 

 

 

 

Beginning of period

 

1,013,325

 

1,095,791

 

End of period

 

$

1,176,403

 

$

1,071,846

 

 

The accompanying notes are an integral part of these consolidated financial statements.

4




Telephone and Data Systems, Inc. and Subsidiaries

Consolidated Balance Sheets

Assets

Unaudited

 

 

March 31,
2007

 

December 31,
2006

 

 

 

(Dollars in thousands)

 

Current Assets

 

 

 

 

 

Cash and cash equivalents

 

$

1,176,403

 

$

1,013,325

 

Accounts receivable

 

 

 

 

 

Due from customers, less allowance of $12,932 and $15,807, respectively

 

341,331

 

357,279

 

Other, principally connecting companies, less allowance of $8,332 and $9,576, respectively

 

146,418

 

162,888

 

Marketable equity securities

 

1,611,464

 

1,205,344

 

Inventory

 

113,477

 

128,981

 

Prepaid expenses

 

53,937

 

43,529

 

Other current assets

 

21,071

 

61,738

 

 

 

3,464,101

 

2,973,084

 

 

 

 

 

 

 

Investments

 

 

 

 

 

Marketable equity securities

 

933,791

 

1,585,286

 

Licenses

 

1,528,307

 

1,520,407

 

Goodwill

 

653,671

 

647,853

 

Customer lists, net of accumulated amortization of $71,883 and $68,110, respectively

 

23,983

 

26,196

 

Investments in unconsolidated entities

 

218,874

 

197,636

 

Other investments, less valuation allowance of $55,144 in both periods

 

10,928

 

11,073

 

 

 

3,369,554

 

3,988,451

 

 

 

 

 

 

 

Property, Plant and Equipment

 

 

 

 

 

In service and under construction

 

7,786,558

 

7,700,746

 

Less accumulated depreciation

 

4,254,252

 

4,119,360

 

 

 

3,532,306

 

3,581,386

 

 

 

 

 

 

 

Other Assets and Deferred Charges

 

53,978

 

56,593

 

 

 

$

10,419,939

 

$

10,599,514

 

 

The accompanying notes are an integral part of these consolidated financial statements.

5




Telephone and Data Systems, Inc. and Subsidiaries

Consolidated Balance Sheets

Liabilities and Stockholders’ Equity

Unaudited

 

 

March 31,
2007

 

December 31,
2006

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

Current Liabilities

 

 

 

 

 

Current portion of long-term debt

 

$

2,967

 

$

2,917

 

Forward contracts

 

1,079,627

 

738,408

 

Notes payable

 

60,000

 

35,000

 

Accounts payable

 

267,883

 

294,932

 

Customer deposits and deferred revenues

 

153,979

 

141,164

 

Accrued interest

 

32,132

 

26,729

 

Accrued taxes

 

46,937

 

38,324

 

Accrued compensation

 

48,951

 

72,804

 

Derivative liability

 

358,193

 

359,970

 

Deferred income tax liability

 

345,548

 

236,397

 

Other current liabilities

 

125,710

 

138,086

 

 

 

2,521,927

 

2,084,731

 

 

 

 

 

 

 

Deferred Liabilities and Credits

 

 

 

 

 

Net deferred income tax liability

 

811,127

 

950,348

 

Derivative liability

 

142,209

 

393,776

 

Asset retirement obligation

 

237,171

 

232,312

 

Other deferred liabilities and credits

 

152,365

 

136,733

 

 

 

1,342,872

 

1,713,169

 

 

 

 

 

 

 

Long-Term Debt

 

 

 

 

 

Long-term debt, excluding current portion

 

1,632,977

 

1,633,308

 

Forward contracts

 

650,816

 

987,301

 

 

 

2,283,793

 

2,620,609

 

 

 

 

 

 

 

Commitment and Contingencies

 

 

 

 

 

 

 

 

 

 

 

Minority Interest in Subsidiaries

 

631,372

 

609,722

 

 

 

 

 

 

 

Preferred Shares

 

860

 

863

 

 

 

 

 

 

 

Common Stockholders’ Equity

 

 

 

 

 

Common Shares, par value $.01 per share; authorized 100,000,000 shares; issued 56,559,000 and 56,558,000 shares, respectively

 

566

 

566

 

Special Common Shares, par value $.01 per share; authorized 165,000,000 shares; issued 62,941,000 and 62,941,000 shares, respectively

 

629

 

629

 

Series A Common Shares, par value $.01 per share; authorized 25,000,000 shares; issued and outstanding 6,444,000 and 6,445,000 shares, respectively

 

64

 

64

 

Capital in excess of par value

 

1,993,730

 

1,992,597

 

Treasury Shares at cost:

 

 

 

 

 

Common Shares, 4,621,000 and 4,676,000 shares, respectively

 

(183,677

)

(187,103

)

Special Common Shares 4,539,000 and 4,676,000 shares, respectively

 

(179,118

)

(187,016

)

Accumulated other comprehensive income

 

386,748

 

522,113

 

Retained earnings

 

1,620,173

 

1,428,570

 

 

 

3,639,115

 

3,570,420

 

 

 

$

10,419,939

 

$

10,599,514

 

 

The accompanying notes are an integral part of these consolidated financial statements.

6




TELEPHONE AND DATA SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.               Basis of Presentation

The accounting policies of Telephone and Data Systems, Inc. (“TDS”) conform to accounting principles generally accepted in the United States of America (“U.S. GAAP”). The consolidated financial statements include the accounts of TDS and its majority-owned subsidiaries, including TDS’s 80.6%-owned wireless telephone subsidiary, United States Cellular Corporation (“U.S. Cellular”), TDS’s 100%-owned wireline telephone subsidiary, TDS Telecommunications Corporation (“TDS Telecom”) and TDS’s 80%-owned printing and distribution company, Suttle Straus, Inc. In addition, the consolidated financial statements include all entities in which TDS has a variable interest that requires TDS to absorb a majority of the entity’s expected gains or losses, or both. All material intercompany accounts and transactions have been eliminated. Certain prior year amounts have been reclassified to conform to the 2007 financial statement presentation.

The consolidated financial statements included herein have been prepared by TDS, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and note disclosures normally included in financial statements prepared in accordance with U.S. GAAP have been condensed or omitted pursuant to such rules and regulations. However, TDS believes that the disclosures included herein are adequate to make the information presented not misleading. It is suggested that these consolidated financial statements be read in conjunction with the consolidated financial statements and the notes thereto included in TDS’s Annual Report on Form 10-K for the year ended December 31, 2006 (“Form 10-K”).

The accompanying unaudited consolidated financial statements contain all adjustments (consisting of only normal recurring items unless otherwise disclosed) necessary to present fairly the financial position as of March 31, 2007, and the results of operations for the three months ended March 31, 2007 and 2006 and the cash flows for the three months ended March 31, 2007 and 2006. The results of operations for the three months ended March 31, 2007 are not necessarily indicative of the results to be expected for the full year.

2.               Summary of Significant Accounting Policies

Pension Plan

TDS sponsors a qualified noncontributory defined contribution pension plan. The plan provides benefits for the employees of TDS Corporate, TDS Telecom and U.S. Cellular. Under this plan, pension benefits and costs are calculated separately for each participant and are funded currently. Pension costs were $3.6 million and $3.5 million for the three months ended March 31, 2007 and March 31, 2006, respectively.

TDS also sponsors an unfunded non-qualified deferred supplemental executive retirement plan for certain employees which supplements the benefits under the qualified plan to offset the reduction of benefits caused by the limitation on annual employer contributions under the tax laws.

Other Postretirement Benefits

TDS sponsors two contributory defined benefit postretirement plans that cover most employees of TDS Corporate, TDS Telecom and the subsidiaries of TDS Telecom. One plan provides medical benefits and the other plan provides life insurance benefits.

7




Net periodic benefit costs for the defined benefit postretirement plans include the following components:

 

Three Months Ended
March 31,

 

 

 

2007

 

2006

 

 

 

(Dollars in thousands)

 

Service Cost

 

$

609

 

$

544

 

Interest on accumulated benefit obligation

 

858

 

692

 

Expected return on plan assets

 

(821

)

(648

)

Amortization of:

 

 

 

 

 

Prior service cost

 

(207

)

(208

)

Net loss

 

340

 

292

 

Net postretirement cost

 

$

779

 

$

672

 

 

TDS contributed $7.0 million to the postretirement plan assets during the second quarter of 2007.

Amounts Collected from Customers and Remitted to Governmental Authorities

The Financial Accounting Standards Board (“FASB”) Emerging Issues Task Force (“EITF”) Issue No. 06-3, How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation), requires disclosure of TDS’s policy related to the presentation of such items. TDS records amounts collected from customers and remitted to governmental authorities net within a tax liability account if the tax is assessed upon the customer and TDS merely acts as an agent in collecting the tax on behalf of the imposing governmental authority. If the tax is assessed upon TDS, then amounts collected from customers as recovery of the tax are recorded in revenues and amounts remitted to governmental authorities are recorded in expenses. The amounts recorded gross in revenues that are billed to customers and remitted to governmental authorities totaled $30.8 million and $21.5 million for the three months ended March 31, 2007 and 2006, respectively.

Recent Accounting Pronouncements

The FASB issued Interpretation 48, Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109 (“FIN 48”) in July 2006. See Note 5 — Income Taxes for information related to TDS’s adoption of FIN 48.

In September 2006, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 157, Fair Value Measurements (“SFAS 157”). This Statement defines fair value as used in numerous accounting pronouncements, establishes a framework for measuring fair value in generally accepted accounting principles (“GAAP”) and expands disclosure related to the use of fair value measures in financial statements. SFAS 157 does not expand the use of fair value measures in financial statements, but standardizes its definition and guidance in GAAP. The Statement emphasizes that fair value is a market-based measurement and not an entity-specific measurement, based on an exchange transaction in which the entity sells an asset or transfers a liability (exit price). SFAS 157 establishes a fair value hierarchy, from observable market data as the highest level to fair value based on an entity’s own fair value assumptions as the lowest level. The Statement is effective for TDS’s 2008 financial statements; however, earlier application is encouraged. TDS is currently reviewing the requirements of SFAS 157 and has not determined the impact, if any, on its financial position or results of operations.

In September 2006, FASB ratified Emerging Issues Task Force Issue No. 06-1, Accounting for Consideration Given by a Service Provider to Manufacturers or Resellers of Equipment Necessary for an End-Customer to Receive Service from the Service Provider (“EITF 06-1”). This guidance requires the application of EITF 01-9, Accounting for Consideration Given by a Vendor to a Customer (“EITF 01-9”), when consideration is given to a reseller or manufacturer for benefit to the service provider’s end customer. EITF 01-9 requires the consideration given be recorded as a liability at the time of the sale of the equipment and also provides guidance for the classification of the expense. EITF 06-1 is effective for TDS’s 2008 financial statements. TDS is currently reviewing the requirements of EITF 06-1 and has not yet determined the impact, if any, on its financial position or results of operations.

8




SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, Including an Amendment of FASB Statement No. 115 (“SFAS 159”), was issued in February 2007. SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value at specified election dates. Unrealized gains and losses on items for which the fair value option has been elected shall be reported in earnings at each subsequent reporting date. SFAS 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. SFAS 159 is effective for TDS’s 2008 financial statements. TDS is currently reviewing the requirements of SFAS 159 and has not yet determined the impact, if any, on its financial position or results of operations.

3.               Acquisitions, Divestitures and Exchanges

TDS assesses its existing wireless and wireline interests on an ongoing basis with a goal of improving competitiveness of its operations and maximizing its long-term return on investment. As part of this strategy, TDS reviews attractive opportunities to acquire additional operating markets, telecommunications companies and wireless spectrum. In addition, TDS may seek to divest outright or include in exchanges for other wireless interests those markets and wireless interests that are not strategic to its long-term success.

In the first quarter of 2007, U.S. Cellular received $0.3 million from escrow that was set up in the fourth quarter of 2006 in conjunction with the sale of Midwest Wireless Communications to ALLTEL Corporation. U.S. Cellular had owned an interest in Midwest Wireless Communications prior to the purchase by ALLTEL.

On February 1, 2007, U.S. Cellular purchased 100% of the membership interests of Iowa 15 Wireless, LLC (“Iowa 15”) and obtained the 25 megahertz Federal Communications Commission (“FCC’) cellular license to provide wireless service in Iowa Rural Service Area (“RSA”) 15 for approximately $18.2 million in cash, subject to a working capital adjustment. This acquisition increased investments in licenses, goodwill and customer lists by $7.9 million, $5.8 million and $1.6 million, respectively. The $5.8 million of goodwill is deductible for income tax purposes.

4.               Fair Value Adjustment of Derivative Instruments

Fair value adjustment of derivative instruments resulted in gains of $255.9 million in the first quarter of 2007 and $0.03 million in the first quarter of 2006. Fair value adjustment of derivative instruments reflects the change in the fair value of the bifurcated embedded collars within the forward contracts related to the Deutsche Telekom and Vodafone marketable equity securities not designated as a hedge. The accounting for the embedded collars as derivative instruments not designated as a hedge results in increased volatility in the results of operations, as fluctuation in the market price of the underlying Deutsche Telekom and Vodafone marketable equity securities results in changes in the fair value of the embedded collars being recorded in the Consolidated Statements of Operations. Also included in the fair value adjustment of derivative instruments are the gains and losses related to the ineffectiveness of the VeriSign fair value hedge which aggregated a $0.4 million gain in both the first quarter of 2007 and the first quarter of 2006.

5.               Income Taxes

The overall effective tax rate on income before income taxes and minority interest for the three months ended March 31, 2007 and 2006 was 37.3% and 40.9%, respectively. The effective tax rate for the 2007 period is lower than 2006 primarily due to the impact of state taxes.

Effective January 1, 2007, TDS adopted FIN 48. In accordance with FIN 48, TDS recognized a cumulative-effect adjustment of $4.4 million, decreasing its liability for unrecognized tax benefits, interest, and penalties and increasing the January 1, 2007 balance of Common Stockholders’ Equity.  Of this amount, $20.7 million increases accumulated other comprehensive income and $16.3 million is a cumulative reduction of beginning retained earnings.

At January 1, 2007, TDS had $28.4 million in unrecognized tax benefits. Approximately $20.1 million of the total amount of unrecognized tax benefits relates to tax benefits that would, if recognized in the financial statements, reduce TDS’s effective tax rate in future periods. Included in the balance of unrecognized tax benefits at January 1, 2007, is an immaterial amount related to tax positions for which it is possible that the total amounts could change during the next twelve months.

TDS recognizes accrued interest and penalties related to unrecognized tax benefits in income tax expense. This amount totaled $1.5 million for the quarter ended March 31, 2007. Accrued interest and penalties were $1.3 million and $2.8 million as of January 1, 2007 and March 31, 2007, respectively.

TDS and its subsidiaries file federal and state income tax returns. With few exceptions, TDS is no longer

9




subject to federal, state and local income tax examinations by tax authorities for years prior to 2002. In June of 2006, the IRS commenced its audit of TDS’s 2002 — 2004 consolidated federal income tax returns. After TDS filed its 2005 consolidated federal tax return in September 2006, the IRS added 2005 to the audit cycle. The audit of 2002 — 2005 is in its preliminary stages.

6.               Earnings per Share

Basic earnings per share is computed by dividing net income (loss) available to common by the weighted average number of common shares outstanding during the period. Diluted earnings per share is computed using net income available to common and weighted average common shares adjusted to include the effect of potentially dilutive securities. Potentially dilutive securities include incremental shares issuable upon exercise of outstanding stock options, the vesting of restricted stock units and the potential conversion of preferred stock to Common and Special Common shares.

The amounts used in computing earnings per share and the effect of potentially dilutive securities on income and the weighted average number of Common, Special Common and Series A Common Shares are as follows:

 

Three Months Ended
March 31,

 

 

 

2007

 

2006

 

 

 

(Dollars and shares in thousands,
except earnings per share)

 

Basic Earnings per Share:

 

 

 

 

 

Net income

 

$

219,325

 

$

35,997

 

Preferred dividend requirement

 

(13

)

(51

)

Net income available to common used in basic earnings per share

 

$

219,312

 

$

35,946

 

 

 

 

 

 

 

Diluted Earnings per Share:

 

 

 

 

 

Net income available to common used in basic earnings per share

 

$

219,312

 

$

35,946

 

Minority income adjustment (1)

 

(529

)

(211

)

Preferred dividend adjustment (2)

 

12

 

12

 

Net income available to common used in diluted earnings per share

 

$

218,795

 

$

35,747

 

 

 

 

 

 

 

Weighted average number of shares of common stock used in basic earnings per share:

 

 

 

 

 

Common Shares

 

51,975

 

51,471

 

Special Common Shares

 

58,417

 

57,823

 

Series A Common Shares

 

6,445

 

6,447

 

Weighted average number of shares of common stock used in basic earnings per share

 

116,837

 

115,741

 

Effects of Dilutive Securities:

 

 

 

 

 

Effects of stock options and restricted stock units (3)

 

1,502

 

532

 

Conversion of preferred shares (4)

 

44

 

54

 

Weighted average number of shares of common stock used in diluted earnings per share

 

118,383

 

116,327

 

 

 

 

 

 

 

Basic Earnings per Share

 

$

1.88

 

$

0.31

 

 

 

 

 

 

 

Diluted Earnings per Share

 

$

1.85

 

$

0.31

 


(1)             The minority income adjustment reflects the additional minority share of U.S. Cellular’s income computed as if all of U.S. Cellular’s issuable securities were outstanding.

(2)             The preferred dividend adjustment reflects the dividend reduction in the event any preferred series were dilutive, and therefore converted for shares.

(3)             Stock options convertible into 224,722 Common Shares and 224,722 Special Common Shares were not included in computing Diluted Earnings per Share in the three months ended March 31, 2007, because their effects were antidilutive. Stock options convertible into 1,294,004 Common Shares and 1,294,004 Special Common Shares were not included in computing Diluted Earnings per Share in the three months ended March 31, 2006 because their effects were antidilutive.

(4)             Preferred shares convertible into 54,540 Common Shares and 54,540 Special Common Shares were not included in computing Diluted Earnings per Share in the three months ended March 31, 2006, because their effects were antidilutive.

10




7.               Licenses and Goodwill

Changes in TDS’s licenses and goodwill are primarily the result of acquisitions, divestitures and impairment of its licenses, wireless markets and telephone companies. See Note 3 — Acquisitions, Divestitures and Exchanges for information regarding purchase and sale transactions which affected licenses and goodwill during the period.

The TDS Telecom’s incumbent local exchange carriers are designated as “ILEC” in the table and its competitive local exchange carrier is designated as “CLEC”.

(Dollars in thousands)

 

U.S.
Cellular(1)

 

TDS Telecom
CLEC

 

Total

 

Licenses

 

 

 

 

 

 

 

Balance December 31, 2006

 

$

1,517,607

 

$

2,800

 

$

1,520,407

 

Acquisitions

 

7,900

 

 

7,900

 

Balance March 31, 2007

 

$

1,525,507

 

$

2,800

 

$

1,528,307

 

 

 

 

 

 

 

 

 

Balance December 31, 2005

 

$

1,385,543

 

$

2,800

 

$

1,388,343

 

Other

 

(227

)

 

(227

)

Balance March 31, 2006

 

$

1,385,316

 

$

2,800

 

$

1,388,116

 


(1)          U.S. Cellular’s beginning and ending balances include $23.3 million of licenses allocated from TDS.

(Dollars in thousands)

 

U.S.
Cellular(1)

 

TDS
Telecom
ILEC

 

Other (2)

 

Total

 

Goodwill

 

 

 

 

 

 

 

 

 

Balance December 31, 2006

 

$

246,920

 

$

398,652

 

$

2,281

 

$

647,853

 

Acquisitions

 

5,818

 

 

 

5,818

 

Balance March 31, 2007

 

$

252,738

 

$

398,652

 

$

2,281

 

$

653,671

 

 

 

 

 

 

 

 

 

 

 

Balance December 31, 2005

 

$

242,703

 

$

398,652

 

$

2,281

 

$

643,636

 

Other

 

318

 

 

 

318

 

Balance March 31, 2006

 

$

243,021

 

$

398,652

 

$

2,281

 

$

643,954

 


(1)          U.S. Cellular’s balances in each period include $(238.5) million of goodwill allocated from TDS.

(2)          Other consists of goodwill related to Suttle Straus.

8.               Customer Lists

Customer lists, which are intangible assets resulting from the acquisition of wireless markets, are amortized based on average customer retention periods using the double declining balance method in the first year, switching to the straight-line method over the remaining estimated life. Amortization expense was $3.8 million and $5.7 million for the first quarter of 2007 and 2006, respectively. Amortization expense for the remainder of 2007 and for the years 2008-2012 is expected to be $6.6 million, $7.5 million, $5.6 million, $3.9 million, $0.3 million and $0.1 million, respectively.

11




9.               Marketable Equity Securities and Forward Contracts

TDS and its subsidiaries hold a substantial amount of marketable equity securities that are publicly traded and can have volatile movements in share prices. TDS and its subsidiaries do not make direct investments in publicly traded companies and all of these interests were acquired as a result of sales, trades or reorganizations of other assets.

Information regarding TDS’s marketable equity securities is summarized as follows:

 

March 31,
2007

 

December 31,
2006

 

 

 

(Dollars in thousands)

 

Marketable Equity Securities — Current Assets

 

 

 

 

 

Deutsche Telekom AG - 75,492,172 and 45,492,172 Ordinary Shares, respectively

 

$

1,247,886

 

$

833,872

 

Vodafone Group Plc — 11,327,674 and 11,327,674 American Depositary Receipts, respectively

 

304,261

 

314,683

 

VeriSign, Inc. - 2,361,333 and 2,361,333 Common Shares, respectively

 

59,317

 

56,789

 

Aggregate fair value included in Current Assets

 

1,611,464

 

1,205,344

 

 

 

 

 

 

 

Marketable Equity Securities — Investments

 

 

 

 

 

Deutsche Telekom AG - 55,969,689 and 85,969,689 Ordinary Shares, respectively

 

925,179

 

1,575,824

 

Rural Cellular Corporation — 719,396 equivalent Common Shares

 

8,604

 

9,453

 

Other

 

8

 

9

 

Aggregate fair value included in investments

 

933,791

 

1,585,286

 

Total aggregate fair value

 

2,545,255

 

2,790,630

 

Accounting cost basis

 

1,507,477

 

1,507,477

 

Gross holding gains

 

1,037,778

 

1,283,153

 

Gross realized holding gains

 

(32,256

)

(29,729

)

Gross unrealized holding gains

 

1,005,522

 

1,253,424

 

Equity method unrealized gains

 

352

 

352

 

Income tax (expense)

 

(367,738

)

(488,817

)

Minority share of unrealized holding gains

 

(14,018

)

(14,981

)

Unrealized holding gains, net of tax and minority share

 

624,118

 

749,978

 

Derivative instruments, net of tax and minority share

 

(224,709

)

(215,122

)

Retirement plans, net of tax

 

(12,661

)

(12,743

)

Accumulated other comprehensive income

 

$

386,748

 

$

522,113

 

 

The investment in Deutsche Telekom AG (“Deutsche Telekom”) resulted from TDS’s disposition of its over 80%-owned personal communication services operating subsidiary, Aerial Communications, Inc., to VoiceStream Wireless Corporation (“VoiceStream”) in exchange for stock of VoiceStream, which was then acquired by Deutsche Telekom in exchange for Deutsche Telekom stock. The investment in Vodafone Group Plc (“Vodafone”) resulted from certain dispositions of non-strategic cellular investments to or settlements with AirTouch Communications Inc. (“AirTouch”), in exchange for stock of AirTouch, which was then acquired by Vodafone whereby TDS and its subsidiaries received American Depositary Receipts representing Vodafone stock. The investment in VeriSign, Inc. (“VeriSign”) is the result of the acquisition by VeriSign of Illuminet, Inc., a telecommunication entity in which several TDS subsidiaries held interests. The investment in Rural Cellular Corporation (“Rural Cellular”) is the result of a consolidation of several cellular partnerships in which TDS subsidiaries held interests in Rural Cellular, and the distribution of Rural Cellular stock in exchange for these interests.

TDS has entered into a number of forward contracts related to the marketable equity securities it holds. The economic hedge risk management objective of the forward contracts is to hedge the value of the marketable equity securities from losses due to decreases in the market prices of the securities while retaining a share of gains from increases in the market prices of such securities. The downside risk is hedged at or above the accounting cost basis of the securities.

12




The forward contracts related to TDS’s 2,361,333 VeriSign common shares and the forward contracts related to U.S. Cellular’s 8,964,698 Vodafone ADRs matured in May 2007. TDS elected to deliver the VeriSign common shares in settlement of the forward contracts, and to dispose of all remaining VeriSign common shares in connection therewith. U.S. Cellular elected to deliver the Vodafone ADRs in settlement of the forward contracts, and to dispose of all remaining Vodafone ADRs in connection therewith. After these forward contracts were settled in May 2007, TDS no longer owns any VeriSign common shares, U.S. Cellular no longer owns any Vodafone ADRs and TDS and U.S. Cellular no longer have any liability or other obligations under the related forward contracts. TDS expects to record a pre-tax gain of approximately $138 million in the second quarter of 2007 on the settlement of such forward contracts and the disposition of such remaining VeriSign common shares and such remaining U.S. Cellular owned Vodafone ADRs.

The forward contracts related to TDS’s 45,492,172 Deutsche Telekom ordinary shares mature between July and September 2007. The forward contracts related to TDS’s 30,000,000 Deutsche Telekom ordinary shares mature between January and February 2008. The forward contracts related to TDS Telecom’s 2,362,976 Vodafone ADR’s mature in October 2007.

See Note 12 — Long-term Debt and Forward Contracts for additional information related to forward contracts.

10.         Investments in Unconsolidated Entities

Investments in unconsolidated entities consist of amounts invested in wireless and wireline entities in which TDS and its subsidiaries holds a minority interest. These investments are accounted for using either the equity or cost method.

TDS and its subsidiaries’ significant investments in unconsolidated entities include the following:

 

March 31,
2007

 

March 31,
2006

 

 

 

 

 

 

 

Los Angeles SMSA Limited Partnership

 

5.5

%

5.5

%

Midwest Wireless Communications, L.L.C. (1)

 

 

14.2

%

North Carolina RSA 1 Partnership

 

50.0

%

50.0

%

Oklahoma City SMSA Limited Partnership

 

14.6

%

14.6

%


(1)          In addition, U.S. Cellular owns a 49% interest in an entity, which owned an approximately 2.9% of Midwest Wireless Holdings, L.L.C., the parent company of Midwest Wireless Communications L.L.C. The investment in Midwest Wireless Communications, L.L.C. was disposed of in the fourth quarter of 2006.

Based primarily on data furnished to TDS by third parties, the following summarizes the combined results of operations of all wireless and wireline entities in which TDS’s investments are accounted for by the equity method:

 

Three Months Ended
March 31,

 

 

 

2007

 

2006

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

Results of operations

 

 

 

 

 

Revenues

 

$

1,097,000

 

$

993,000

 

Operating expenses

 

730,000

 

688,000

 

Operating income

 

367,000

 

305,000

 

Other income (expense), net

 

7,000

 

8,000

 

Net Income

 

$

374,000

 

$

313,000

 

 

11.         Revolving Credit Facilities

TDS has a $600 million revolving credit facility available for general corporate purposes. At March 31, 2007, letters of credit were $3.4 million, leaving $596.6 million available for use. Borrowings under the revolving credit facility bear interest at the London InterBank Offered Rate (“LIBOR”) plus a contractual spread based on TDS’s credit rating. At March 31, 2007, the contractual spread was 75 basis points. TDS may select borrowing periods of either seven days or one, two, three or six months (the one-month LIBOR was 5.32% at March 31, 2007). If TDS provides less than two days’ notice of intent to borrow, interest on borrowings is at the prime rate less 50 basis points (the prime rate was 8.25% at March 31, 2007). This credit facility expires in December 2009.

TDS also has $75 million of direct bank lines of credit at March 31, 2007, all of which were unused. The terms of the direct lines of credit bear negotiated interest rates up to the prime rate (the prime rate was 8.25% at March 31, 2007).

13




U.S. Cellular has a $700 million revolving credit facility available for general corporate purposes. At March 31, 2007, outstanding notes payable and letters of credit were $60.0 million and $0.4 million, respectively, leaving $639.6 million available for use. Borrowings under the revolving credit facility bear interest at the London InterBank Offered Rate (“LIBOR”) plus a contractual spread based on U.S. Cellular’s credit rating. At March 31, 2007, the contractual spread was 75 basis points. U.S. Cellular may select borrowing periods of either seven days or one, two, three or six months (the one-month LIBOR was 5.32% at March 31, 2007). If U.S. Cellular provides less than two days’ notice of intent to borrow, interest on borrowings is the prime rate less 50 basis points (the prime rate was 8.25% at March 31, 2007). This credit facility expires in December 2009.

TDS’s and U.S. Cellular’s interest cost on their revolving credit facilities would increase if their current credit ratings from Moody’s Investor Service (“Moody’s”) were lowered. However, the credit facilities would not cease to be available or accelerate solely as a result of a decline in TDS’s or U.S. Cellular’s credit rating. A downgrade in TDS’s or U.S. Cellular’s credit rating could adversely affect their ability to renew existing, or obtain access to new, credit facilities in the future. TDS’s and U.S. Cellular’s credit ratings as of the date of this filing are as follows:

Moody’s (Issued November 10, 2005)

Baa3 — under review for possible further downgrade

Standard & Poor’s (Issued April 23, 2007)

BB+ — on credit watch with negative implications

Fitch (Issued November 10, 2005)

BBB+ — on ratings watch negative

 

On February 13, 2007, Standard & Poor’s lowered its credit ratings on TDS and U.S. Cellular to BBB- from BBB. The ratings remained on credit watch with negative implications. On April 23, 2007, Standard & Poor’s lowered its credit rating on TDS and U.S. Cellular to BB+ from BBB-. The ratings remain on credit watch with negative implications.

The maturity dates of borrowings under TDS’s and U.S. Cellular’s revolving credit facilities would accelerate in the event of a change in control.

The continued availability of the revolving credit facilities requires TDS and U.S. Cellular to comply with certain negative and affirmative covenants, maintain certain financial ratios and represent certain matters at the time of each borrowing. On November 6, 2006, TDS and U.S. Cellular announced that they would restate certain financial statements which caused TDS and U.S. Cellular to be late in certain filings. In addition, on April 23, 2007, TDS announced another restatement that caused a further delay in TDS’s SEC filings. The restatements and late filings resulted in defaults under the revolving credit agreements and one line of credit agreement. TDS and U.S. Cellular were not in violation of any covenants that require TDS and U.S. Cellular to maintain certain financial ratios. TDS and U.S. Cellular did not fail to make any scheduled payments under such credit agreements. TDS and U.S. Cellular received waivers from the lenders associated with the credit agreements, under which the lenders agreed to waive any defaults that may have occurred as a result of the restatements and late filings. The waivers, as amended, require the Form 10-K for the year ended December 31, 2006 to be filed by June 30, 2007 and the Form 10-Q for the quarter ended March 31, 2007 to filed within 45 days after the filing of the Form 10-K for the year ended December 31, 2006. U.S. Cellular’s Form 10-K for the year ended December 31, 2006 and the Form 10-Q for the quarter ended March 31, 2007 were filed on April 23, 2007 and May 15, 2007, respectively. TDS’s Form 10-K for the year ended December 31, 2006 and Form 10-Q for the quarter ended March 31, 2007 were filed on June 19, 2007.

12.         Long-Term Debt and Forward Contracts

The late filing of TDS’s and U.S. Cellular’s Forms 10-Q for the quarterly period ended September 30, 2006 and Forms 10-K for the year ended December 31, 2006 and the failure to deliver such Forms 10-Q and 10-K to the trustees of the TDS and U.S. Cellular debt indentures on a timely basis, resulted in non-compliance under such debt indentures. However, this non-compliance did not result in an event of default or a default. TDS and U.S. Cellular believe that non-compliance was cured upon the filing of such Forms 10-Q and 10-K. In addition, the late filing of TDS’s Form 10-Q for the quarterly period ended March 31, 2007 and the failure to deliver such Form 10-Q to the trustee of the TDS debt indenture on a timely basis resulted in further non-compliance under such debt indenture. However, this non-compliance did not result in an event of default or a default. TDS believes that such non-compliance was cured upon the filing of this Form 10-Q. TDS and U.S. Cellular have not failed to make nor do they expect to fail to make any scheduled payment of principal or interest under such indentures.

14




Except as noted above, TDS believes that it and its subsidiaries were in compliance as of March 31, 2007 with all covenants and other requirements set forth in its long-term debt indentures. Such indentures do not contain any provisions resulting in acceleration of the maturities of outstanding debt in the event of a change in TDS’s credit rating. However, a downgrade in TDS’s credit rating could adversely affect its ability to obtain long-term debt financing in the future.

TDS redeemed $35.0 million of medium-term notes in January and February of 2006 which carried an interest rate of 10.0%.

Forward Contracts

TDS and its subsidiaries maintain a portfolio of available-for-sale marketable equity securities, the majority of which are the result of sales or trades of non-strategic assets. Subsidiaries of TDS have prepaid forward contracts with counterparties in connection with its Deutsche Telekom, Vodafone and VeriSign marketable equity securities. The principal amount of the prepaid forward contracts was accounted for as a loan. The collar portions of the forward contracts are accounted for as derivative instruments. The prepaid forward contracts contain embedded collars that are bifurcated and receive separate accounting treatment in accordance with SFAS No. 133, Accounting for Derivatives and Hedging Activities.

The Deutsche Telekom forward contracts mature from July 2007 to September 2008. A majority of the contracts require quarterly interest payments at the LIBOR rate plus 50 basis points (the three-month LIBOR rate was 5.35% at March 31, 2007). The remaining contracts are structured as zero coupon obligations with a weighted average effective interest rate of 4.4% per year. No interest payments are required for the zero coupon obligations during the contract period.

U.S. Cellular’s Vodafone forward contracts matured in May and TDS Telecom’s Vodafone contracts mature in October 2007. The Vodafone forward contracts require quarterly interest payments at the LIBOR rate plus 50 basis points (the three-month LIBOR rate was 5.35% at March 31, 2007).

The VeriSign forward contract matured in May 2007 and was structured as a zero coupon obligation with an effective interest rate of 5.00% per year. TDS was not required to make interest payments during the contract period.

The economic hedge risk management objective of the forward contracts is to hedge the value of the marketable equity securities from losses due to decreases in the market prices of the securities (“downside limit”) while retaining a share of gains from increases in the market prices of such securities (“upside potential”). The downside limit is hedged at or above the accounting cost basis of the securities.

Under the terms of the forward contracts, subsidiaries of TDS and U.S. Cellular will continue to own the contracted shares and will receive dividends paid on such contracted shares, if any. The forward contracts, at TDS’s and U.S. Cellular’s option, may be settled in shares of the respective security or in cash, pursuant to formulas that “collar” the price of the shares. The collars effectively reduce downside risk and upside potential on the contracted shares. The collars are typically contractually adjusted for any changes in dividends on the underlying shares. If the dividend increases, the collar’s upside potential is typically reduced. If the dividend decreases, the collar’s upside potential is typically increased. If TDS and U.S. Cellular elect to settle in shares, they will be required to deliver the number of shares of the contracted security determined pursuant to the formula. If shares are delivered in the settlement of the forward contract, TDS and U.S. Cellular would incur a current tax liability at the time of delivery based on the difference between the tax basis of the marketable equity securities delivered and the net amount realized through maturity. If TDS and U.S. Cellular elect to settle in cash, they will be required to pay an amount in cash equal to the fair market value of the number of shares determined pursuant to the formula. TDS and U.S. Cellular have provided guarantees to the counterparties which provide assurance that all principal and interest amounts will be paid by its consolidated subsidiaries upon settlement of the contracts.

The forward contracts related to the VeriSign common shares held by TDS and the Vodafone ADRs held by U.S. Cellular matured in May 2007. TDS elected to deliver the VeriSign common shares in settlement of the forward contracts, and to dispose of all remaining VeriSign common shares in connection therewith. U.S. Cellular elected to deliver the Vodafone ADRs in settlement of the forward contracts, and to dispose of all remaining Vodafone ADRs in connection therewith. After these forward contracts were settled in May 2007, TDS no longer owns any VeriSign common shares, U.S. Cellular no longer owns any Vodafone ADRs and TDS and U.S. Cellular no longer have any liability or other obligations under the related forward contracts.

15




TDS and U.S. Cellular are required to comply with certain covenants under the forward contracts. On November 6, 2005, TDS and U.S. Cellular announced that they would restate certain financial statements which caused TDS and U.S. Cellular to be late in certain SEC filings. In addition, on April 23, 2007, TDS announced another restatement that caused a further delay in TDS’s SEC filings. The restatements and late filings resulted in defaults under the forward contracts. TDS and U.S. Cellular were not in violation of any covenants that require TDS and U.S. Cellular to maintain certain financial ratios. TDS and U.S. Cellular did not fail to make any scheduled payments under such forward contracts. TDS and U.S. Cellular received waivers from the counterparty to such forward contracts, under which the counterparty agreed to waive any defaults that may have occurred as a result of the restatements and late filings. The waivers, as amended, require the Form 10-K for the year ended December 31, 2006 to be filed by June 30, 2007 and the Form 10-Q for the quarter ended March 31, 2007 to filed within 45 days after the filing of the Form 10-K for the year ended December 31, 2006. U.S. Cellular’s Form 10-K for the year ended December 31, 2006 and the Form 10-Q for the quarter ended march 31, 2007 were filed on April 23, 2007 and May 15, 2007, respectively. TDS’s Form 10-K for the year ended December 31, 2006 and Form 10-Q for the quarter ended March 31, 2007 were filed on June 19, 2007.

13.         Commitments and Contingencies

Indemnifications

TDS enters into agreements in the normal course of business that provide for indemnification of counterparties. These agreements include certain asset sales and financings with other parties. The terms of the indemnifications vary by agreement. The events or circumstances that would require TDS to perform under these indemnities are transaction specific; however, these agreements may require TDS to indemnify the counterparty for costs and losses incurred from litigation or claims arising from the underlying transaction. TDS is unable to estimate the maximum potential liability for these types of indemnifications as the amounts are dependent on the outcome of future events, the nature and likelihood of which cannot be determined at this time. Historically, TDS has not made any significant indemnification payments under such agreements.

TDS is party to an indemnity agreement with T-Mobile USA Inc., (“T-Mobile”) regarding certain contingent liabilities at Aerial Communications, Inc. (“Aerial”) for the period prior to Aerial’s merger into VoiceStream Wireless. As of March 31, 2007, TDS has recorded liabilities of $0.9 million relating to this indemnity, which represents its best estimate of its probable liability.

Legal Proceedings

TDS is involved in a number of legal proceedings before the FCC and various state and federal courts. In accordance with SFAS No. 5, if TDS believes that a loss arising from such legal proceedings is probable and can be reasonably estimated, an amount is accrued in the financial statements for the estimated loss. If only a range of loss can be determined, the best estimate within that range is accrued; if none of the estimates within that range is better than another, the low end of the range is accrued. The assessment of the expected outcomes of legal proceedings is a highly subjective process that requires judgments about future events. The legal proceedings are reviewed at least quarterly to determine the adequacy of accruals and related financial statement disclosures. The ultimate outcomes of legal proceedings could differ materially from amounts accrued in the financial statements.

16




Regulatory Environment

Changes in the telecommunications regulatory environment, including the effects of potential changes in the rules governing universal service funding and potential changes in the amounts or methods of intercarrier compensation, could have a material adverse effect on TDS Telecom’s financial condition, results of operations and cash flows.

14.         Minority Interest in Subsidiaries

Under SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity,” certain minority interests in consolidated entities with finite lives may meet the standard’s definition of a mandatorily redeemable financial instrument and thus require reclassification as liabilities and remeasurement at the estimated amount of cash that would be due and payable to settle such minority interests under the applicable entity’s organization agreement assuming an orderly liquidation of the finite-lived entity, net of estimated liquidation costs (the “settlement value”). TDS’s consolidated financial statements include certain minority interests that meet the standard’s definition of mandatorily redeemable financial instruments. These mandatorily redeemable minority interests represent interests held by third parties in consolidated partnerships and limited liability companies (“L.L.C.s”), where the terms of the underlying partnership or L.L.C. agreement provide for a defined termination date at which time the assets of the subsidiary are to be sold, the liabilities are to be extinguished and the remaining net proceeds are to be distributed to the minority interest holders and TDS in accordance with the respective partnership and L.L.C. agreements. The termination dates of TDS’s mandatorily redeemable minority interests range from 2042 to 2105.

The settlement value of TDS’s mandatorily redeemable minority interests is estimated to be $158.9 million at March 31, 2007. This represents the estimated amount of cash that would be due and payable to settle minority interests assuming an orderly liquidation of the finite-lived consolidated partnerships and L.L.C.s on March 31, 2007, net of estimated liquidation costs. This amount is being disclosed pursuant to the requirements of FASB Staff Position (“FSP”) No. FAS 150-3; TDS has no current plans or intentions to liquidate any of the related partnerships or L.L.C.s prior to their scheduled termination dates. The corresponding carrying value of the minority interests in finite-lived consolidated partnerships and L.L.C.s at March 31, 2007 is $33.3 million, and is included in the Balance Sheet caption Minority interest in subsidiaries. The excess of the aggregate settlement value over the aggregate carrying value of the mandatorily redeemable minority interests of $125.6 million is primarily due to the unrecognized appreciation of the minority interest holders’ share of the underlying net assets in the consolidated partnerships and L.L.C.s. Neither the minority interest holders’ share, nor TDS’s share, of the appreciation of the underlying net assets of these subsidiaries is reflected in the consolidated financial statements. The estimate of settlement value was based on certain factors and assumptions which are subjective in nature. Changes in those factors and assumptions could result in a materially larger or smaller settlement amount.

15.         Common Share Repurchase Programs

On March 2, 2007, the Board of Directors of TDS authorized the repurchase of up to $250 million of TDS Special Common Shares from time to time through open market purchases, block transactions, private purchases or otherwise. The authorization will expire March 2, 2010.

The Board of Directors of U.S. Cellular has authorized the repurchase of a limited amount of U.S. Cellular common shares on a quarterly basis, primarily for use in employee benefit plans. This authorization does not have an expiration date. No U.S. Cellular common shares were repurchased in the first quarter of 2007 or 2006.

On March 6, 2007, the Board of Directors of U.S. Cellular authorized the repurchase of up to 500,000 Common Shares of U.S. Cellular from time to time through open market purchases, block transactions, private transactions or other methods. This authorization will expire on March 6, 2010. This authorization is in addition to U.S. Cellular’s existing limited share repurchase authorization discussed above. See Note 19 — Subsequent Events for additional information related to this share repurchase authorization.

17




16.         Accumulated Other Comprehensive Income

The cumulative balances of unrealized gains (losses) on marketable equity securities and derivative instruments and related income tax effects included in Accumulated other comprehensive income are as follows.

 

Three Months Ended
March 31,

 

 

 

2007

 

2006

 

 

 

(Dollars in thousands)

 

Marketable Equity Securities

 

 

 

 

 

Balance, beginning of period

 

$

749,978

 

$

578,273

 

Add (deduct):

 

 

 

 

 

Unrealized gains (losses) on marketable equity securities

 

(247,902

)

22,929

 

Income tax (expense) benefit

 

90,774

 

(9,212

)

 

 

(157,128

)

13,717

 

Minority share of unrealized losses

 

962

 

651

 

Net change in unrealized gains (losses) on marketable equity securities in comprehensive income

 

(156,166

)

14,368

 

 

 

 

 

 

 

Application of FIN 48

 

30,306

 

 

Balance, end of period

 

$

624,118

 

$

592,641

 

 

 

 

 

 

 

Derivative Instruments

 

 

 

 

 

Balance, beginning of period

 

$

(215,122

)

$

(214,632

)

Add (deduct):

 

 

 

 

 

Minority share of unrealized losses

 

(4

)

(3

)

Net change in unrealized gains (losses) on derivative instruments included in comprehensive income

 

(4

)

(3

)

 

 

 

 

 

 

Application of FIN 48

 

(9,583

)

 

Balance, end of period

 

$

(224,709

)

$

(214,635

)

 

 

 

 

 

 

Retirement Plans

 

 

 

 

 

Balance, beginning of period

 

$

(12,743

)

$

 

Add (deduct):

 

 

 

 

 

Amounts included in net periodic benefit cost for the period

 

 

 

 

 

Amortization of prior service cost, net of taxes

 

(127

)

 

Amortization of unrecognized net loss, net of taxes

 

209

 

 

Net change in retirement plans included in comprehensive income

 

82

 

 

Balance, end of year

 

$

(12,661

)

$

 

 

 

 

 

 

 

Accumulated Other Comprehensive Income

 

 

 

 

 

Balance, beginning of period

 

$

522,113

 

$

363,641

 

Net change in marketable equity securities

 

(156,166

)

14,368

 

Net change in derivative instruments

 

(4

)

(3

)

Net change due to retirement plans

 

82

 

 

Net change in unrealized gains (losses) included in comprehensive income

 

(156,088

)

14,365

 

Application of FIN 48

 

20,723

 

 

Balance, end of period

 

$

386,748

 

$

378,006

 

 

 

Three Months Ended
March 31,

 

 

 

2007

 

2006

 

 

 

(Dollars in thousands)

 

Comprehensive Income

 

 

 

 

 

Net income

 

$

219,325

 

$

35,997

 

Net change in unrealized gains (losses) included in comprehensive income

 

(156,088

)

14,365

 

 

 

$

63,237

 

$

50,362

 

 

18




17.         Stock-Based Compensation

At March 31, 2007, unrecognized compensation cost for all stock-based compensation awards was $15.4 million. The unrecognized compensation cost for stock-based compensation awards at March 31, 2007 is expected to be recognized over a weighted average period of 0.8 years.

For the three months ended March 31, 2007 and 2006, $4.7 million and $8.6 million of stock-based compensation expense was recorded. For the three months ended March 31, 2007, $0.4 million of stock-based compensation expense was recorded in cost of services and $4.3 million was recorded in Selling, general and administrative expenses. For the three months ended March 31, 2006, all stock-based compensation expense was recorded in Selling, general and administrative expense.

TDS

The information in this section relates to stock-based compensation plans utilizing the equity instruments of TDS. Participants in these plans are generally employees of TDS Corporate and TDS Telecom, although U.S. Cellular employees are eligible to participate in the TDS Employee Stock Purchase Plan. Information related to plans utilizing the equity instruments of U.S. Cellular are shown in the U.S. Cellular section following the TDS section.

Effective January 1, 2006, TDS adopted the fair value recognition provisions of SFAS No. 123(R), “Share-Based Payment” (“SFAS 123(R)”), using the modified prospective transition method. Upon adoption of SFAS 123(R), TDS elected to continue to value its share-based payment transactions using a Black-Scholes valuation model, which was previously used by TDS for purposes of preparing the pro forma disclosures under SFAS 123.

Under the TDS 2004 Long-Term Incentive Plan (and a predecessor plan), TDS may grant fixed and performance-based incentive and non-qualified stock options, restricted stock, restricted stock units, and deferred compensation stock unit awards to key employees. TDS had reserved 3,194,000 Common Shares and 11,325,000 Special Common Shares at March 31, 2007, for equity awards granted and to be granted under this plan. At March 31, 2007, the only types of awards outstanding are fixed non-qualified stock option awards, restricted stock unit awards, and deferred compensation stock unit awards. As of March 31, 2007 TDS had also reserved 313,000 Special Common Shares under an employee stock purchase plan. The maximum number of TDS Common Shares, TDS Special Common Shares and TDS Series A Common Shares that may be issued to employees under all stock-based compensation plans in effect at March 31, 2007 was 3,194,000, 11,638,000 and 0 shares, respectively. TDS has also created a Non-Employee Directors’ Plan under which it has reserved 67,000 Special Common Shares of TDS stock for issuance as compensation to members of the board of directors who are not employees of TDS. TDS currently utilizes treasury stock to satisfy stock option exercises, issuances under its employee stock purchase plan, restricted stock unit awards and deferred compensation stock unit awards.

Stock Options—Stock options granted to key employees are exercisable over a specified period not in excess of ten years. Stock options generally vest over periods up to four years from the date of grant. Stock options outstanding at March 31, 2007 expire between 2007 and 2016. TDS estimates the fair value of stock options granted using the Black-Scholes valuation model. TDS did not grant stock options during the three months ended March 31, 2007 and March 31, 2006.

19




A summary of outstanding and exercisable stock options as of March 31, 2007 is presented below:

Tandem Options (1)

Options Outstanding

 

Options Exercisable

 

Range of
Exercise
Prices

 

Number
Outstanding
at March 31,
2007

 

Weighted
Average
Remaining
Contractual
Life
(in years)

 

Weighted
Average
Exercise
Price

 

Number
Exercisable
at March 31,
2007

 

Weighted
Average
Remaining
Contractual
Life
(in years)

 

Weighted
Average
Exercise
Price

 

$33.87-$49.99

 

276,000

 

2.2

 

$

42.05

 

276,000

 

N/A

 

$

42.05

 

$50.00-$74.99

 

758,000

 

5.9

 

61.92

 

698,000

 

N/A

 

61.57

 

$75.00-$99.99

 

675,000

 

6.2

 

82.19

 

675,000

 

N/A

 

82.19

 

$100.00-$127.00

 

485,000

 

3.1

 

111.74

 

485,000

 

N/A

 

111.74

 

 

 

2,194,000

 

4.9

 

$

76.66

 

2,134,000

 

4.9

 

$

76.96

 

 

Special Common Options

Options Outstanding

 

Options Exercisable

 

Range of
Exercise
Prices

 

Number
Outstanding
at March 31,
2007

 

Weighted
Average
Remaining
Contractual
Life
(in years)

 

Weighted
Average
Exercise
Price

 

Number
Exercisable
at March 31,
2007

 

Weighted
Average
Remaining
Contractual
Life
(in years)

 

Weighted
Average
Exercise
Price

 

$38.00-$39.99

 

979,000

 

8.1

 

$

38.00

 

979,000

 

N/A

 

$

38.00

 

$40.00-$49.99

 

343,000

 

9.6

 

46.76

 

343,000

 

N/A

 

46.76

 

 

 

1,322,000

 

8.5

 

$

40.27

 

1,322,000

 

8.5

 

$

40.27

 


(1)                        Upon exercise, each tandem option is converted into one TDS Common Share and one TDS Special Common Share. All TDS tandem stock options outstanding were granted prior to the distribution of the TDS Special Common Share Dividend in 2005.

The aggregate intrinsic value of Tandem Options outstanding and Special Common Options outstanding was $86.1 million and $20.7 million at March 31, 2007. The aggregate intrinsic value of Tandem Options exercisable and Special Common Options exercisable was $83.2 million and $20.6 million at March 31, 2007. The aggregate intrinsic value represents the total pretax intrinsic value (the difference between TDS’s closing stock price on the last trading day of the period and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised their options on March 31, 2007. This amount will change in future periods based on the market price of TDS’s stock.

Restricted Stock Units—Beginning in April 2005, TDS granted restricted stock unit awards to key employees. These awards generally vest after three years. TDS estimates the fair value of restricted stock units based on the closing market price of TDS shares on the date of grant.

Deferred Compensation Stock Units—Certain TDS employees may elect to defer receipt of all or a portion of their annual bonuses and to receive stock unit matches on the amount deferred up to $400,000. TDS match amounts depend on the amount of annual bonus that is deferred into stock units. The matched stock units vest ratably at a rate of one-third per year over three years. TDS estimates the fair value of deferred compensation matching stock units based on the closing market price of TDS shares on the date of grant.

Employee Stock Purchase Plan—Under the 2003 Employee Stock Purchase Plan, eligible employees of TDS and its subsidiaries may purchase a limited number of shares of TDS common stock on a quarterly basis. The per share cost to each participant is 85% of the market value of the Common Shares or Special Common Shares as of the issuance date.

U.S. Cellular

Effective January 1, 2006, U.S. Cellular adopted the fair value recognition provisions of SFAS. 123(R), using the modified prospective transition method. Upon adoption of SFAS 123(R), U.S. Cellular elected to continue to value its share-based payment transactions using a Black-Scholes valuation model, which was previously used by U.S. Cellular for purposes of preparing the pro forma disclosures under SFAS 123.

U.S. Cellular has established the following stock-based compensation plans: a long-term incentive plan, an employee stock purchase plan, and a non-employee director compensation plan.

20




Under the U.S. Cellular 2005 Long-Term Incentive Plan, U.S. Cellular may grant fixed and performance-based incentive and non-qualified stock options, restricted stock, restricted stock units, and deferred compensation stock unit awards to key employees. At March 31, 2007, the only types of awards outstanding are fixed non-qualified stock option awards, restricted stock awards, restricted stock unit awards, and deferred compensation stock unit awards.

At March 31, 2007, U.S. Cellular had reserved 4,734,000 Common Shares for equity awards granted and to be granted under the long-term incentive plan, and also had reserved 106,000 Common Shares for issuance to employees under an employee stock purchase plan. The maximum number of U.S. Cellular Common Shares that may be issued to employees under all stock-based compensation plans in effect at March 31, 2007 was 4,840,000 shares. U.S. Cellular currently utilizes treasury stock to satisfy stock option exercises, issuances under its employee stock purchase plan, restricted stock unit awards and deferred compensation stock unit awards.

Long-Term Incentive Plan — Stock Options— Stock options granted to key employees are exercisable over a specified period not in excess of ten years. Stock options generally vest over periods up to four years from the date of grant. Stock options outstanding at March 31, 2007 expire between 2007 and 2016.

U.S. Cellular did not grant any options during the three months ended March 31, 2007 and 2006. U.S. Cellular estimates the fair value of stock options granted using the Black-Scholes valuation model.

A summary of outstanding and exercisable stock options as of March 31, 2007 is presented below:

Options Outstanding

 

Options Exercisable

 

Range of
Exercise
Prices

 

Number
Outstanding
at March 31,
2007

 

Weighted
Average
Remaining
Contractual
Life
(in years)

 

Weighted
Average
Exercise
Price

 

Number
Exercisable
at March 31,
2007

 

Weighted
Average
Remaining
Contractual
Life
(in years)

 

Weighted
Average
Exercise
Price

 

$15.00-$36.99

 

569,000

 

6.0

 

$

25.83

 

558,000

 

N/A

 

$

25.73

 

$37.00-$49.99

 

1,119,000

 

7.1

 

$

42.94

 

805,000

 

N/A

 

$

42.55

 

$50.00-$75.00

 

716,000

 

7.6

 

$

61.21

 

321,000

 

N/A

 

$

63.29

 

 

 

2,404,000

 

7.0

 

$

44.33

 

1,684,000

 

6.4

 

$

40.93

 

 

The aggregate intrinsic values of options outstanding and exercisable at March 31, 2007 were $70.0 million and $54.8 million, respectively. The aggregate intrinsic value represents the total pretax intrinsic value (the difference between U.S. Cellular’s closing stock price on the last trading day of the period and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised their options on March 31, 2007. This amount will change in future periods based on the market price of U.S. Cellular’s stock.

Long-Term Incentive Plan — Restricted Stock Units—U.S. Cellular grants restricted stock unit awards, which generally vest after three years, to key employees. U.S. Cellular estimates the fair value of restricted stock units based on the closing market price of U.S. Cellular shares on the date of grant.

Long-Term Incentive Plan — Deferred Compensation Stock Units—Certain U.S. Cellular employees may elect to defer receipt of all or a portion of their annual bonuses and to receive a company matching contribution on the amount deferred. All bonus compensation that is deferred by employees electing to participate is immediately vested and is deemed to be invested in U.S. Cellular Common Share stock units. The amount of U.S. Cellular’s matching contribution depends on the portion of the annual bonus that is deferred. U.S. Cellular estimates the fair value of deferred compensation matching contribution stock units based on the closing market price of U.S. Cellular Common Shares on the date of match.

Employee Stock Purchase Plan—Under the 2003 Employee Stock Purchase Plan, eligible employees of U.S. Cellular and its subsidiaries may purchase a limited number of U.S. Cellular Common Shares on a quarterly basis. The per share cost to each participant is 85% of the market value of the Common Shares as of the issuance date. U.S. Cellular employees are also eligible to participate in the TDS employee stock purchase plan. The effective dates and per share costs in the TDS plan are the same as those for the U.S. Cellular plan. Under SFAS 123(R), both of these employee stock purchase plans are considered compensatory plans; therefore recognition of compensation costs for stock issued under these plans is required.

21




18.         Business Segment Information

Financial data for TDS’s business segments for the three month period ended or at March 31, 2007 and 2006 are as follows. TDS Telecom’s incumbent local exchange carriers are designated as “ILEC” in the table and its competitive local exchange carrier is designated as “CLEC”.

Three Months Ended or at March 31, 2007

 

U.S.

 

TDS Telecom

 

Non-
Reportable

 

Other
Reconciling

 

 

 

(Dollars in thousands)

 

Cellular

 

ILEC

 

CLEC

 

Segment (1)

 

Items(2)

 

Total

 

Operating revenues

 

$

934,674

 

$

157,592

 

$

61,350

 

$

9,323

 

$

(6,382

)

$

1,156,557

 

Cost of services and products

 

321,963

 

49,097

 

28,957

 

7,298

 

(1,347

)

405,968

 

Selling, general and administrative expense

 

354,931

 

41,859

 

21,603

 

1,466

 

(3,377

)

416,482

 

Operating income before depreciation, amortization and accretion (3)

 

257,780

 

66,636

 

10,790

 

559

 

(1,658

)

334,107

 

Depreciation, amortization and accretion expense

 

149,257

 

34,046

 

5,859

 

632

 

1,516

 

191,310

 

Operating income (loss)

 

108,523

 

32,590

 

4,931

 

(73

)

(3,174

)

142,797

 

Significant noncash items:

 

 

 

 

 

 

 

 

 

 

 

 

 

Equity in earning of unconsolidated entities

 

23,098

 

 

 

 

598

 

23,696

 

Fair value adjustment of derivative instruments

 

12,461

 

 

 

 

243,409

 

255,870

 

Marketable equity securities

 

245,228

 

 

 

 

2,300,027

 

2,545,255

 

Investment in unconsolidated entities

 

171,040

 

3,623

 

 

 

44,211

 

218,874

 

Total assets

 

5,798,194

 

1,663,824

 

155,870

 

25,001

 

2,777,050

 

10,419,939

 

Capital expenditures

 

$

109,729

 

$

16,055

 

$

2,583

 

$

1,306

 

$

1,293

 

$

130,966

 

 

Three Months Ended or at March 31, 2006

 

U.S.

 

TDS Telecom

 

Non-
Reportable

 

Other
Reconciling

 

 

 

(Dollars in thousands)

 

Cellular

 

ILEC

 

CLEC

 

Segment (1)

 

Items(2)

 

Total

 

Operating revenues

 

$

836,376

 

$

161,026

 

$

59,495

 

$

7,583

 

$

(5,403

)

$

1,059,077

 

Cost of services and products

 

296,634

 

46,079

 

29,074

 

5,272

 

(753

)

376,306

 

Selling, general and administrative expense

 

327,704

 

44,047

 

22,716

 

1,907

 

(3,753

)

392,621

 

Operating income before depreciation, amortization and accretion (3)

 

212,038

 

70,900

 

7,705

 

404

 

(897

)

290,150

 

Depreciation, amortization and accretion expense

 

142,025

 

33,576

 

6,654

 

711

 

 

182,966

 

Operating income (loss)

 

70,013

 

37,324

 

1,051

 

(307

)

(897

)

107,184

 

Significant noncash items:

 

 

 

 

 

 

 

 

 

 

 

 

 

Equity in earning of unconsolidated entities

 

19,483

 

 

 

 

322

 

19,805

 

Fair value adjustment of derivative instruments

 

4,815

 

 

 

 

(4,785

)

30

 

Marketable equity securities

 

219,584

 

 

 

 

2,339,923

 

2,559,507

 

Investment in unconsolidated entities

 

187,672

 

3,623

 

 

 

41,658

 

232,953

 

Total assets

 

5,393,567

 

1,698,711

 

149,762

 

27,664

 

2,897,221

 

10,166,925

 

Capital expenditures

 

$

117,209

 

$

17,109

 

$

2,673

 

$

1,873

 

$

4,912

 

$

143,776

 


(1)          Represents Suttle Straus.

(2)          Consists of the TDS Corporate operations, intercompany and intracompany revenue and expense eliminations, TDS Corporate and TDS Telecom marketable equity securities and all other businesses not included in the U.S. Cellular, TDS Telecom or the Non-Reportable segments.

(3)          The amount of operating income before depreciation, amortization and accretion is a non-GAAP financial measure. The amount may also be commonly referred to by management as operating cash flow. TDS has presented operating cash flow because this financial measure, in combination with other financial measures, is an integral part of our internal reporting system utilized by management to assess and evaluate the performance of its business. Operating cash flow is also considered a significant performance measure. It is used by management as a measurement of its success in obtaining, retaining and servicing customers by reflecting its ability to generate subscriber revenue while providing a high level of customer service in a cost effective manner. The components of operating cash flow include the key revenue and expense items for which operating managers are responsible and upon which TDS evaluates its performance.

Other companies in the telecommunications industry may define operating cash flow in a different manner or present other varying financial measures, and, accordingly, TDS’s presentation may not be comparable to other similarly titled measures of other companies.

Operating cash flow should not be construed as an alternative to operating income (loss), as determined in accordance with GAAP, as an alternative to cash flows from operating activities, as determined in accordance with GAAP, or as a measure of liquidity. TDS believes operating cash flow is useful to investors as a means to evaluate TDS’s operating performance prior to non-cash depreciation and amortization expense, and certain other non-cash charges. Although operating cash flow may be defined differently by other companies in the telecommunications industry, TDS believes that operating cash flow provides some commonality of measurement in analyzing operating performance of companies in the telecommunications industry.

22




 

 

Three Months Ended
March 31,

 

 

 

2007

 

2006

 

 

 

(Dollars in thousands)

 

Total operating income from reportable and other segments

 

$

142,797

 

$

107,184

 

Total investment and other income (expense)

 

235,737

 

(28,141

)

Income before income taxes and minority interest

 

$

378,534

 

$

79,043

 

 

19.         Subsequent Events

Barat Wireless, L.P.

A wholly-owned subsidiary of U.S. Cellular is a limited partner in Barat Wireless, L.P. (“Barat Wireless”), an entity which participated in the auction of wireless spectrum designated by the FCC as Auction 66. Barat Wireless was qualified to receive a 25% discount available to “very small businesses” which were defined as having annual gross revenues of less than $15 million. At the conclusion of the auction on September 18, 2006, Barat Wireless was the high bidder with respect to 17 licenses and had bid $127.1 million, net of its discount. On April 30, 2007, the FCC granted Barat Wireless’ applications with respect to the 17 licenses for which it was the winning bidder.

Common Stock Repurchase Program

On April 4, 2007, U.S. Cellular entered into an agreement to purchase 670,000 of its Common Shares from an investment banking firm in a private transaction in connection with an accelerated share repurchase (“ASR”). Including a per share discount and commission payable to the investment bank, the shares were repurchased for approximately $49.1 million or $73.22 per share. The repurchased shares are being held as treasury shares.

In connection with the ASR, the investment bank will purchase an equivalent number of shares in the open-market over time. The program must be completed within two years. At the end of the program, U.S. Cellular will receive or pay a price adjustment based on the average price of shares acquired by the investment bank pursuant to the ASR during the purchase period. The purchase price adjustment can be settled, at U.S. Cellular’s option, in cash or in U.S. Cellular Common Shares. The subsequent purchase price adjustment will change the cost basis of the U.S. Cellular treasury shares.

TDS’s ownership percentage of U.S. Cellular increases upon such U.S. Cellular share repurchases. Therefore, TDS accounts for U.S. Cellular’s purchases of U.S. Cellular common shares as step acquisitions using purchase accounting. In addition, the subsequent ASR purchase price adjustment may result in additional amounts being allocated to licenses and goodwill at TDS.

Deutsche Telekom Dividend

Deutsche Telekom paid a dividend of EUR 0.72 per share in May 2007. Using a weighted-average exchange rate of $1.36 per EUR, TDS will record dividend income of $128.5 million, before taxes, in the second quarter of 2007.

23




ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

TELEPHONE AND DATA SYSTEMS, INC. AND SUBSIDIARIES

Telephone and Data Systems, Inc. (“TDS”- AMEX symbol: TDS and TDS.S) is a diversified telecommunications company providing high-quality telecommunications services to approximately 7.2 million wireless telephone customers and wireline telephone equivalent access lines. TDS conducts substantially all of its wireless telephone operations through its 80.6%-owned subsidiary, United States Cellular Corporation (“U.S. Cellular”), its incumbent local exchange carrier and competitive local exchange carrier wireline telephone operations through its wholly owned subsidiary, TDS Telecommunications Corporation (“TDS Telecom”) and its printing and distribution operations through its 80%-owned subsidiary, Suttle Straus, Inc.

The following discussion and analysis should be read in conjunction with TDS’s interim consolidated financial statements included herein, and with its audited consolidated financial statements and Management’s Discussion and Analysis of Financial Condition and Results of Operations included in its Annual Report on Form 10-K (“Form 10-K”) for the year ended December 31, 2006.

OVERVIEW

The following is a summary of certain selected information contained in the comprehensive Management’s Discussion and Analysis of Financial Condition and Results of Operations that follows. The overview does not contain all of the information that may be important. You should carefully read the entire Management’s Discussion and Analysis of Financial Condition and Results of Operations and not rely solely on this overview.

Results of Operations

U.S. Cellular — U.S. Cellular differentiates itself from its competitors through a customer satisfaction strategy, reflecting broad product distribution, a customer service focus and a high-quality wireless network. U.S. Cellular’s business development strategy is to acquire, develop and operate controlling interests in wireless licenses in areas adjacent to or in proximity to its other wireless licenses, thereby building contiguous operating market areas. U.S. Cellular’s operating strategy is to strengthen the geographic areas where it can continue to build long-term operating synergies and to exit those areas where it does not have opportunities to build such synergies.

Operating highlights in the first quarter of 2007 included the following:

·            Total customers increased 6% year-over-year to 5,973,000 and average monthly service revenue per customer increased 5% to $48.69;

·            The postpay churn rate per month was 1.5%;

·            Additions to property, plant and equipment totaled $109.7 million, including expenditures to construct cell sites, increase capacity in existing cell sites and switches, outfit new and remodel existing retail stores and continue the development and enhancements of U.S. Cellular’s support systems. Total cell sites in service increased 10% year-over-year to 6,004; and

·            In February 2007, U.S. Cellular completed an acquisition of Iowa 15 Wireless, LLC (“Iowa 15”) and obtained the 25 megahertz Federal Communications Commission (“FCC”) cellular license to provide wireless service in Iowa RSA 15 for approximately $18.2 million in cash, subject to completion of working capital adjustments.

Service Revenues increased $91.4 million, or 12%, to $860.6 million in 2007 from $769.2 million in 2006. Revenues from data products and services increased 71% to $77.6 million in 2007 from $45.5 million in 2006 as customers continue to increase usage of U.S. Cellular’s easyedgeSM products and offerings such as Short Messaging Service (SMS) and Blackberry® handsets and service.

Operating Income increased $38.5 million, or 55%, to $108.5 million in 2007 from $70.0 million in 2006. The increase in Operating Income reflected both higher operating revenues and a higher operating income margin (as a percent of service revenues), which was 12.6% in 2007 compared to 9.1% in 2006.

24




Although operating income margin improved in 2007, U.S. Cellular anticipates that there will be continued pressure on its operating income and operating income margin in the next few years related to the following factors:

·                  costs of customer acquisition and retention;

·                  effects of competition;

·                  providing service in recently launched areas;

·                  potential increases in prepaid and reseller customers as a percentage of U.S. Cellular’s customer base; and

·                  continued enhancements to its wireless networks.

See “U.S. Cellular Operations.”

TDS Telecom—TDS Telecom provides high-quality telecommunication services, including full-service local exchange service, long distance telephone service and Internet access, to rural, suburban and selected small urban area communities. TDS Telecom’s business plan is designed for a full-service telecommunications company, including competitive local exchange carrier operations, by leveraging TDS Telecom’s strength as an incumbent local exchange carrier. TDS Telecom is focused on achieving three central strategic objectives: growth, market leadership, and profitability. TDS Telecom’s strategy includes gaining additional market share and deepening penetration of vertical services within established markets.

TDS Telecom increased its total equivalent access lines served by 28,100, or 2%, since March 31, 2006, ending the quarter with 1,219,600 equivalent access lines served. An equivalent access line is derived by converting a high-capacity data line to an estimated equivalent number, in terms of capacity, of switched access lines.

Operating revenues decreased $1.4 million, or 0.6%, to $217.6 million in the three months ended March 31, 2007 from $219.0 million in 2006, reflecting lower ILEC revenues partially offset by higher CLEC revenues.

Operating income decreased $0.9 million, or 2%, to $37.5 million in 2007 from $38.4 million in 2006, primarily as a result of the decrease in revenues.

Incumbent and competitive local exchange carriers are faced with significant challenges, including growing competition from wireless and other wireline providers, changes in regulation and new technologies such as Voice over Internet Protocol. Despite these challenges, TDS Telecom has successfully increased equivalent access line levels while maintaining excellent customer satisfaction.

See “TDS Telecom Operations.”

Cash Flows and Investments

At March 31, 2007, TDS and its subsidiaries had cash and cash equivalents totaling $1,176.4 million, available borrowing capacity of $1,236.2 million under its revolving credit facilities and an additional $75 million of bank lines of credit. Also, during the quarter ended March 31, 2007, TDS generated cash flows from operating activities of $287.1 million. Management believes that cash on hand, expected future cash flows from operating activities and sources of external financing provide substantial financial flexibility and are sufficient to permit TDS and its subsidiaries to finance their contractual obligations and anticipated capital expenditures. TDS continues to seek to maintain a strong balance sheet and an investment grade credit rating.

See “Financial Resources” and “Liquidity and Capital Resources.”

25




RESULTS OF OPERATIONS

Three Months Ended March 31, 2007 Compared to Three Months Ended March 31, 2006

Operating Revenues increased $97.5 million, or 9%, to $1,156.6 million during the three months ended March 31, 2007 from $1,059.1 million during the three months ended March 31, 2006. U.S. Cellular’s operating revenues increased $98.3 million, or 12%, to $934.7 million in 2007 from $836.4 million in 2006 as customers served increased by 340,000, or 6%, since March 31, 2006, to 5,973,000. TDS Telecom’s operating revenues decreased $1.4 million, or 0.6%, to $217.6 million in 2007 from $219.0 million in 2006. Decreases in revenues generated from network access were partially offset by increased revenues from additional digital subscriber lines and long distance customers. Equivalent access lines grew 28,100 or 2%, since March 31, 2006, to 1,219,600. An equivalent access line is derived by converting a high-capacity data line to an estimated equivalent number, in terms of capacity, of switched access lines.

Operating Expenses increased $61.9 million, or 6%, to $1,013.8 million in 2007 from $951.9 million in 2006 primarily reflecting growth in operations. U.S. Cellular’s operating expenses increased $59.8 million, or 8%, to $826.2 million in 2007 from $766.4 million in 2006 primarily reflecting costs associated with acquiring customers and serving and retaining its expanding customer base. TDS Telecom’s expenses remained relatively constant at $180.1 million for 2007 and $180.6 million for 2006.

Operating Income increased $35.6 million, or 33%, to $142.8 million in 2007 from $107.2 million in 2006. The operating margin was 12.3% in 2007 and 10.1% in 2006 on a consolidated basis. U.S. Cellular’s operating income increased $38.5 million, or 55%, to $108.5 million from $70.0 million in 2006 and its operating margin, as a percentage of service revenues, increased to 12.6% in 2007 from 9.1% in 2006. TDS Telecom’s operating income decreased $0.9 million, or 2%, to $37.5 million from $38.4 million in 2006 and its operating margin declined to 17.2% from 17.5% in 2006.

Investment and Other Income (Expense) primarily includes interest and dividend income, investment income, gains and losses on investments, fair value adjustment of derivative instruments and interest expense. Investment and other income (expense) totaled $235.7 million in 2007 and $(28.1) million in 2006.

Equity in earnings of unconsolidated entities increased $3.9 million, or 20%, to $23.7 million in 2007 from $19.8 million in 2006. Equity in earnings of unconsolidated entities represents TDS’s share of net income from markets in which it or U.S. Cellular has a minority interest and that are accounted for by the equity method. U.S. Cellular’s investment in the Los Angeles SMSA Limited Partnership contributed $18.0 million and $14.6 million to equity in earnings of unconsolidated entities for the three months ended March 31, 2007 and 2006, respectively.

Interest and dividend income increased $4.7 million to $16.2 million in 2007 from $11.5 million in 2006 primarily due to higher average rates of interest earned on investments in 2007 than 2006.

Interest expense decreased $0.7 million, or 1%, to $57.8 million in 2007 from $58.5 million in 2006. The decrease in interest expense in the three months ended March 31, 2007 was primarily due to a decrease in interest related to TDS’s 7.0% senior notes that were paid off in the third quarter of 2006 ($3.5 million) offset by an increase in interest paid on forward contracts related to interest rate increases ($2.9 million).

Fair value adjustment of derivative instruments totaled a gain of $255.9 million in 2007 and $0.03 million in 2006. Fair value adjustment of derivative instruments reflects the change in the fair value of the bifurcated embedded collars within the forward contracts related to the Deutsche Telekom and Vodafone marketable equity securities not designated as a hedge. The accounting for the embedded collars as derivative instruments not designated in a hedging relationship results in increased volatility in the results of operations, as fluctuation in the market price of the underlying Deutsche Telekom and Vodafone marketable equity securities results in changes in the fair value of the embedded collars being recorded in the consolidated statement of operations. Also included in the fair value adjustment of derivative instruments are the gains and losses related to the ineffectiveness of the VeriSign fair value hedge which aggregated a $0.4 million gain in both 2007 and 2006.

Other income (expense) totaled $(2.2) million in 2007 and $(0.9) million in 2006. Borrowing costs on the prepaid forward contracts increased $0.4 million in 2007 compared to 2006.

26




Income Tax Expense increased $108.9 million to $141.2 million in 2007 from $32.3 million in 2006 primarily due to the increase in pre-tax income. The overall effective tax rates on income before income taxes and minority interest for the three months ended March 31, 2007 and 2006 were 37.3% and 40.9%, respectively. The effective tax rate for the 2007 period is lower than for 2006 primarily due to the impact of state taxes. For further analysis and discussion of TDS’s effective tax rates in 2007 and 2006, see Note 5 — Income Taxes.

Minority Share of Income includes the minority public shareholders’ share of U.S. Cellular’s net income, the minority shareholders’ or partners’ share of U.S. Cellular’s subsidiaries’ net income or loss and other minority interests.

 

Three Months Ended
March 31,

 

 

 

2007

 

2006

 

 

 

(Dollars in thousands)

 

Minority Share of Income

 

 

 

 

 

U.S. Cellular

 

 

 

 

 

Minority Public Shareholders’

 

$

(14,466

)

$

(7,411

)

Minority Shareholders’ or Partners’

 

(3,511

)

(3,193

)

 

 

(17,977

)

(10,604

)

Other

 

6

 

(100

)

 

 

$

(17,971

)

$

(10,704

)

 

Net Income Available to Common totaled $219.3 million, or $1.85 per diluted share, in 2007 and $35.9 million, or $0.31 per diluted share, in 2006.

27




U.S. CELLULAR OPERATIONS

TDS provides wireless telephone service through United States Cellular Corporation (“U.S. Cellular”), an 80.6%-owned subsidiary. U.S. Cellular owns, manages and invests in wireless markets throughout the United States. Growth in the customer base is the primary reason for the change in U.S. Cellular’s results of operations in 2007 and 2006. The number of customers increased 6% to 5,973,000 at March 31, 2007, from 5,633,000 at March 31, 2006, due to customer additions from its marketing channels and acquisition, divestitures and exchange activities.

SUMMARY OF HOLDINGS

U.S. Cellular owned, or had the right to acquire pursuant to certain agreements, either majority or minority interests in 236 wireless markets at March 31, 2007. A summary of the number of markets U.S. Cellular owned or had rights to acquire as of March 31, 2007 follows:

 

Number of
Markets

 

Consolidated markets (1)

 

202

 

Consolidated markets acquirable pursuant to existing agreements (2)

 

17

 

Minority interests accounted for using equity method

 

12

 

Minority interests accounted for using cost method

 

5

 

Total markets to be owned after completion of pending transactions(3)

 

236

 


(1)             Includes majority interests in 191 markets and other interests in 11 licenses acquired through Carroll Wireless, L.P. (“Carroll Wireless”). U.S. Cellular consolidates Carroll Wireless and Carroll PCS, Inc., the general partner of Carroll Wireless, for financial statement purposes, pursuant to the guidelines of FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities— an interpretation of ARB No. 51 (“FIN 46(R)”), as U.S. Cellular anticipates benefiting from or absorbing a majority of Carroll Wireless’ expected gains or losses.

Carroll Wireless was the winning bidder of 17 wireless licenses in the auction of wireless spectrum designated by the Federal Communications Commission (“FCC”) as Auction 58. On January 6, 2006, the FCC granted Carroll Wireless applications with respect to 16 of the 17 licenses for which it was the winning bidder and dismissed one application relating to Walla Walla, Washington. Following the completion of Auction 58, the FCC determined that a portion of the Walla Walla license was already licensed to another party and should not have been included in Auction 58. In March 2006, Carroll Wireless received a full refund of the amount paid to the FCC with respect to the Walla Walla license. Of the 16 licenses which were granted to Carroll Wireless, 11 licenses represent markets which are incremental to U.S. Cellular’s currently owned or acquirable markets and 5 represent markets in which U.S. Cellular currently owns spectrum. Only licenses which add incremental territory to U.S. Cellular’s consolidated operating markets are included in the number of consolidated markets so as to avoid duplicate reporting of overlapping markets.

(2)             U.S. Cellular owns rights to acquire majority interests in 17 wireless licenses resulting from an exchange transaction which closed in August 2003 with AT&T Wireless Services, Inc. (“AT&T Wireless”), a subsidiary of Cingular Wireless LLC, which is now a subsidiary of AT&T Inc. (formerly SBC Communications, Inc.). Pursuant to the exchange transaction, U.S. Cellular also has rights to acquire 4 additional licenses. However, those 4 additional licenses are in markets where U.S. Cellular currently owns spectrum. Only licenses which add incremental territory to U.S. Cellular’s consolidated operating markets are included in the number of consolidated markets so as to avoid duplicate reporting of overlapping markets. The rights to acquire licenses from AT&T Wireless expire on August 1, 2008.

(3)             Total markets to be owned after completion of pending transactions does not include the 17 licenses for which Barat Wireless, L.P. (“Barat Wireless”) was the successful bidder in Auction 66, which ended on September 18, 2006. The FCC awarded the licenses to Barat Wireless on April 30, 2007.

28




RESULTS OF OPERATIONS

Following is a table of summarized operating data for U.S. Cellular’s consolidated operations.

 

Three Months Ended or At
March 31,

 

 

 

2007

 

2006

 

As of March 31, (1a)

 

 

 

 

 

Total market population (2) (4)

 

56,048,000

 

55,164,000

 

Customers (3)

 

5,973,000

 

5,633,000

 

Market penetration (4)

 

10.7

%

10.2

%

Total full-time equivalent employees

 

7,484

 

7,350

 

Cell sites in service

 

6,004

 

5,438

 

For the Three Months Ended March 31, (1b)

 

 

 

 

 

Net customer additions (5)

 

152,000

 

151,000

 

Net retail customer additions (5)

 

146,000

 

122,000

 

Average monthly service revenue per customer (6)

 

$

48.69

 

$

46.17

 

Postpay churn rate per month (7)

 

1.5

%

1.5

%

Sales and marketing cost per gross customer addition (8)

 

$

426

 

$

412

 


(1a)       Amounts in 2007 include information related to all markets included in U.S. Cellular’s consolidated operations as of March 31, 2007. Such markets include the market acquired during February 2007 from February 1 through March 31.

(1b)      Amounts in 2006 include results from all markets included in U.S. Cellular’s consolidated operations for the period January 1, 2006 through March 31, 2006. The 11 markets granted to Carroll Wireless by the FCC in January 2006 are included for the period January 6 through March 31, 2006.

(2)             Represents 100% of the population of the markets in which U.S. Cellular had a controlling financial interest for financial reporting purposes as of March 31 of each respective year.

(3)             U.S. Cellular’s customer base consists of the following types of customers:

 

March 31,

 

 

 

2007

 

2006

 

Customers on postpay service plans in which the end user is a customer of U.S. Cellular (“postpay customers”)

 

5,048,000

 

4,707,000

 

End user customers acquired through U.S. Cellular’s agreement with a third party (“reseller customers”) *

 

596,000

 

604,000

 

Total postpay customer base

 

5,644,000

 

5,311,000

 

Customers on prepaid service plans in which the end user is a customer of U.S. Cellular (“prepaid customers”)

 

329,000

 

322,000

 

Total customers

 

5,973,000

 

5,633,000

 


*                   Pursuant to its agreement with the third party, U.S. Cellular is compensated by the third party on a postpay basis; as a result, all customers U.S. Cellular has acquired through this agreement are considered to be postpay customers.

(4)             Calculated using 2006 and 2005 Claritas population estimates for 2007 and 2006, respectively. “Total market population” is used only for the purposes of calculating market penetration, which is calculated by dividing customers by the total market population, including unbuilt licenses (without duplication of population in overlapping markets).

(5)             “Net customer additions” represents the number of net customers added to U.S. Cellular’s overall customer base through all of its marketing distribution channels, excluding any customers transferred through acquisitions, divestitures or exchanges. “Net retail customer additions” represents the number of net customers added to U.S. Cellular’s customer base, excluding net reseller customers added to its reseller customer base, through its marketing distribution channels, excluding any customers transferred through acquisitions, divestitures or exchanges. See “Operating Income” below for information related to U.S. Cellular’s estimate of net retail customer additions for the full year 2007.

29




(6)             Management uses this measurement to assess the amount of service revenue U.S. Cellular generates each month on a per customer basis. Variances in this measurement are monitored and compared to variances in expenses on a per customer basis. Average monthly service revenue per customer is calculated as follows:

 

Three Months Ended
March 31,

 

 

 

2007

 

2006

 

 

 

(Dollars in thousands)

 

Service Revenues per Consolidated Statements of Operations

 

$

860,583

 

$

769,222

 

Divided by average customers during period (000s) *

 

5,892

 

5,554

 

Divided by number of months in each period

 

3

 

3

 

Average monthly service revenue per customer

 

$

48.69

 

$

46.17

 


*                   “Average customers during period” is calculated by adding the number of total customers, including reseller customers, at the beginning of the first month of the period and at the end of each month in the period and dividing by the number of months in the period plus one. Acquired and divested customers are included in the calculation on a prorated basis for the amount of time U.S. Cellular included such customers during each period.

(7)             Postpay churn rate per month represents the percentage of the postpay customer base that disconnects service each month, including both postpay customers and reseller customers. Reseller customers can disconnect service without the associated account number being disconnected from U.S. Cellular’s network if the reseller elects to reuse the customer telephone number. Only those reseller customer numbers that are disconnected from U.S. Cellular’s network are counted in the number of postpay disconnects. The calculation is performed by first dividing the total number of postpay and reseller customers who disconnect service during the period by the number of months in such period, and then dividing that quotient by the average monthly postpay customer base, which includes both postpay and reseller customers, for such period.

(8)             For a discussion of the components of this calculation, see “Operating expenses — Selling, general and administrative expenses” below.

Operating revenues increased $98.3 million, or 12%, to $934.7 million in 2007 from $836.4 million in 2006.

 

Three Months Ended
March 31,

 

 

 

2007

 

2006

 

 

 

(Dollars in thousands)

 

Retail service

 

$

754,515

 

$

679,256

 

Inbound roaming

 

41,268

 

35,344

 

Long-distance and other service revenues

 

64,800

 

54,622

 

Service Revenues

 

860,583

 

769,222

 

Equipment sales

 

74,091

 

67,154

 

 

 

$

934,674

 

$

836,376

 

 

Service revenues increased $91.4 million, or 12%, to $860.6 million in 2007 from $769.2 million in 2006. Service revenues primarily consist of: (i) charges for access, airtime, roaming, recovery of regulatory costs and value-added services, including data products and services, provided to U.S. Cellular’s retail customers and to end users through third party resellers (“retail service”); (ii) charges to other wireless carriers whose customers use U.S. Cellular’s wireless systems when roaming (“inbound roaming”); and (iii) charges for long-distance calls made on U.S. Cellular’s systems. The increase in service revenues in 2007 was primarily due to the following factors:

·                  a 6% growth in the average customer base; and

·                  a 5% increase in monthly service revenue per customer, which averaged $48.69 in the first three months of 2007 and $46.17 in the first three months of 2006.

See footnote 6 to the table of summarized operating data in “Results of Operations” above for the calculation of average monthly service revenue per customer.

Retail service revenues increased $75.2 million, or 11%, to $754.5 million in 2007 from $679.3 million in 2006. Growth in U.S. Cellular’s average customer base and an increase in average monthly retail revenue per customer, driven by growth in revenues from data services, were the primary reasons for the increase in retail service revenue. Average monthly retail service revenue per customer increased 5% to $42.69 in 2007 from $40.77 in 2006.

U.S. Cellular’s average customer base increased 6% in 2007, primarily driven by the 311,000 net new customer additions that U.S. Cellular generated from its marketing (including reseller) distribution channels over the past twelve months. The average number of customers was also affected by the timing of acquisitions, divestitures and exchanges.

30




U.S. Cellular anticipates that net additions to its customer base will increase during 2007 as a result of its continuing focus on customer satisfaction; attractively priced service plans, a broader line of handsets and other products, and improvements in distribution; and growth in customers in newer markets. However, the level of growth in the customer base for 2007 will depend upon U.S Cellular’s ability to attract new customers and retain existing customers in a highly, and increasingly, competitive marketplace. See Operating Income, below, for U.S. Cellular’s estimate of net retail customer additions for the full year.

Monthly retail minutes of use per customer increased to 783 in 2007 from 658 in 2006, primarily driven by U.S. Cellular’s focus on designing sales incentive programs and customer billing rate plans to stimulate overall usage. The impact on retail service revenue of the increases in average monthly minutes of use was offset by decreases in average revenue per minute of use in both years. The decreases in average revenue per minute of use reflect the impact of increasing competition, which has led to the inclusion of an increasing number of minutes in package pricing plans and the inclusion of features such as unlimited night and weekend minutes and unlimited incoming call minutes in certain pricing plans. U.S. Cellular anticipates that its average revenue per minute of use may continue to decline in the future, reflecting increased competition and continued penetration of the consumer market.

Revenues from data products and services grew significantly year-over-year, totaling $77.6 million in 2007 from $45.5 million in 2006. Such growth, which positively impacted average monthly retail service revenues per customer, reflected customers’ increasing acceptance and usage of U.S. Cellular’s easyedgeSM products and offerings such as Short Messaging Services (“SMS”) and BlackBerry® handsets and service.

Inbound roaming revenues increased $6.0 million, or 17%, to $41.3 million in 2007 from $35.3 million in 2006. The increase in revenues was related primarily to an increase in roaming minutes of use, partially offset by a decrease in revenue per roaming minute of use. The increase in inbound roaming minutes of use was driven primarily by the overall growth in the number of customers throughout the wireless industry and traffic from other wireless carriers. The decline in revenue per minute of use is due primarily to the general downward trend in negotiated rates.

U.S. Cellular anticipates that inbound roaming minutes of use might continue to grow over the next few years, reflecting continuing industry-wide growth in customers and increased usage of data services while roaming, but that the rate of growth will decline due to higher penetration and slower growth in the consumer wireless market. In addition, U.S. Cellular anticipates that the rate of decline in average inbound roaming revenue per roaming minute of use may be lower over the next few years, reflecting the wireless industry trend toward longer term negotiated rates.

Long-distance and other service revenues increased $10.2 million, or 19%, to $64.8 million in 2007 from $54.6 million in 2006. The increase primarily reflected a $3.7 million increase in long-distance revenues and a $6.5 million increase in other revenues. The increase in long-distance revenues was driven by an increase in the volume of long-distance calls billed both to U.S. Cellular’s customers and to other wireless carriers whose customers used U.S. Cellular’s systems to make long-distance calls. The growth in other revenues was primarily due to an increase in the amount of funds received from the federal Universal Service Fund (“USF”). As of March 31, 2007 and March 31, 2006, U.S. Cellular was eligible to receive eligible telecommunication carrier (“ETC”) funds in seven states. The increase in funds received from USF was due to both an increase in U.S. Cellular’s customer base and an increase due to U.S. Cellular receiving ETC eligibility in the seventh state during February 2006.

Equipment sales revenues increased $6.9 million, or 10%, to $74.1 million in 2007 from $67.2 million in 2006. Equipment sales revenues include revenues from sales of handsets and related accessories to both new and existing customers, as well as revenues from sales of handsets to agents. All equipment sales revenues are recorded net of anticipated rebates.

U.S. Cellular continues to offer a competitive line of quality handsets to both new and existing customers. U.S. Cellular’s customer retention efforts include offering new handsets at discounted prices to existing customers as the expiration date of the customer’s service contract approaches. U.S. Cellular also continues to sell handsets to agents; this practice enables U.S. Cellular to provide better control over the quality of handsets sold to its customers, establish roaming preferences and earn quantity discounts from handset manufacturers which are passed along to agents. U.S. Cellular anticipates that it will continue to sell handsets to agents in the future.

The increase in equipment sales revenues in 2007 was driven by an increase in average revenue per handset sold. Average revenue per handset sold increased 10% in 2007, primarily reflecting a shift to more expensive handsets sold with expanded capabilities. The number of handsets sold was flat year-over-year.

31




Operating expenses increased $59.8 million, or 8%, to $826.2 million in 2007 from $766.4 million in 2006. The major components of operating expenses are shown in the table below.

 

Three Months Ended
March 31,

 

 

 

2007

 

2006

 

 

 

(Dollars in thousands)

 

System operations (exclusive of depreciation, amortization and accretion included below)

 

$