Commission File Number 000-51466

 

 

 

 

 

121 South 17th Street
Mattoon, Illinois 61938-3987
(Address of principal executive offices)

 

Registrant’s telephone number, including area code:

(217) 235-3311

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act:

None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes  o      No  þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes  o      No  þ

 

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  þ      No  o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this form 10-K.   o

 

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

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes  o      No  þ

 

The number of shares of the registrant’s common stock, $.01 par value, outstanding as of February 29, 2008 was 29,440,587. The aggregate market value of the registrant’s common stock held by non-affiliates as of June 30, 2007 was approximately $447,076,183, computed by reference to the closing sales price of such common stock on The NASDAQ Global Market as of June 30, 2007. Determination of stock ownership by non-affiliates was made solely for the purpose of responding to this requirement and the registrant is not bound by this determination for any other purpose.

 

 

 

TABLE OF CONTENTS

 

 

 

Any statements contained in this Report that are not statements of historical fact, including statements about our beliefs and expectations, are forward-looking statements and should be evaluated as such. The words “anticipates”, “believes”, “expects”, “intends”, “plans”, “estimates”, “targets”, “projects”, “should”, “may”, “will” and similar words and expressions are intended to identify forward-looking statements. These forward-looking statements are contained throughout this Report, including, but not limited to, statements found in Part I — Item 1 — “Business”, Part II — Item 5 — “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities”, Part II — Item 7 — “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, and Part II — Item 7A — “Quantitative and Qualitative Disclosures about Market Risk”. Such forward-looking statements reflect, among other things, our current expectations, plans, strategies and anticipated financial results and involve a number of known and unknown risks, uncertainties and factors that may cause our actual results to differ materially from those expressed or implied by these forward-looking statements. Many of these risks are beyond our ability to control or predict. All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the cautionary statements contained throughout this Report. Because of these risks, uncertainties and assumptions, you should not place undue reliance on these forward-looking statements. Furthermore, forward-looking statements speak only as of the date they are made. Except as required under the federal securities laws or the rules and regulations of the SEC, we do not undertake any obligation to update or review any forward-looking information, whether as a result of new information, future events or otherwise.

 

Please see Part I — Item 1A — “Risk Factors” of this Report, as well as the other documents that we file with the SEC from time to time for important factors that could cause our actual results to differ from our current expectations and from the forward-looking statements discussed in this Report.

 

Market and industry data and other information used throughout this report are based on independent industry publications, government publications, publicly available information, reports by market research firms or other published independent sources. Some data is also based on estimates of our management, which are derived from their review of internal surveys and industry knowledge. Although we believe these sources are reliable, we have not independently verified the information. In addition, we note that our market share in each of our markets or for our services is not known or reasonably obtainable given the nature of our businesses and the telecommunications market in general (for example, wireless providers both compete with and complement local telephone services).

 

On April 14, 2004, we acquired TXU Communications Ventures Company, or TXUCV, from TXU Corporation. TXUCV owned rural telephone operations in Lufkin, Conroe, and Katy, Texas, which through its predecessor companies had been operating in those markets for over 90 years. This acquisition approximately tripled the size of the Company.

 

On July 27, 2005, we completed the initial public offering, or IPO, of our common stock. Concurrent with the IPO, Spectrum Equity sold its entire investment and Providence Equity sold 50 percent of its investment in Consolidated Communications. On July 28, 2006, the Company repurchased the remaining shares owned by Providence Equity.

 

On December 31, 2007, we completed the acquisition of North Pittsburgh. Through its subsidiaries it provides advanced communication services to residential and business customers in several counties in western Pennsylvania.

 

Our Strengths

 

Stable Local Telephone Business

 

We are the incumbent local telephone company in the rural communities we serve, and demand for local telephone services from our residential and business customers has been stable despite changing economic conditions. We operate in a supportive regulatory environment, and competition in our markets is limited. As a result of these favorable characteristics, the cash flow generated by our local telephone business is relatively consistent from year to year. Our long-standing relationship with our local telephone customers provides us with an opportunity to pursue increased revenue per access line by selling additional services to existing customers through a bundling strategy, such as our triple play offering of local voice service, DSL and IPTV.

 

Attractive Markets and Limited Competition

 

The geographic areas in which our rural telephone companies operate are characterized by a balanced mix of stable, insular territories in which we have limited competition and growing suburban areas. Historically, we have had limited competition for basic voice services from wireless carriers and non-facilities based providers using Voice Over Internet Protocol, or VOIP. Cable providers have recently started offering a voice product. As of December 31, 2007, Mediacom is the only cable operator to have launched a voice product in our Texas and Illinois markets, by our estimate overlapping approximately 15% of our total access lines in those states. The two incumbent cable providers in our North Pittsburgh territory, Armstrong and Comcast, have each launched a competitive VOIP offering.

 

Our Lufkin, Texas and central Illinois markets have experienced only nominal population growth over the past decade. As of December 31, 2007, 115,062, or approximately 40.8%, of our local access lines were located in these markets. We have experienced limited competition in these markets because the low customer density and high residential component have discouraged the significant capital investment required to offer service over a competing network.

 

Our Conroe, Texas and Katy, Texas markets are suburban areas located on the outskirts of the Houston metropolitan area. As of December 31, 2007, 108,725, or approximately 38.6%, of our local access lines were located in these markets. They have experienced above-average population and business employment growth over the past decade as compared to Texas and the United States as a whole. According to the most recent census, the median household income in the primary county in our Conroe market was over $50,000 per year and in our Katy market was over $60,000 per year, both significantly higher than the median household income in Texas, which was $39,927 per year, and the United States, which was $42,148 per year.

 

At the time of the acquisition, North Pittsburgh had three operating subsidiaries including an ILEC, a CLEC, and an Internet service provider (ISP). North Pittsburgh operates in an approximately 285 square mile territory in western Pennsylvania, which includes portions of Allegheny, Armstrong, Butler and Westmoreland Counties. Over the past decade, its ILEC territory has experienced population growth due to the continued expansion of suburban communities into its serving area, with the southernmost point of its territory only 12 miles from the City of Pittsburgh. As a result of the population growth, the ILEC also benefits from growth

in business activity and favorable market demographics. Approximately 58,241, or 20.6%, of our access lines are located in the North Pittsburgh territory.

 

North Pittsburgh’s CLEC business furnishes telecommunication and broadband services south of the ILEC’s territory to customers in Pittsburgh and its surrounding suburbs as well as to the north in the City of Butler and its surrounding areas. Verizon is the ILEC in the Pittsburgh area, while Embarq (formerly Sprint) is the ILEC in the City of Butler and its surrounding areas.

 

Technologically Advanced Network

 

We have invested significantly over the last several years in building a technologically advanced network capable of delivering a broad array of reliable, high quality voice and data and video services to our Illinois and Texas customers on a cost-effective basis. For example, approximately 95% of our total local access lines in Illinois and Texas were DSL-capable as of December 31, 2007. Of these DSL capable lines, approximately 80% are capable of speeds of 3 mega bits per second (Mbps) or greater. This is made possible by leveraging our Internet Protocol, or IP, backbone network in Illinois and Texas. We believe this IP network will position us with a lower cost, better quality and flexible platform that will enable the development and delivery of new broadband applications to our customers. The service options we are able to provide over our existing network allow us to generate additional revenues per customer. Other than the provision of success-based set-top boxes for subscribers, we believe our current network is capable of supporting increased IPTV subscribers with limited additional network preparation.

 

Our Pennsylvania market offers many of the same advanced IP network capabilities with DSL availability to 100% of the customer base. Metro-Ethernet, VoIP tunneling, and other additional IP services leverage the extensive MPLS (Multi-Protocol Label Switching) core network providing for a more efficient and scalable network. The broad fiber deployment provides an easy reach into existing and new areas bringing the network closer to the customer enhancing service offerings and quality for the end subscriber.

 

Broad Service Offerings and Bundling of Services

 

In Illinois and Texas we offer our residential and business customers a single point of contact for access to a broad array of voice, data, and video services. We provide local and long distance service, multiple speeds or tiers of DSL service and a robust IPTV video offering with over 200 all digital channels. We also offer custom calling services, carrier access services, network capacity services and directory publishing.

 

We generate additional revenues per customer by bundling services. Bundling enables us to provide a more complete package of services to our customers, which increases our average revenue per user, or ARPU, while adding additional value for the consumer. We also believe the bundling of services results in increased customer loyalty and higher customer retention. As of December 31, 2007, we had 45,971 customers who subscribed to service bundles that included local service and a selection of other services including items such as, custom calling features, DSL and IPTV. Collectively, this represents an increase of approximately 6.5% over the number of customers who subscribed to service bundles as of December 31, 2006.

 

Favorable Regulatory Environment

 

We benefit from federal and Texas state subsidies designed to promote widely available, quality telephone service at affordable prices in rural areas, which is also referred to as universal service. For the year ended December 31, 2007 we received $27.0 million in payments from the federal universal service fund and $19.0 million from the Texas universal service fund. In the aggregate, these payments comprised 14.0% of our revenues for the year ended December 31, 2007. For the year ended December 31, 2006, we received $28.1 million from the federal universal service fund and $19.5 million from the Texas universal service fund. In the aggregate, these payments comprised 14.8% of revenues for the year ended December 31, 2006. For both 2007 and 2006 our subsidies included a net refund from us back to the universal service funds associated with prior period adjustments. Those amounts were $2.6 million and $1.3 million for 2007 and 2006, respectively.

Experienced Management Team with Proven Track Record

 

With an average of over 20 years of experience in both regulated and non-regulated telecommunications businesses, our management team has demonstrated the ability to deliver profitable growth while providing high levels of customer satisfaction. Specifically, our management team has:

 

 

Business Strategy

 

Increase Revenues Per Customer

 

We continue to focus on increasing our revenues per customer, primarily by improving our DSL and IPTV market penetration, increasing the sale of other value-added services and encouraging customers to take advantage of our service bundles. We believe that our strategy enables us to provide a more complete package of services to our customers and increase our ARPU, while improving the value for the customer.

 

Over the last two years we have expanded our service bundle with the introduction of IPTV in selected Illinois and Texas markets. Having made the necessary upgrades to our network and purchased programming content, we launched our last major market, Lufkin, Texas, in March 2007. We have been focused on marketing our “triple play” bundle, which includes local voice, DSL and IPTV services. As of December 31, 2007, over 87% of the customers that have subscribed to our video service have taken our triple play offering. In total, we had 12,241 video subscribers and passed approximately 108,000 homes at year-end 2007. We expect to launch IPTV and the “triple play” bundle in our Pennsylvania markets early in the second quarter of 2008.

 

Improve Operating Efficiency

 

Since acquiring our Illinois operations in December 2002 and our Texas operations in April 2004, we have made significant operating and management improvements. We have centralized many of our business and back office operations into one functional organization with common work groups, processes and systems. By providing these centrally managed resources, we have allowed our management and customer service functions to focus on the business and to better serve our customers in a cost-effective manner. We intend to apply the same practices as we integrate North Pittsburgh into our existing operations. For example, effective on the date of closing, we were able to transition all of North Pittsburgh’s financial, human resource and supply chain systems to our existing systems. We have identified several “fast track” projects that will allow us to improve our cost structure while launching new products and improving the customer experience.

 

Maintain Capital Expenditure Discipline

 

We have successfully managed our capital expenditures in order to optimize our returns, while allocating resources to maintain and upgrade our network and enable new service delivery. This was demonstrated by the completion of the IP network in Illinois and Texas and the subsequent rollout of IPTV service. By upgrading the network to an IP based architecture we were able to provide not only a more efficient network, but also one that is capable of offering new services such as IPTV.

Pursue Selective Acquisitions

 

Although we expect to focus on integration of North Pittsburgh in 2008, in the longer term we intend to continue to pursue a disciplined process of selective acquisitions of access lines or operating companies. Our acquisition criteria include:

 

 

 

Telephone Operations

 

The following discussion of telephone operations relates to Illinois and Texas, except where otherwise expressly stated.

 

Our Telephone Operations segment consists of local calling services, network access services, subsidies, long distance services, data and Internet services, and other services. As of December 31, 2007, our Telephone Operations segment had approximately:

 

 

Our Telephone Operations segment generated approximately $82.5 million and $82.9 million of cash flows from operating activities for the years ended December 31, 2007 and 2006, respectively. As of December 31, 2007, our Telephone Operations had total assets of approximately $1,281.0 million.

 

Local calling services include dial tone and local calling services. We generally charge residential and business customers a fixed monthly rate for access to the network and for originating and receiving telephone calls within their local calling area. Custom calling features consist of caller name and number identification, call forwarding and call waiting. Value added services consist of teleconferencing and voicemail. For custom calling features and value added services, we usually either charge a flat monthly fee, or bundle the local calling services together with other services at a discounted rate to consumers. In addition, we offer local private lines providing direct connections between two or more local locations primarily to business customers at flat monthly rates. In our Texas markets we offer small and medium sized businesses a hosted VOIP solution that delivers local service, calling features, IP business telephones and unified messaging all in an attractive bundle.

 

Network access services allow the origination or termination of calls in our service area for which we charge long distance or other carriers network access charges, which are regulated. Network access fees also apply to private lines provisioned between a customer in our service areas and a location outside of our service areas. Included in this category are subscriber line charges, local number portability and universal services surcharges paid by the end user.

 

We record the details of the long distance and private line calls through our carrier access billing system and bill the applicable carrier on a monthly basis. The network access charge rates for intrastate long distance calls and private lines within Illinois and Texas are regulated and approved by the Illinois Commerce Commission, or ICC, and the Public Utility Commission of Texas, or PUCT, respectively, whereas the access charge rates for interstate long distance calls and private lines are regulated and approved by the Federal Communications Commission, or FCC.

 

Subsidies consist of federal and state subsidies designed to promote widely available, quality telephone service at affordable prices in rural areas. The subsidies are allocated and distributed to us from funds to which telecommunications providers, including local, long distance and wireless carriers, must contribute on a monthly basis. Funds are distributed to us on a monthly basis based upon our costs for providing local service in our two service territories. In Illinois we receive federal but not state subsidies, while in Texas we receive both federal and state subsidies.

 

Long distance services include services provided to subscribers to our long distance plans to originate calls that terminate outside the caller’s local calling area. We offer a variety of plans and charge our subscribers a combination of subscription and usage fees including an unlimited long distance plan.

 

Data and Internet services include revenues from non-local private lines and the provision of access to the Internet by DSL, T-1 lines and dial-up access and IPTV. We also offer a variety of data connectivity services, including Asynchronous Transfer Mode and gigabit Ethernet products and frame relay networks. Frame relay networks are public data networks commonly used for local area network to local area network communications as an alternative to private line data communications. In addition, we launched IPTV in our Illinois markets in 2005 and began launching in our Texas markets in August 2006.

 

Other Services within our Telephone Operations segment include revenues from telephone directory publishing, wholesale transport services on a fiber optic network in Texas, billing and collection services, inside wiring service and maintenance. It also includes our limited partnership interests in the following two cellular partnerships:

 

 

 

San Antonio MTA, L.P., a wholly owned partnership of Cellco Partnership (doing business as Verizon Wireless), is the general partner for both partnerships.

 

Other Operations

 

Our Other Operations segment, which does not include any North Pittsburgh operations, consists of complementary businesses including Public Services, Business Systems, Market Response, Operator Services and Mobile Services. Public Services provides local and long distance service and automated calling service for correctional facilities. Business Systems sells and installs telecommunications equipment, such as key, private branch exchange (PBX) and IP based telephone systems to residential and business customers. Market Response provides telemarketing and order fulfillment services. Operator Services offers both live and automated local and long distance operator services and national directory assistance on a wholesale and retail basis. Mobile Services provides one-way messaging service to residential and business customers and includes revenues from our Illinois cellular agency and Texas Mobile Virtual Network Operator (MVNO) operations.

 

Our Other Operations segment generated approximately ($0.4) million and $1.7 million of cash flows from operating activities for the years ended December 31, 2007 and 2006, respectively. As of December 31, 2007, our Other Operations had total assets of approximately $23.6 million.

 

North Pittsburgh Operations

 

ILEC

 

The North Pittsburgh ILEC in general recognizes revenue from the same sources as our Illinois and Texas telephone operations. The ILEC benefits from both federal and Pennsylvania state universal service and other funds. We intend to implement many of the strategies and processes used by our Illinois and Texas telephone operations to maximize the revenue potential of the North Pittsburgh ILEC.

 

CLEC

 

The North Pittsburgh CLEC follows an “edge-out” strategy, in which it has leveraged the ILEC’s network, human capital skills and reputation in the surrounding markets. The sales strategy in these edge-out markets has been to focus on small to mid-sized business customers (defined as 5 to 500 lines), educational institutions and healthcare facilities, offering local and long distance voice services, broadband services including DSL and multi-megabit metro Ethernet.

 

Internet Service Provider

 

The North Pittsburgh ISP furnishes Internet access and broadband services in western Pennsylvania. The majority of its DSL and other broadband customers are served over its ILEC and CLEC networks, with the ISP providing a gateway to the Internet. In addition, the ISP also provides virtual hosting services, collocation services, web page design and e-commerce enabling technologies to customers.

 

Investments

 

North Pittsburgh owns limited partnership interests of 3.6%, 16.6725%, and 23.67%, respectively, in the Pittsburgh SMSA, Pennsylvania RSA 6(I), and Pennsylvania RSA 6(II) wireless partnerships, all of which are

majority owned and operated by Verizon Wireless. These partnerships cover territories which almost entirely overlap the markets served by North Pittsburgh’s ILEC and CLEC operations.

 

Customers and Markets

 

Our Illinois local telephone markets consist of 35 geographically contiguous exchanges serving predominantly small towns and rural areas in an approximately 2,681 square mile area primarily in five central Illinois counties: Coles; Christian; Montgomery; Effingham; and Shelby. An exchange is a geographic area established for administration and pricing of telecommunications services. We are the incumbent provider of basic telephone services within these exchanges, with approximately 74,369 local access lines, or approximately 28 lines per square mile, as of December 31, 2007. Approximately 61% of our local access lines serve residential customers and the remainder serve business customers. Our business customers are predominantly small retail, commercial, light manufacturing and service industry accounts, as well as universities and hospitals.

 

Our 21 exchanges in Texas serve three principal geographic markets: Lufkin, Conroe, and Katy in an approximately 2,054 square mile area. Lufkin is located in east Texas and Conroe and Katy are located in the suburbs of Houston and adjacent rural areas. We are the incumbent provider of basic telephone services within these exchanges, with approximately 149,418 local access lines, or approximately 73 lines per square mile, as of December 31, 2007. Approximately 68% of our Texas local access lines served residential customers and the remainder served business customers. Our Texas business customers are predominately manufacturing and retail industries accounts, and our largest business customers are hospitals, local governments and school districts.

 

The Lufkin market is centered primarily in Angelina County in east Texas, approximately 120 miles northeast of Houston and extends into three neighboring counties. Lufkin is the largest town within this market, which also includes the towns of Diboll, Hudson and Huntington. The area is a center for the lumber industry and includes other significant industries such as education, health care, manufacturing, retail and social services.

 

The Conroe market is located primarily in Montgomery County and is centered approximately 40 miles north of Houston on Interstate I-45. Parts of the Conroe operating territory extend south to within 28 miles of downtown Houston, including parts of the affluent suburb of The Woodlands. Major industries in this market include education, health care, manufacturing, retail and social services.

 

The Katy market is located in parts of Fort Bend, Harris, Waller and Brazoria counties and is centered approximately 30 miles west of downtown Houston along the busy and expanding I-10 corridor. The majority of the Katy market is considered part of metropolitan Houston with major industries including administrative, education, health care, management, professional, retail, scientific and waste management services.

 

The North Pittsburgh market covers 285 square miles and serves portions of Allegheny, Armstrong, Butler and Westmorland Counties in western Pennsylvania. The southernmost point of the ILEC territory is just 12 miles from the City of Pittsburgh. Through its CLEC operations, our North Pittsburgh operations are able to expand south to serve Pittsburgh and north to the City of Butler. The CLEC primarily targets small to mid-sized business customers, educational institutions and healthcare facilities.

 

Sales and Marketing

 

Telephone Operations

 

The key components of our overall marketing strategy in our Telephone Operations segment include the following:

 

 

 

Our consumer sales strategy is focused on increasing DSL and IPTV service penetration in all of our service areas, cross-selling our services, developing additional services to maximize revenues and increase ARPU, and increasing customer loyalty through superior customer service, local presence and motivated service employees.

 

Our Telephone Operations segment currently has three sales channels: call centers, communication centers and commissioned sales people. Our customer service call centers serve as the primary sales channels for residential and business customers with one or two phone lines, whereas commissioned sales representatives provide customized proposals to larger business customers. In 2006, we formed a new team of commissioned sales people, our “Feet on the Street” team. This team canvasses our territory offering residential customers our full suite of products, leading with our triple-play bundled offering of voice, DSL and IPTV services. Beyond the strong sales point of contact, this sales channel also helps us to identify and address customer service issues, if any, on a proactive face to face basis. This team of individuals can be scaled up or down to match our business needs, including, for example, if a new product launches or a period of extended inclement weather is experienced. Our customers can also visit one of our eight communications centers for their various communications needs, including new telephone, Internet service and IPTV purchases. We believe that communication centers have helped decrease our customers’ late payments and bad debt due to their ability to pay their bills easily at these centers. Our Telephone Operations’ sales efforts are supported by direct mail, bill inserts, newspaper advertising, public relations activities, sponsorship of community events and website promotions.

 

Directory Publishing is supported by a dedicated sales force, which spends a certain number of months each year focused on each of the directory markets in order to maximize the advertising sales in each directory. We believe the directory business has been an efficient tool for marketing our other services and for promoting brand development and awareness.

 

Transport Services has a sales force that consists of commissioned sales people specializing in wholesale transport products.

 

Other Operations

 

Each of our Other Operations businesses primarily uses an independent sales and marketing team comprised of dedicated field sales account managers, management teams and service representatives to execute our sales and marketing strategy. These efforts are supported by attendance at industry trade shows and leadership in industry groups including the US Telecom Association, the Associated Communications Companies of America and the Independent Telephone and Telecommunications Alliance.

 

Information Technology and Support Systems

 

Our information technology and support systems staff is a seasoned organization that supports day-to-day operations and develops system enhancements. The technology supporting our Telephone Operations segment is centered on a core of commercially available and internally maintained systems.

 

In 2005 and 2006 we successfully migrated most of the key business processes of our Illinois and Texas telephone operations onto single, company-wide systems and platforms including common network provisioning, network management, workforce management systems and financial systems. Our final project, Phase Three of billing integration, was successfully completed during the second half of 2007. Phase Three involved the upgrade of our telephone billing system in Illinois to our latest version of our core billing software utilized by the rest of telephone operations. Our core systems and hardware platform provide for significant scalability.

Just as we migrated our Illinois and Texas properties to common systems, we intend to integrate North Pittsburgh billing systems into our existing platform and move other telephone operation systems to established common platforms.

 

Network Architecture and Technology

 

Our Texas and Illinois local networks are based on a carrier serving area architecture. Carrier serving area architecture is a structure that allows access equipment to be placed closer to customer premises enabling the customer to be connected to the equipment over shorter copper loops than would be possible if all customers were connected directly to the carrier’s main switch. The access equipment is then connected back to that switch on a high capacity fiber circuit, resulting in extensive fiber deployment throughout the network. The access equipment is sometimes referred to as a digital loop carrier and the geographic area that it serves is the carrier serving area.

 

A single engineering team is responsible for the overall architecture and interoperability of the various elements in the combined network of our Illinois and Texas telephone operations. Our network operations center, or NOC, in Lufkin, Texas, monitors the performance of our communications network at a system level, 24 hours per day, 365 days per year. This center is connected to our customer facing NOC in Mattoon, Illinois which deals with customer specific issues and together they function as one organization. We believe these NOCs allow our Illinois and Texas Telephone Operations to maintain high network performance standards, using common network systems and platforms, which allows us to efficiently handle weekend and after-hours coverage between markets and more efficiently allocate personnel to manage fluctuations in our workload volumes.

 

Our network is supported by advanced 100% digital switches, with a fiber network connecting 54 of our 56 exchanges. These switches provide all of our local telephone customers with access to custom calling features, value-added services and dial-up Internet access. We have four additional switches: one which supports feature rich Voice Over Internet Protocol known as VOIP, two dedicated to long distance service and one which supports our Public Services and Operator Services businesses. In addition, approximately 95% of our total local access lines are served by exchanges or carriers equipped with digital subscriber line access multiplexers, or DSLAMs, and are within distance limitations for providing DSL service. DSLAMs are devices designed to separate voice-frequency signals from DSL traffic.

 

We commenced the network improvements needed to support the introduction of our IPTV service, which is functionally similar to a digital cable television offering, in our Illinois markets in 2003 and in our Texas markets in 2005. We have since completed the initial capital investments including associated IP backbone projects and developed the content relationships necessary to provide these services and introduced IPTV in selected Illinois markets in 2005 and Texas markets in August 2006. Other than the provision of set-top boxes, which will be purchased in quantities sufficient to match subscriber demand, we do not anticipate having to make any material capital upgrades to our network infrastructure in connection with our expansion of IPTV in these markets. As of December 31, 2007, IPTV was available to approximately 90,000 homes in our markets. Our IPTV subscriber base has grown from 6,954 as of December 31, 2006 to 12,241 as of December 31, 2007.

 

In Texas we also operate a transport network which consists of approximately 2,500 route-miles of fiber optic cable. Approximately 54% of this network consists of cable sheath owned by us, either directly or through our majority-owned subsidiary East Texas Fiber Line Incorporated and a partnership partly owned by us, Fort Bend Fibernet. For most of the remaining route-miles of the network, we purchased strands on third-party fiber networks pursuant to contracts commonly known as indefeasible rights of use. In limited cases, we also lease capacity on third-party fiber networks to complete routes, in addition to these fiber routes. These assets also support our IPTV video product in Texas as well as our Texas transport services business.

 

In the past ten years, North Pittsburgh has invested over $160 million to develop a high quality network. The Pennsylvania network is a 100% digital switching network, comprised of nine central offices and 86 Carrier Serving Areas (CSAs). The CSA architecture, in which nearly all loop lengths are kept to 12,000 feet or less, has enabled North Pittsburgh to provide DSL service, with speeds up to 3 Mbps, to 100% of its access

lines. In addition, North Pittsburgh has deployed fiber optic cable extensively throughout its network, resulting in a 100% Synchronous Optical Network (SONET) that supports all of the inter-office and host-remote links as well as the majority of business parks within its ILEC serving area.

 

North Pittsburgh is nearing completion of a capital construction project to deploy fiber closer to the homes and businesses it serves. As of December 31, 2007, approximately 90 percent of its addressable access lines have fiber provisioned to within 5,000 feet, which will allow for DSL deployment at speeds ranging between 20 to 25 megabits per second. North Pittsburgh has also upgraded its data transmission network to a gigabit Ethernet backbone using a Multiple Protocol Label Switching (MPLS) network that will more efficiently and effectively handle the increased bandwidth demands of its network, especially its next-generation DSL products as well as its business class Ethernet offerings. The CLEC operates an extensive SONET optical network with over 300 route miles of fiber optic facilities in the Pittsburgh metropolitan area. It has physical collocation in 27 Verizon central offices and one Embarq central office and primarily serves its customers using unbundled network element (UNE) loops. In the Pittsburgh market, it operates a carrier hotel that serves as the hub for its fiber optic network. In addition, North Pittsburgh also offers space in this carrier hotel to ISPs, IXCs, other CLECs and other customers who need a carrier-class location to house voice and data equipment as well as gain access to a number of networks, including the Company’s.

 

Employees

 

As of December 31, 2007, without taking the North Pittsburgh acquisition into effect, we had a total of 1,081 employees, of which 952 were full-time and 129 were part-time. Approximately 343 of the employees located in Illinois are represented by the International Brotherhood of Electrical Workers under a collective bargaining agreement that was renewed on November 15, 2005 for a period of three years. Approximately 186 of the employees located in Texas are represented by the Communications Workers of America under a collective bargaining agreement that was renewed on October 15, 2007 for a period of three years. We believe that management currently has a good relationship with our employees.

 

As of December 31, 2007, North Pittsburgh had a total of 281 employees, of which 274 were full-time and 7 were part-time. Approximately 97 of the employees located in Pennsylvania are represented by the Communications Workers of America under a collective bargaining agreement that was renewed in September of 2007 and will expire on September 30, 2008.

 

Competition

 

Local Telephone Market

 

In general, telecommunications service in rural areas is more costly to provide than service in urban areas because the lower customer density necessitates higher capital expenditures on a per customer basis. As a result, it is generally not economically viable for new entrants to overbuild in rural territories. Despite the barriers to entry for voice services, rural telephone companies face some competition for voice services from new market entrants, such as cable providers, wireless providers and competitive telephone companies. Cable providers are entering the telecommunications market by upgrading their networks with fiber optics and installing facilities to provide fully interactive transmission of broadband voice, data and video communications. Competitive telephone companies are competitors that have been granted permission by a state regulatory commission to offer local telephone service in an area already served by a local telephone company. Electric utility companies have existing assets and low cost access to capital that may allow them to enter a market rapidly and accelerate network development.

 

VOIP service is increasingly being embraced by all industry participants. VOIP service essentially involves the routing of voice calls, at least in part, over the Internet through packets of data instead of transmitting the calls over the existing telephone system. While current VOIP applications typically complete calls using incumbent telephone company infrastructure and networks, as VOIP services obtain acceptance and market penetration and technology advances further, a greater quantity of communication may be placed without the use of the telephone system. On March 10, 2004, the FCC issued a Notice of Proposed Rulemaking with respect to IP-enabled Services. Among other things, the FCC is considering whether VOIP

Services are regulated telecommunications services or unregulated information services. We cannot predict the outcome of the FCC’s rulemaking or the impact on the revenues of our rural telephone companies. The proliferation of VOIP, particularly to the extent such communications do not utilize our rural telephone companies’ networks, may result in an erosion of our customer base and loss of access fees and other funding.

 

Currently Mediacom, which serves the eastern portion of our Illinois service territory, is providing competition for basic voice services with its VOIP offering. We estimate that Mediacom overlaps approximately 15% of our total access lines. The major cable television supplier in the western portion of our Illinois territory is New Wave Communications. Our Texas properties face video and DSL competition from Comcast and Suddenlink. While Mediacom is the only cable provider offering a competitive voice offering in our service area, we are preparing for the launch of voice products by the other cable providers in our service area.

 

The two cable companies that overlay the majority of the North Pittsburgh ILEC territory, Armstrong and Comcast, have each launched an aggressive triple play package of voice, video and broadband service. In general, these cable companies have modern networks, a high percentage of homes passed and a high penetration of their video services.

 

Wireless Service

 

Rural telephone companies face competition for voice services from wireless carriers. However, rural telephone companies usually face less wireless competition than non-rural providers of voice services because wireless networks in rural areas are generally less developed than in urban areas. Our service areas in Conroe and Katy, Texas are exceptions to this general rule due to their proximity to Houston and, as a result, are facing increased competition from wireless service providers. Additionally, due to the concentration of interstate and major highways in the territory, our Pennsylvania markets are also exposed to increased competition from wireless service providers. Although we do not believe that wireless technology represents a significant threat to our rural telephone companies in the near term, we expect to face increased competition from wireless carriers as technology, wireless network capacity and economies of scale improve, wireless service prices continue to decline and subscribers continue to increase.

 

Internet Service

 

The Internet services market in which we operate is highly competitive and there are few barriers to entry. Industry sources expect competition to intensify. Internet services, meaning both Internet access, wired and wireless, and on-line content services, are provided by cable providers, Internet service providers, long distance carriers and satellite-based companies. Many of these companies provide direct access to the Internet and a variety of supporting services to businesses and individuals. In addition, many of these companies offer on-line content services consisting of access to closed, proprietary information networks. Cable providers and long distance carriers, among others, are aggressively entering the Internet access markets. Both have substantial transmission capabilities, traditionally carry data to large numbers of customers and have a billing system infrastructure that permits them to add new services. Satellite companies are also offering broadband access to the Internet. We expect that competition for Internet services will increase.

 

Long Distance Service

 

The long distance telecommunications market is highly competitive. Competition in the long distance business is based primarily on price, although service bundling, branding, customer service, billing service and quality play a role in customers’ choices.

 

Other Competition

 

Our other lines of business are subject to substantial competition from local, regional and national competitors. In particular, our directory publishing and transport businesses operate in competitive markets. We expect that competition as a general matter in our businesses will continue to intensify as new technologies and new services are offered. Our businesses operate in a competitive environment where long-term contracts

are either not the norm or have cancellation clauses that allow quick termination of the agreements. Where long-term contracts are common, they are being renewed with shorter duration terms. Customers in these businesses can and do change vendors frequently. Customer business failures and consolidation of customers through mergers and buyouts can cause loss of customers.

 

Regulatory Environment

 

The following summary does not describe all present and proposed federal, state and local legislation and regulations affecting the telecommunications industry. Some legislation and regulations are currently the subject of judicial proceedings, legislative hearings and administrative proposals that could change the manner in which this industry operates. Neither the outcome of any of these developments, nor their potential impact on us, can be predicted at this time. Regulation can change rapidly in the telecommunications industry, and these changes may have an adverse effect on us in the future. See “Risk Factors — Regulatory Risks”.

 

Overview

 

The telecommunications industry in which we operate is subject to extensive federal, state and local regulation. Pursuant to the Telecommunications Act of 1996, federal and state regulators share responsibility for implementing and enforcing statutes and regulations designed to encourage competition and the preservation and advancement of widely available, quality telephone service at affordable prices. At the federal level, the Federal Communications Commission, or FCC, generally exercises jurisdiction over facilities and services of local exchange carriers, such as our rural telephone companies, to the extent they are used to provide, originate or terminate interstate or international communications. State regulatory commissions, such as the ICC, PAPUC and the PUCT, generally exercise jurisdiction over these facilities and services to the extent they are used to provide, originate or terminate intrastate communications. In particular, state regulatory agencies have substantial oversight over interconnection and network access by competitors of our rural telephone companies. In addition, municipalities and other local government agencies regulate the public rights-of-way necessary to install and operate networks.

 

The FCC has the authority to condition, modify, cancel, terminate or revoke our operating authority for failure to comply with applicable federal laws or rules, regulations and policies of the FCC. Fines or other penalties also may be imposed for any of these violations. In addition, the states have the authority to sanction our rural telephone companies or to revoke our certifications if we violate relevant laws or regulations.

 

Federal Regulation

 

Our rural telephone companies and competitive local exchange companies must comply with the Communications Act of 1934, as amended, or the Communications Act, which requires, among other things, that telecommunications carriers offer services at just and reasonable rates and on non-discriminatory terms and conditions. The amendments to the Communications Act enacted in 1996 and contained in the Telecommunications Act dramatically changed, and are expected to continue to change, the landscape of the telecommunications industry.

 

Access Charges

 

A significant portion of our rural telephone companies’ revenues come from network access charges paid by long distance and other carriers for originating or terminating calls within our rural telephone company’s service areas. The amount of network access charge revenues our rural telephone companies receive is based on rates set or approved by federal and state regulatory commissions, and these rates are subject to change at any time. The FCC regulates the prices our rural telephone companies may charge for the use of our local telephone facilities in originating or terminating interstate and international transmissions. The FCC has structured these prices as a combination of flat monthly charges paid by the end-users and usage sensitive charges or flat monthly rate charges paid by long distance or other carriers. Intrastate network access charges are regulated by state commissions. Our Illinois rural telephone company’s intrastate network access charges currently mirror interstate network access charges for all but one element, local switching. Our North

Pittsburgh rural telephone company’s intrastate and interstate network access charges are also very similar. In contrast, our Texas rural telephone companies currently charge significantly higher intrastate network access charges than interstate network access charges, in accordance with the regulatory regime in Texas.

 

The FCC regulates levels of interstate network access charges by imposing price caps on Regional Bell Operating Companies, referred to as RBOC’s, and large incumbent telephone companies. These price caps can be adjusted based on various formulas, such as inflation and productivity, and otherwise through regulatory proceedings. Small incumbent telephone companies may elect to base network access charges on price caps, but are not required to do so. Our Illinois, Pennsylvania, and Texas rural telephone companies have elected not to apply federal price caps. Instead, our rural telephone companies employ rate-of-return regulation for their network interstate access charges, whereby they earn a fixed return on their investment over and above operating costs. The FCC determines the profits our rural telephone companies can earn by setting the rate-of-return on their allowable investment base, which is currently 11.25%.

 

Our Illinois and Texas rural telephone companies currently are cost based rate of return companies and file their own rates for switched and special access. They participate in the National Exchange Carrier Associations (“NECA”) pool for common line services. On December 4, 2007, however, we filed a petition with the FCC seeking to permit our Illinois and Texas companies to convert to price cap regulation. The conversion to a price cap regime will advance FCC goals and serve the public interest in a number of ways. Efficient access pricing mechanisms like price cap regulation generate incentives to optimize a carrier’s cost structure and promote competition. The price cap rate structure is far more conducive to efficiency and competition than the rate of return rate structure, and price cap regulation will benefit our customers and provide us with a regulatory structure that delivers appropriate incentives. If approved, this conversion would give us greater pricing flexibility for interstate services, particularly the increasingly competitive special access segment, and the potential to increase our net earnings through greater productivity and introduction of new services. Offsetting these advantages, however, we would be required to reduce our interstate access charges in Illinois significantly, and also would receive somewhat reduced subsidies from the interstate Universal Service Fund program. Because our Illinois intrastate access charges generally mirror interstate rates, this conversion may also result in lower intrastate revenues in Illinois. The FCC has not yet ruled on this petition. Because access tariffs are filed on an annual basis, our companies can convert to price cap regulation effective on July 1, 2008 if the FCC approves our petition in advance of that date; if not, the next opportunity to convert would be on July 1, 2009.

 

Our Pennsylvania rural telephone company is an average schedule rate of return company, which means its interstate settlements are determined by formulas based on a statistical sampling of the allocation of costs to the interstate jurisdiction of comparable companies that perform cost studies. NECA’s average schedule formulas for the July 1, 2006 through June 30, 2007 period reflected the normal projected changes in cost and demand for the July 1, 2006 through June 30, 2007 period and also implemented some structural changes to the formulas to more closely align average schedule company settlements to the companies’ estimated interstate revenue requirements based on statistical sampling.

 

Traditionally, regulators have allowed network access rates to be set higher in rural areas than the actual cost of terminating or originating long distance calls as an implicit means of subsidizing the high cost of providing local service in rural areas. Following a series of federal circuit court decisions ruling that subsidies must be explicit rather than implicit, in 2001, the FCC adopted an order beginning to reform the network access charge system for rural carriers. The FCC reforms reduced per-minute network access charges and shifted a portion of cost recovery, which historically was imposed on long distance carriers, to flat-rate, monthly subscriber line charges imposed on end-user customers. While the FCC also increased explicit subsidies through the universal service fund to rural telephone companies, the aggregate amount of interstate network access charges paid by long distance carriers to access providers, such as our rural telephone companies, has decreased and may continue to decrease.

 

The FCC’s 2001 access reform order had a negative impact on the intrastate network access revenues of our Illinois rural telephone company. Consistent with ICC policy, our Illinois rural telephone company’s intrastate network access rates mirror interstate network access rates. Illinois, however, unlike the federal

system, does not provide an explicit subsidy in the form of a universal service fund. Therefore, while subsidies from the federal universal service fund offset Illinois Telephone Operations’ decrease in revenues resulting from the reduction in interstate network access rates, there was not a corresponding offset for the decrease in revenues from the reduction in intrastate network access rates. In Pennsylvania and Texas, because the intrastate network access rate regime applicable to our rural telephone companies does not mirror the FCC regime, the impact of the reforms was revenue neutral. The PAPUC and PUCT are continuing to investigate possible changes to the structure for intrastate access charges. The Texas legislature is expected to consider potential changes to rates during the legislative session beginning in January, 2009.

 

In recent years, long distance carriers and other such carriers have become more aggressive in disputing interstate access charge rates set by the FCC and the applicability of access charges to their telecommunications traffic. We believe that these disputes have increased in part due to advances in technology which have rendered the identity and jurisdiction of traffic more difficult to ascertain and which have afforded carriers an increased opportunity to assert regulatory distinctions and claims to lower access costs for their traffic. For example in September 2003, Vonage Holdings Corporation filed a petition with the FCC to preempt an order of the Minnesota Public Utilities Commission which had issued an order requiring Vonage to comply with the Minnesota Commission’s order. The FCC determined that Vonage’s VOIP service was such that it was impossible to divide it into interstate and intrastate components without negating federal rules and policies. Accordingly, the FCC found it was an interstate service not subject to traditional state telephone regulation. While the FCC order did not specifically address the issue of the application of intrastate access charges to Vonage’s VOIP service, the fact that the service was found to be solely interstate raises that concern. We cannot predict what other actions other long distance carriers may take before the FCC or with their local exchange carriers, including our rural telephone companies, to challenge the applicability of access charges. To date, no long distance or other carrier has made a claim to us contesting the applicability of network access charges billed by our rural telephone companies. We cannot assure you, however, that long distance or other carriers will not make such claims in the future nor, if such a claim is made, can we predict the magnitude of the claim. As a result of the increasing deployment of VOIP services and other technological changes, we believe that these types of disputes and claims will likely increase.

 

On July 25, 2006 the FCC issued for comment CC Docket 01-92, Missoula Intercarrier Compensation Plan, or the Missoula Plan, a proposal for a comprehensive reform of network access charges and other forms of compensation for the exchange of traffic among telecommunications carriers. Consolidated is a signed supporter of the Missoula Plan. The ICC, PAPUC and PUCT have filed comments in opposition to the Missoula Plan. The FCC has taken no action on the proposal to date. We continue to actively participate in shaping intercarrier compensation and universal service reforms through our own efforts as well as through industry associations and coalitions.

 

On October 23, 2006, Verizon Pennsylvania, Inc., along with a number of its affiliated companies, filed a formal complaint with the PAPUC claiming that our Pennsylvania CLEC’s intrastate switched access rates are in violation of Pennsylvania statute. For a detailed description of the dispute, see “Regulatory Risks” included in Item 1A. “Risk Factors.”

 

Removal of Entry Barriers

 

The central aim of the Telecommunications Act of 1996 is to open local telecommunications markets to competition while enhancing universal service. Prior to the enactment of the Telecommunications Act, many states limited the services that could be offered by a company competing with an incumbent telephone company. The Telecommunications Act preempts these state and local laws.

 

The Telecommunications Act imposes a number of interconnection and other requirements on all local communications providers. All telecommunications carriers have a duty to interconnect directly or indirectly with the facilities and equipment of other telecommunications carriers. Local exchange carriers, including our rural telephone companies, are required to:

 

 

 

Furthermore, the Telecommunications Act imposes on incumbent telephone companies, other than rural telephone companies that maintain their so-called “rural exemption”, additional obligations, by requiring them to:

 

 

Unbundled Network Element Rules

 

The unbundling requirements have been some of the most controversial requirements of the Telecommunications Act. The FCC, in its initial implementation of the law, had generally required incumbent telephone companies to lease a wide range of unbundled network elements to competitive telephone companies to enable delivery of services to the competitor’s customers in combination with the competitive telephone companies’ network or as a recombined service offering on an unbundled network element platform, commonly known as an UNE-P. These unbundling requirements, and the duty to offer UNEs to competitors, imposed substantial costs on, and resulted in customer attrition for, the incumbent telephone companies that had to comply with these requirements. In response to a decision by the U.S. Court of Appeals for the D.C. Circuit vacating portions of its UNE and UNE-P rules, the FCC issued revised rules on February 4, 2005 that reinstated some unbundling requirements for incumbent telephone companies that are not protected by the rural exemption but eliminated certain other unbundling requirements. In particular, incumbent telephone companies are no longer required to offer the UNE-P, although they are still required to offer loop and transport UNEs in most markets.

 

Each of the subsidiaries through which we operate our local telephone businesses is an incumbent telephone company and provides service in rural areas. The Telecommunications Act exempts rural telephone companies from certain of the more burdensome interconnection requirements such as unbundling of network elements, information sharing and co-location. The Telecommunications Act, though, provides that the rural exemption will cease to apply as to competing cable companies if and when the rural carrier introduces video services in a service area. In that event, a competing cable operator providing video programming and seeking to provide telecommunications services in the area may interconnect without the restrictions of the rural exemption. Since each of our subsidiaries now provides, or will soon provide, video services in their major

service areas, the rural exemption no longer applies to cable company competitors in those service areas. Additionally, in Texas, the PUCT has removed the rural exemption for our Texas subsidiaries with respect to telecommunications services furnished by Sprint Communications, LP. on behalf of cable companies. We believe the benefits of providing video services outweigh the unavailability of the rural exemptions as to cable operators.

 

Under its current rules, the FCC has eliminated unbundling requirements for ILEC’s in regard to broadband services provided over fiber facilities but continues to require unbundled access to mass-market narrowband loops. ILEC’s are no longer required to unbundle packet switching services. In addition, the FCC found that CLEC’s are not impaired at certain wire center locations in regard to high bandwidth (DS-1 and DS-3) loops, dark fiber loops and dedicated interoffice transport facilities based on such criteria as the number of business lines and fiber-based collocators within the wire center. Where these non-impairment criteria are not satisfied, however, ILEC’s continue to be required to unbundle these loops and transport facilities.

 

The FCC rules regarding the unbundling of network elements did not have an impact on our Illinois and Pennsylvania ILEC operations, because we are not required to offer UNE’s to competitors as long as we retain our rural exemption. In regard to our Pennsylvania CLEC operations, because we do not currently utilize line sharing and utilize our own switching for business customers that are served by high-capacity loops, the elimination of unbundling requirements for these network elements had no effect on our operations or revenues from our existing customer base. In July of 2005, our Pennsylvania CLEC executed a three-year commercial agreement with Verizon that has set the terms of the pricing and provisioning of lines served utilizing UNE-P. We currently provision 8% of our CLEC access lines (or 3% of our consolidated access lines) utilizing UNE-P. Although the costs for UNE-P will increase over time pursuant to the terms of the agreement, our relatively low use of UNE-P and our ability to migrate some of the lines to alternative provisioning methodologies will limit the overall impact on our current cost structure. The CLEC has experienced moderate increases in the overall cost to provision high capacity loops, interoffice transport facilities and dark fiber as a result of the FCC’s changes to unbundling requirements for those facilities.

 

On September 6, 2006, Verizon filed a Petition with the FCC requesting that it forbear from applying a number of regulations to the Verizon operations in six major metropolitan markets, one of which was the Pittsburgh market area. In addition to seeking forbearance from dominant carrier tariffing requirements, price cap regulations, comparably efficient interconnection and open network architecture requirements, Verizon also sought forbearance from applying loop and transport unbundling regulations, claiming that there was sufficient competition in the Pittsburgh market, so that the public interest no longer required the application of these rules. On December 5, 2007, the FCC denied Verizon’s petition for forbearance based on the levels of competition existing at the time Verizon filed its petition. Verizon (and other ILECs) remain free to petition the FCC for similar relief, in these and other markets, in the future; if any such petitions are granted in markets in which our CLEC operates, the result could be to greatly increase our cost to obtain access to loop and transport facilities.

 

Promotion of Universal Service

 

In general, telecommunications service in rural areas is more costly to provide than service in urban areas because there is a lower customer density and higher capital requirements compared to urban areas. The low customer density in rural areas means that switching and other facilities serve fewer customers and loops are typically longer requiring greater capital expenditure per customer to build and maintain. By supporting the high cost of operations in our rural markets, the federal universal service fund subsidies our rural telephone companies receive are intended to promote widely available, quality telephone service at affordable prices in rural areas. In 2007 and 2006 received $46.0 million and $47.6 million, respectively, in aggregate payments from the federal universal service fund and the Texas universal service fund.

 

Federal universal service fund subsidies are paid only to carriers that are designated as eligible telecommunications carriers, or ETCs, by a state commission. Each of our rural telephone companies has been designated as an ETC by the applicable state commission. Under the Telecommunications Act, however, competitors can obtain the same level of federal universal service fund subsidies as we do, per line served, if

the ICC, PaPUC, or PUCT, as applicable, determines that granting such federal universal service fund subsidies to competitors would be in the public interest and the competitors offer and advertise certain telephone services as required by the Telecommunications Act and the FCC. The ICC has granted several petitions for ETC designations, but to date no other ETCs are operating in our Illinois service area. We are not aware of any having been filed in our Pennsylvania or Texas service areas. Under current rules, the subsidies received by our rural telephone companies are not affected by any such payments to competitors. The FCC proposed on January 29, 2008, to amend its rules to reduce the support available to competitors, but we are unable to predict whether or when it may adopt this proposal.

 

With some limitations, incumbent telephone companies receive federal universal service fund subsidies pursuant to existing mechanisms for determining the amounts of such payments on a cost per loop basis. In 2001, the FCC adopted an interim embedded, or historical, cost mechanism for a five-year period that provides predictable levels of support to rural carriers. The FCC has extended the five-year period while it considers various proposals for reforming the high-cost support fund. On November 20, 2007 the Federal-State Joint Board on Universal Service (Joint Board) recommended that the Federal Communications Commission ( the Commission) address the long-term reform issues facing the high-cost universal service support system and make fundamental revisions in the structure of existing Universal Service mechanisms. Some of the key components of the Joint Board recommendation are to eliminate the identical support rule, creation of mobility and broadband funds, and capping the overall fund size. In addition they recommend the FCC seek comments on contribution mechanisms and reverse auctions, on January 29, 2008, the FCC issued a public notice requesting comments on the Joint Board’s proposals.

 

We cannot predict the outcome of any FCC rulemaking or similar proceedings. The outcome of any of these proceedings or other legislative or regulatory changes could affect the amount of universal service support received by our rural telephone companies.

 

State Regulation of CCI Illinois

 

Illinois requires providers of telecommunications services to obtain authority from the ICC prior to offering common carrier services. Our Illinois rural telephone company is certified to provide local telephone services. In addition, Illinois Telephone Operations’ long distance, operator services and payphone services subsidiaries hold the necessary certifications in Illinois and the other states in which they operate. In Illinois, our long distance, operator services and payphone services subsidiaries are required to file tariffs with the ICC but generally can change the prices, terms and conditions stated in their tariffs on one day’s notice, with prior notice of price increases to affected customers. Our Illinois Telephone Operations other services are not subject to any significant state regulations in Illinois. Our Other Illinois Operations are not subject to any significant state regulation outside of any specific contractually imposed obligations.

 

Our Illinois rural telephone company operates as a distinct company from an Illinois regulatory standpoint and is regulated under a rate of return system for intrastate revenues. Although the FCC has preempted certain state regulations pursuant to the Telecommunications Act, as explained above, Illinois retains the authority to impose requirements on our Illinois rural telephone company to preserve universal service, protect public safety and welfare, ensure quality of service and protect consumers. For instance, our Illinois rural telephone company must file tariffs setting forth the terms, conditions and prices for its intrastate services and these tariffs may be challenged by third parties. Our Illinois rural telephone company has not had, however, a general rate proceeding before the ICC since 1983.

 

The ICC has broad authority to impose service quality and service offering requirements on our Illinois rural telephone company, including credit and collection policies and practices, and to require our Illinois rural telephone company to take other actions in order to insure that it meets its statutory obligation to provide reliable local exchange service. In particular, we were required to obtain the approval of the ICC to effect the reorganization we implemented in connection with our IPO. The ICC imposed various conditions as part of its approval of the reorganization, including (1) prohibitions on payment of dividends or other cash transfers from ICTC to us if ICTC fails to meet or exceed agreed benchmarks for a majority of seven service quality metrics and (2) the requirement that ICTC have access to the higher of $5.0 million or its currently approved capital

expenditure budget for each calendar year through a combination of available cash and amounts available under credit facilities. During 2007 we satisfied each of the applicable Illinois regulatory requirements necessary to permit ICTC to pay dividends to us.

 

Any requirements or restrictions of this type could limit the amount of cash that is available to be transferred from our Illinois rural telephone company to the Company and could adversely impact our ability to meet our debt service requirements and to pay dividends on our common stock.

 

The Illinois General Assembly has made major revisions and added significant new provisions to the portions of the Illinois Public Utilities Act governing the regulation and obligations of telecommunications carriers on at least three occasions since 1985. In 2007, the Illinois General Assembly addressed competition for cable and video services and enacted legislation authorizing a statewide licensing by the ICC. This legislation also imposed substantial state-mandated consumer service and consumer protection requirements on providers of cable and video services. The requirements generally became applicable to us on January 1, 2008. We are operating in compliance with the requirements of the new law. Although we have franchise agreements for cable and video services in all the towns we serve, this statewide franchising authority will simplify the process in the future. The Illinois General Assembly concluded its session in May 2007 and made no additional changes to the current state telecommunications law except to extend the sunset date from July 1, 2007 to July 1, 2009. The governor signed the statewide video bill and the extension into law. As a result, we expect that the Illinois General Assembly will again consider amendments to the telecommunications article of the Illinois Public Utilities Act in 2009.

 

State Regulation of CCI Texas

 

Texas requires providers of telecommunications services to obtain authority from the PUCT prior to offering common carrier services. Our Texas rural telephone companies are each certified to provide local telephone services in their respective territories. In addition, our Texas long distance and transport subsidiaries are registered with the PUCT as interexchange carriers. The transport subsidiary also has obtained from the PUCT a service provider certificate of operating authority (“SPCOA”) to better assist the transport subsidiary with its operations in municipal areas. Recently, to assist with expanding services offerings, Consolidated Communications Network Services, Inc. also obtained an SPCOA from the PUCT. While our Texas rural telephone company services are extensively regulated by the PUCT, our other services, such as long distance and transport services, are not subject to any significant state regulation.

 

Our Texas rural telephone companies operate as distinct companies from a Texas regulatory standpoint. Each Texas rural telephone company is separately regulated by the PUCT in order to preserve universal service, protect public safety and welfare, ensure quality of service and protect consumers. Each Texas rural telephone company also must file and maintain tariffs setting forth the terms, conditions and prices for its intrastate services.

 

Currently, both Texas rural telephone companies have immunity from adjustments to their rates, including their intrastate network access rates, due to their election of incentive regulation under the Texas Public Utilities Regulatory Act, or PURA. In order to qualify for this incentive regulation, our rural telephone companies agreed to fulfill certain infrastructure requirements and, in exchange, they are not subject to challenge by the PUCT regarding their rates, overall revenues, return on invested capital or net income.

 

There are two different forms of incentive regulation designated by PURA: Chapter 58 and Chapter 59. Generally under either election, the rates, including network access rates, an incumbent telephone company may charge in connection with basic local services cannot be increased from the amount(s) on the date of election without PUCT approval. Even with PUCT approval, increases can only occur in very specific situations. Pricing flexibility under Chapter 59 is extremely limited. In contrast, Chapter 58 allows greater pricing flexibility on non-basic network services, customer specific contracts and new services.

 

Initially, both Texas rural telephone companies elected incentive regulation under Chapter 59 and fulfilled the applicable infrastructure requirements to maintain their election status. Consolidated Communications of Texas Company made its election on August 17, 1997. Consolidated Communications of Fort Bend Company

made its election on May 12, 2000. On March 25, 2003, both Texas rural telephone companies changed their election status from Chapter 59 to Chapter 58. The rate freezes for basic services with respect to the current Chapter 58 elections expired on March 24, 2007. After the rate freeze related to the Chapter 58 elections expires, the Texas telephone companies are allowed, with PUCT approval, additional pricing flexibility for basic services. Furthermore, the Texas telephone companies have taken the necessary steps to ensure the other protections afforded by their Chapter 58 elections continue after the initial rate freeze for basic services expires.

 

In connection with the 2003 election by each of our Texas rural telephone companies to be governed under an incentive regulation regime, our Texas rural telephone companies were obligated to fulfill certain infrastructure requirements. While our Texas rural telephone companies have met the current infrastructure requirements, the PUCT could impose additional or other restrictions of this type in the future. Any requirements or restrictions of this type could limit the amount of cash that is available to be transferred from our rural telephone companies to Consolidated Communications Acquisition Texas, Inc. and could adversely impact our ability to meet our debt service requirements and repayment obligations.

 

In September 2005, the Texas Legislature adopted significant telecommunications legislation. This legislation created, among other provisions, a statewide video franchise for telecommunications carriers, established a framework for deregulation of the retail telecommunications services offered by incumbent local telecommunications carriers, created requirements for incumbent local telecommunications carriers to reduce intrastate access charges upon the deregulation of markets and directed the PUCT to initiate a study of the Texas Universal Service Fund. The PUCT study was completed and submitted to the Texas Legislature in 2007. That study recommended that the Small Company Area High-Cost Program, which covers our Texas telephone companies, should be reviewed by the PUCT from a policy perspective regarding basic local telephone service rates and lines eligible for support. The PUCT has not yet initiated a proceeding to conduct such a review. Additionally, the Texas Legislature may address issues of importance to rural telecommunications carriers in Texas, including the Texas Universal Service Fund, in the 2009 Legislative session.

 

Texas Universal Service

 

The Texas universal service fund was established within PURA and is administered by NECA. The law directs the PUCT to adopt and enforce rules requiring local exchange carriers to contribute to a state universal service fund which assists telecommunications providers in providing basic local telecommunications service at reasonable rates in high cost rural areas. The Texas universal service fund is also used to reimburse telecommunications providers for revenues lost by providing Tel-Assistance and to reimburse carriers for providing lifeline service. The Texas universal service fund is funded by a statewide charge payable by specified telecommunications providers at rates determined by the PUCT. Our Texas rural telephone companies qualify for disbursements from this fund pursuant to criteria established by the PUCT. We received Texas universal service fund subsidies of $19.0 million or 5.8% of our revenues in 2007 and $19.5 million, or 6.0% of our revenues in 2006. Under the new PURA rules the PUCT has reviewed the Texas universal service fund and is in the process of conducting a hearing to determine the size and scope of the Large Company Area High-Cost Program. The PUCT has not yet taken any action to change the Small Company Area High-Cost Program, which covers our Texas telephone companies. We anticipate the Texas legislature may take some action regarding the Texas universal service fund during the 2009 legislative session. What specific action will be taken is uncertain at this time.

 

State Regulation of North Pittsburgh

 

The PAPUC regulates the rates, the system of financial accounts for reporting purposes, certain aspects of service quality, billing procedures, universal service funding and other aspects related to our rural telephone company and CLEC’s provision of intrastate services. In addition, the PAPUC sets the rates and terms for interconnection between carriers within the guidelines ordered by the FCC.

Price Regulation

 

Effective January 22, 2001, under a statutory framework referred to as Chapter 30, North Pittsburgh moved from rate-of-return regulation in the intrastate jurisdiction to an alternative form of regulation, which was a price cap plan. Under North Pittsburgh’s price cap plan, rates for non-competitive intrastate services were allowed to increase based on an index that measures economy-wide price increases less a productivity offset. In return for approval of the alternative form of regulation, North Pittsburgh committed to continue to upgrade its network in the future to ensure that all its customers would have access to broadband services. The original Chapter 30 legislation expired due to legislative sunset provisions on December 31, 2003. On November 30, 2004, Act 183 was signed into law in Pennsylvania. Act 183 implemented new Chapter 30 legislation, which continued many aspects of the former Chapter 30 provisions (as described above) but also added some options for ILECs in regard to alternative regulation. On February 25, 2005, North Pittsburgh filed an Amended Alternative Form of Regulation and Network Modernization Plan with the PAPUC pursuant to Act 183. In that filing, in addition to modifying its prior Chapter 30 Plan to comport with the new statute, North Pittsburgh committed to accelerate its deployment of a ubiquitous broadband (defined as 1.544 mbps) network throughout its entire service area to December 31, 2008. In return for making this commitment, North Pittsburgh is no longer subject to a productivity offset when calculating the Price Stability Index component of its annual price stability mechanism filing. On June 2, 2005, the PAPUC approved North Pittsburgh’s amended plan with no significant changes. North Pittsburgh is already in the process of updating its broadband infrastructure for general business and competitive purposes, and we do not anticipate that the acceleration of our broadband commitment date under our amended Network Modernization Plan will require any material additional amount of capital expenditures from what otherwise is planned to be spent in the normal course of business.

 

Pennsylvania Universal Service and Access Charges

 

In an order entered September 30, 1999, the PAPUC, as part of a proceeding that resolved a number of pending issues, ordered ILECs, including North Pittsburgh, to rebalance and lower intrastate toll and switched access rates. In that same Order, the PAPUC also created a Pennsylvania Universal Service Fund (PAUSF) to help offset the loss of ILEC revenues due to the reduction in toll and access rates. In 2003, the PAPUC, pursuant to a settlement, ordered ILECs to further rebalance and reduce intrastate access charges and left the PAUSF in place pending further review. Currently, North Pittsburgh’s annual receipts from and contributions to the PAUSF total $5.2 million and $0.3 million, respectively. Penn Telecom receives no funding from the PAUSF but currently contributes $0.2 million on an annual basis. Under the Act 183 changes to the Public Utility Code, the PAPUC may not require a LEC to reduce intrastate access rates except on a revenue neutral basis.

 

In 2004, PAPUC instituted a third generic review of access charges. This proceeding may affect both North Pittsburgh’s and Penn Telecom’s access charge rates. The proceeding also may affect the amount of funding that North Pittsburgh receives from the PAUSF and the amounts that North Pittsburgh and Penn Telecom contribute to that fund. The PAPUC, subsequently, has twice agreed that a stay is appropriate while awaiting an FCC ruling in its Unified Compensation docket. The request for a third stay is now pending before the PAPUC and is opposed by several parties. It is not known when the PAPUC will rule. During the period of the stay the current PAUSF continues under the existing regulations.

 

Local Government Authorizations

 

In Illinois, we historically have been required to obtain franchises from each incorporated municipality in which our Illinois rural telephone company operates. Effective January 1, 2003, an Illinois state statute prescribes the fees that a municipality may impose on our Illinois rural telephone company for the privilege of originating and terminating messages and placing facilities within the municipality. Illinois Telephone Operations may also be required to obtain from municipal authorities permits for street opening and construction, or operating franchises to install and expand fiber optic facilities in specified rural areas and from county authorities in unincorporated areas. These permits or other licenses or agreements typically require the payment of fees. Similar to Illinois, Pennsylvania also operates under a fee based structure.

In Texas, incumbent telephone companies have historically been required to obtain franchises from each incorporated municipality in which our Texas rural telephone companies operate. In 1999, Texas enacted legislation generally eliminating the need for incumbent telephone companies to obtain franchises or other licenses to use municipal rights-of-way for delivering services. Payments to municipalities for rights-of-way are administered through the PUCT and through a reporting process by each incumbent telephone company and other similar telecommunications provider. Incumbent telephone companies still need to obtain permits from municipal authorities for street opening and construction, but most burdens of obtaining municipal authorizations for access to rights-of-way have been streamlined or removed.

 

Our Texas rural telephone companies still operate pursuant to the terms of municipal franchise agreements in some territories served by Consolidated Communications of Fort Bend Company. As the franchises expire, they are not being renewed.

 

Broadband and Internet Regulatory Obligations

 

In connection with our Internet access offerings, we could become subject to laws and regulations as they are adopted or applied to the Internet. To date, the FCC has treated Internet Service Providers, or ISP’s, as enhanced service providers, rather than common carriers, and therefore ISPs are exempt from most federal and state regulation, including the requirement to pay access charges or contribute to the federal USF. As Internet services expand, federal, state and local governments may adopt rules and regulations, or apply existing laws and regulations to the Internet.

 

In 2005, the FCC adopted a comprehensive regulatory framework for facilities-based providers of wireline broadband Internet access service. The FCC determined that facilities-based wireline broadband Internet access service is an information service. This decision places the federal regulatory treatment of DSL service in parity with the federal regulatory treatment of cable modem service. Facilities-based wireline carriers are permitted to offer broadband Internet access transmission arrangements for wireline broadband Internet access services on a common carrier basis or a non-common carrier basis. Revenues from wireline broadband Internet access service are no longer subject to assessment for the federal Universal Service Fund.

 

The emerging technology application known as VOIP can be used to carry voice communications services over a broadband Internet connection. The FCC has ruled that some VOIP arrangements are not subject to regulation as telephone services. In 2004, the FCC ruled that certain VOIP services are jurisdictionally interstate, and it preempted the ability of the states to regulate some VOIP applications or providers. A number of state regulators have filed judicial challenges to that preemption decision. The FCC has pending a proceeding that will address the applicability of various regulatory requirements to VOIP providers, including the payment of access charges and the support of programs such as Universal Service and Enhanced-911. Expanded use of VOIP technology could reduce the access revenues received by local exchange carriers like us. We cannot predict whether or when VOIP providers may be required to pay or be entitled to receive access charges or USF support, the extent to which users will substitute VOIP calls for traditional wireline communications or the impact of the growth of VOIP on our revenues.

 

Our Internet access offerings may become subject to newly adopted laws and regulations. Currently, there exists only a small body of law and regulation applicable to access to, or commerce on, the Internet. As the significance of the Internet expands, federal, state and local governments may adopt new rules and regulations or apply existing laws and regulations to the Internet. The FCC is currently reviewing the appropriate regulatory framework governing high speed access to the Internet through telephone and cable providers’ communications networks. We cannot predict the outcome of these proceedings, and they may affect our regulatory obligations and the form of competition for these services.

 

Video service is lightly regulated by the FCC and state regulators. Such regulation is limited to company registration, broadcast signal call sign management, fee collection and administrative matters such as Equal Employment Opportunity reporting. IPTV rates are not regulated.

 

On February 26, 2008, we gave notice of our intention to call the outstanding senior notes on April 1, 2008. We anticipate replacing the senior notes with proceeds from a term loan under our credit facility, which is described in more detail under “Liquidity and Capital Resources” contained in Item 7. “Management’s Discussion and Analyis of Financial Condition and Results of Operations.” The term loan will bear interest at LIBOR + 2.50%. Assuming the redemption is completed as anticipated, the restrictions under the indenture referred to throughout this Annual Report on Form 10-K would no longer apply.

 

Risks Relating to Our Common Stock

 

You may not receive dividends because our board of directors could, in its discretion, depart from or change our dividend policy at any time.

 

We are not required to pay dividends, and our stockholders are not guaranteed, and do not have contractual or other rights, to receive dividends. Our board of directors may decide at any time, in its discretion, to decrease the amount of dividends, otherwise change or revoke the dividend policy or discontinue entirely the payment of dividends. Our board could depart from or change our dividend policy, for example, if it were to determine that we had insufficient cash to take advantage of other opportunities with attractive rates of return. In addition, if we do not pay dividends, for whatever reason, your shares of our common stock could become less liquid and the market price of our common stock could decline.

 

We might not have cash in the future to pay dividends in the intended amounts or at all.

 

Our ability to pay dividends, and our board of directors’ determination to maintain our dividend policy, will depend on numerous factors, including the following:

 

 

While our estimated cash available to pay dividends for the year ended December 31, 2007 was sufficient to pay dividends in accordance with our dividend policy, if our future estimated cash available to pay dividends were to fall below our expectations, our assumptions as to estimated cash needs are too low or if other applicable assumptions were to prove incorrect, we may need to:

 

 

 

Over time, our capital and other cash needs will invariably be subject to uncertainties, which could affect whether we pay dividends and the level of any dividends we may pay in the future. In addition, if we seek to raise additional cash from additional debt incurrence or equity security issuances, we cannot assure you that such financing will be available on reasonable terms or at all. Each of the results listed above could negatively affect our results of operations, financial condition, liquidity and ability to maintain and expand our business.

 

Because we are a holding company with no operations, we will not be able to pay dividends unless our subsidiaries transfer funds to us.

 

As a holding company we have no direct operations and our principal assets are the equity interests we hold in our respective subsidiaries. In addition, our subsidiaries are legally distinct from us and have no obligation to transfer funds to us. As a result, we are dependent on the results of operations of our subsidiaries and, based on their existing and future debt agreements (such as the credit agreement), state corporation law of the subsidiaries and state regulatory requirements, their ability to transfer funds to us to meet our obligations and to pay dividends.

 

You may not receive dividends because of restrictions in our debt agreements, Delaware, Illinois and Pennsylvania law and state regulatory requirements.

 

Our ability to pay dividends will be restricted by current and future agreements governing our debt, including our credit agreement and our indenture, Delaware and Illinois law and state regulatory requirements.

 

 

 

We expect that our cash income tax liability will increase in 2008 as a result of the use of, and limitations on, our net operating loss carryforwards, which will reduce our after-tax cash available to pay dividends and may require us to reduce dividend payments in future periods.

 

We expect that our cash income tax liability will increase in 2008, which may limit the amount of cash we have available to pay dividends. Under the Internal Revenue Code, in general, to the extent a corporation has losses in excess of taxable income in a taxable period, it will generate a net operating loss or NOL that may be carried back or carried forward and used to offset taxable income in prior or future periods. As of December 31, 2007, we have approximately $5.2 million of federal net operating losses, net of valuation allowances, available to us to carry forward to periods beginning after December 31, 2007. The amount of an NOL that may be used in a taxable year to offset taxable income may be limited, such as when a corporation undergoes an “ownership change” under Section 382 of the Internal Revenue Code. We expect to generate taxable income in the future, which will be offset by our NOLs, subject to limitations, such as under Section 382 of the Internal Revenue Code as a result of our IPO and prior ownership changes. Once our NOLs have been used or have expired, we will be required to pay additional cash income taxes. The increase in our cash income tax liability will have the effect of reducing our after-tax cash available to pay dividends in future periods and may require us to reduce dividend payments on our common stock in such future periods.

 

If we continue to pay dividends at the level currently anticipated under our dividend policy, our ability to pursue growth opportunities may be limited.

 

We believe that our dividend policy could limit, but not preclude, our ability to grow. If we continue paying dividends at the level currently anticipated under our dividend policy, we may not retain a sufficient amount of cash, and may need to seek financing, to fund a material expansion of our business, including any significant acquisitions or to pursue growth opportunities requiring capital expenditures significantly beyond our current expectations. The risks relating to funding any dividends, or other cash needs as a result of paying dividends, are summarized above. In addition, because we expect a significant portion of cash available will be distributed to the holders of our common stock under our dividend policy, our ability to pursue any material expansion of our business will depend more than it otherwise would on our ability to obtain third party financing. We cannot assure you that such financing will be available to us on reasonable terms or at all.

Our organizational documents could limit or delay another party’s ability to acquire us and, therefore, could deprive our investors of the opportunity to obtain a takeover premium for their shares.

 

A number of provisions in our amended and restated certificate of incorporation and bylaws will make it difficult for another company to acquire us. These provisions include, among others, the following:

 

 

We are also subject to laws that may have a similar effect. For example, federal, Illinois and Pennsylvania telecommunications laws and regulations generally prohibit a direct or indirect transfer of control over our business without prior regulatory approval. Similarly, section 203 of the DGCL prohibits us from engaging in a business combination with an interested stockholder for a period of three years from the date the person became an interested stockholder unless certain conditions are met. As a result of the foregoing, it will be difficult for another company to acquire us and, therefore, could limit the price that possible investors might be willing to pay in the future for shares of our common stock. In addition, the rights of our common stockholders will be subject to, and may be adversely affected by, the rights of holders of any class or series of preferred stock that may be issued in the future.

 

The concentration of the voting power of our common stock ownership could limit your ability to influence corporate matters.

 

On December 31, 2007, Central Illinois Telephone, which is controlled by our Chairman, Richard A. Lumpkin, owned approximately 19.1% of our common stock. In addition, our executive management owned approximately 2.1%. As a result, these investors will be able to significantly influence all matters requiring stockholder approval, including:

 

 

This concentrated share ownership will limit your ability to influence corporate matters and, as a result, we may take actions that other stockholders do not view as beneficial, which may adversely affect the market price of our common stock.

 

Risks Relating to Our Indebtedness and Our Capital Structure

 

We have a substantial amount of debt outstanding and may incur additional indebtedness in the future, which could restrict our ability to pay dividends.

 

We have a significant amount of debt outstanding. As of December 31, 2007, we had $891.6 million of total long-term debt outstanding, excluding the current portion, and $155.4 million of stockholders’ equity. The degree to which we are leveraged could have important consequences for you, including:

 

 

We cannot assure you that we will generate sufficient revenues to service and repay our debt and have sufficient funds left over to achieve or sustain profitability in our operations, meet our working capital and capital expenditure needs, compete successfully in our markets or pay dividends to our stockholders. In addition, because we have an additional 3.32 million shares outstanding as a result of the North Pittsburgh merger, our annual amount expended for dividends will increase materially if the current dividend per share is maintained.

 

Subject to the restrictions in our indenture and credit agreement, we may be able to incur additional debt. As of December 31, 2007, we would have been able to incur approximately $134.3 million of additional debt. Although our indenture and credit agreement contain restrictions on our ability to incur additional debt, these restrictions are subject to a number of important exceptions. If we incur additional debt, the risks associated with our substantial leverage, including our ability to service our debt, would likely increase.

 

We will require a significant amount of cash to service and repay our debt and to pay dividends on our common stock, and our ability to generate cash depends on many factors beyond our control.

 

We currently expect our cash interest expense to be approximately $64.0 to $67.0 million in fiscal year 2008. Future interest expense will be significantly higher than historic interest expense as a result of higher levels of indebtedness incurred to consummate the North Pittsburgh merger. Our ability to make payments on our debt and to pay dividends on our common stock will depend on our ability to generate cash in the future, which will depend on many factors beyond our control. We cannot assure you that:

 

 

If we cannot generate sufficient cash from our operations to meet our debt service and repayment obligations, we may need to reduce or delay capital expenditures, the development of our business generally and any acquisitions. If for any reason we are unable to meet our debt service and repayment obligations, we would be in default under the terms of the agreements governing our debt, which would allow the lenders under our credit facilities to declare all borrowings outstanding to be due and payable, which would in turn trigger an event of default under our indenture. If the amounts outstanding under our credit facilities or our senior notes were to be accelerated, we cannot assure you that our assets would be sufficient to repay in full the money owed to the lenders or to our other debt holders.

 

Our indenture and credit agreement contain covenants that limit the discretion of our management in operating our business and could prevent us from capitalizing on business opportunities and taking other corporate actions.

 

Our indenture and credit agreement impose significant operating and financial restrictions on us. These restrictions limit or restrict, among other things, our ability and the ability of our subsidiaries that are restricted by these agreements to:

 

 

In addition, our credit agreement requires, and any future credit agreements may require, us to comply with specified financial ratios, including ratios regarding total leverage, and interest coverage. Our ability to comply with these ratios may be affected by events beyond our control. These restrictions:

 

 

In the event of a default under the credit agreement, the lenders could foreclose on the assets and capital stock pledged to them.

 

A breach of any of the covenants contained in our credit agreement, or in any future credit agreements, or our inability to comply with the financial ratios could result in an event of default, which would allow the lenders to declare all borrowings outstanding to be due and payable, which would in turn trigger an event of default under the indenture. If the amounts outstanding under our credit facilities were to be accelerated, we cannot assure you that our assets would be sufficient to repay in full the money owed to the lenders or to our other debt holders.

We face the risks of either not being able to refinance our existing debt if necessary or doing so at a higher interest expense.

 

Our senior notes mature in 2012 and our credit facilities mature in full in 2014. We may not be able to refinance our senior notes or renew or refinance our credit facilities or any renewal or refinancing may occur on less favorable terms. If we are unable to refinance or renew our senior notes or our credit facilities, our failure to repay all amounts due on the maturity date would cause a default under the indenture or the credit agreement. In addition, our interest expense may increase significantly if we refinance our senior notes or our credit facilities on terms that are less favorable to us than the existing terms of our senior notes or credit facilities, which could impair our ability to pay dividends. As of December 31, 2007, our senior notes bear interest at 9 3 / 4 % per year and our credit facilities bear interest at LIBOR + 2.50%.

 

Risks Relating to Our Business

 

The telecommunications industry is generally subject to substantial regulatory changes, rapid development and introduction of new technologies and intense competition that could cause us to suffer price reductions, customer losses, reduced operating margins or loss of market share.

 

The telecommunications industry has been, and we believe will continue to be, characterized by several trends, including the following:

 

 

We expect competition to intensify as a result of new competitors and the development of new technologies, products and services. Some or all of these risks may cause us to have to spend significantly more in capital expenditures than we currently anticipate to keep existing and attract new customers.

 

Many of our voice and data competitors, such as cable providers, Internet access providers, wireless service providers and long distance carriers have brand recognition and financial, personnel, marketing and other resources that are significantly greater than ours. In addition, due to consolidation and strategic alliances within the telecommunications industry, we cannot predict the number of competitors that will emerge, especially as a result of existing or new federal and state regulatory or legislative actions. Such increased competition from existing and new entities could lead to price reductions, loss of customers, reduced operating margins or loss of market share.

 

The use of new technologies by other, existing companies may increase our costs and cause us to lose customers and revenues.

 

The telecommunications industry is subject to rapid and significant changes in technology, frequent new service introductions and evolving industry standards. Technological developments may reduce the competitiveness of our services and require unbudgeted upgrades, significant capital expenditures and the procurement of additional services that could be expensive and time consuming. New services arising out of technological developments may reduce the competitiveness of our services. If we fail to respond successfully to technological changes or obsolescence or fail to obtain access to important new technologies, we could lose customers and revenues and be limited in our ability to attract new customers or sell new services to our

existing customers. The successful development of new services, which is an element of our business strategy, is uncertain and dependent on many factors, and we may not generate anticipated revenues from such services, which would reduce our profitability. We cannot predict the effect of these changes on our competitive position, costs or our profitability.

 

In addition, part of our marketing strategy is based on market acceptance of DSL and IPTV. We expect that an increasing amount of our revenues will come from providing DSL and IPTV. The market for high-speed Internet access is still developing, and we expect current competitors and new market entrants to introduce competing services and to develop new technologies. Likewise, the ability to deliver high quality video service over traditional telephone lines is a new development that has not yet been proven. The markets for these services could fail to develop, grow more slowly than anticipated or become saturated with competitors with superior pricing or services. In addition, our DSL and IPTV offerings may become subject to newly adopted laws and regulations. We cannot predict the outcome of these regulatory developments or how they may affect our regulatory obligations or the form of competition for these services. As a result, we could have higher costs and capital expenditures, lower revenues and greater competition than expected for DSL and IPTV services.

 

The integration of the Company and North Pittsburgh may present significant challenges.

 

We may face significant challenges in combining North Pittsburgh’s operations into our existing operations in a timely and efficient manner and in retaining key North Pittsburgh personnel. The failure to integrate successfully North Pittsburgh and to manage successfully the challenges presented by the integration process may result in us not achieving the anticipated benefits of the merger, including operational and financial synergies.

 

We will incur additional integration and restructuring costs in connection with the completed North Pittsburgh merger.

 

We have incurred and will continue to incur significant costs in connection with the North Pittsburgh merger, including fees of our attorneys, accountants and financial advisor. We will incur integration and restructuring costs following the completion of the merger as we integrate our businesses with the businesses of North Pittsburgh. Although we expect that the realization of efficiencies related to the integration of the businesses will offset incremental transaction, integration and restructuring costs over time, we cannot give any assurance that this net benefit will be achieved in the near term.

 

Our possible pursuit of future acquisitions could be expensive, may not be successful and, even if it is successful, may be more costly than anticipated.

 

Our acquisition strategy entails numerous risks. The pursuit of acquisition candidates could be expensive and may not be successful. Our ability to complete future acquisitions will depend on our ability to identify suitable acquisition candidates, negotiate acceptable terms for their acquisition and, if necessary, finance those acquisitions, in each case, before any attractive candidates are purchased by other parties, some of whom may have greater financial and other resources than us. Whether or not any particular acquisition is closed successfully, each of these activities is expensive and time consuming and would likely require our management to spend considerable time and effort to accomplish them, which would detract from their ability to run our current business. We may face unexpected challenges in receiving any required approvals from the FCC, the ICC, the PAPUC or other applicable state regulatory commissions, which could result in delay or our not being able to consummate the acquisition. Although we may spend considerable expense and effort to pursue acquisitions, we may not be successful in closing them.

 

If we are successful in closing any acquisitions, we would face several risks in integrating them. In addition, any due diligence we perform may not prove to have been accurate. For example, we may face unexpected difficulties in entering markets in which we have little or no direct prior experience or in generating expected revenue and cash flow from the acquired companies or assets.

If we do pursue an acquisition or other strategic transactions and any of these risks materialize, they could have a material adverse effect on our business and our ability to achieve sufficient cash flow, provide adequate working capital, service and repay our indebtedness and leave sufficient funds to pay dividends.

 

Poor economic conditions in our service areas in Illinois, Pennsylvania and Texas could cause us to lose local access lines and revenues.

 

Substantially all of our customers and operations are located in Illinois, Pennsylvania and Texas. The customer base for telecommunications services in each of our rural telephone companies’ service areas in Illinois, Pennsylvania and Texas is small and geographically concentrated, particularly for residential customers. Due to our geographical concentration, the successful operation and growth of our business is primarily dependent on economic conditions in our rural telephone companies’ service areas. The economies of these areas, in turn, are dependent upon many factors, including:

 

 

Poor economic conditions and other factors beyond our control in our rural telephone companies’ service areas could cause a decline in our local access lines and revenues.

 

A system failure could cause delays or interruptions of service could cause us to lose customers.

 

In the past, we have experienced short, localized disruptions in our service due to factors such as cable damage, inclement weather and service failures of our third party service providers. To be successful, we will need to continue to provide our customers reliable service over our network. The principal risks to our network and infrastructure include:

 

 

Disruptions may cause interruptions in service or reduced capacity for customers, either of which could cause us to lose customers and incur unexpected expenses, and thereby adversely affect our business, revenue and cash flow.

 

Loss of a large customer could reduce our revenues. In addition, a significant portion of our revenues from the State of Illinois is based on contracts that are favorable to the government.

 

In 2007 and 2006, 46.5% and 47.0%, respectively, of our Other Operations revenues were derived from our relationships with various agencies of the State of Illinois, principally the Department of Corrections through Public Services. Our relationship with the Department of Corrections accounted for 93.5% and 93.3%, respectively, of our Public Services revenues during 2007 and 2006. Our predecessor’s relationship with the Department of Corrections has existed since 1990 despite changes in government administrations. Nevertheless, obtaining contracts from government agencies is challenging, and government contracts, like our contracts with the State of Illinois, often include provisions that are favorable to the government in ways that are not standard in private commercial transactions. Specifically, each of our contracts with the State of Illinois:

 

 

 

The failure of the State of Illinois to perform under the existing agreements for any reason, or to renew the agreements when they expire, could have a material adverse effect on our revenues. For example, the State of Illinois, which represented 40.8% of the revenues of our Market Response business for 2004, awarded the renewal of the Illinois State Toll Highway Authority contract, the sole source of those revenues, to another provider.

 

If we are unsuccessful in obtaining and maintaining necessary rights-of-way for our network, our operations may be interrupted and we would likely face increased costs.

 

We need to obtain and maintain the necessary rights-of-way for our network from governmental and quasi-governmental entities and third parties, such as railroads, utilities, state highway authorities, local governments and transit authorities. We may not be successful in obtaining and maintaining these rights-of-way or obtaining them on acceptable terms whether in existing or new service areas. Some of the agreements relating to these rights-of-way may be short-term or revocable at will, and we cannot be certain that we will continue to have access to existing rights-of-way after they have expired or terminated. If any of our rights-of-way agreements were terminated or could not be renewed, we may be forced to remove our network facilities from under the affected rights-of-way or relocate or abandon our networks. We may not be able to maintain all of our existing rights-of-way and permits or obtain and maintain the additional rights-of-way and permits needed to implement our business plan. In addition, our failure to maintain the necessary rights-of-way, franchises, easements, licenses and permits may result in an event of default under the credit agreement and other credit agreements we may enter into in the future and, as a result, other agreements governing our debt. As a result of the above, our operations may be interrupted and we may need to find alternative rights-of-way and make unexpected capital expenditures.

 

We are dependent on third party vendors for our information, billing and network systems as well as IPTV service. Any significant disruption in our relationship with these vendors could increase our costs and affect our operating efficiencies.

 

Sophisticated information and billing systems are vital to our ability to monitor and control costs, bill customers, process customer orders, provide customer service and achieve operating efficiencies. We currently rely on internal systems and third party vendors to provide all of our information and processing systems as well as applications that support our IP services, including IPTV. Some of our billing, customer service and management information systems have been developed by third parties for us and may not perform as anticipated. In addition, our plans for developing and implementing our information systems, billing systems, network systems and IPTV service rely primarily on the delivery of products and services by third party vendors. Our right to use these systems is dependent upon license agreements with third party vendors. Some of these agreements are cancelable by the vendor, and the cancellation or nonrenewable nature of these agreements could impair our ability to process orders or bill our customers. Since we rely on third party vendors to provide some of these services, any switch in vendors could be costly and affect operating efficiencies.

 

The loss of key management personnel, or the inability to attract and retain highly qualified management and other personnel in the future, could have a material adverse effect on our business, financial condition and results of operations.

 

Our success depends upon the talents and efforts of key management personnel, many of whom have been with our company and our industry for decades, including Mr. Lumpkin, Robert J. Currey, Steven L. Childers, Joseph R. Dively, Steven J. Shirar, C. Robert Udell, Jr. and Christopher A. Young. The loss of any such management personnel, due to retirement or otherwise, and the inability to attract and retain highly qualified technical and management personnel in the future, could have a material adverse effect on our business, financial condition and results of operations.

Regulatory Risks

 

The telecommunications industry in which we operate is subject to extensive federal, state and local regulation that could change in a manner adverse to us.

 

Our main sources of revenues are our local telephone businesses in Illinois, Pennsylvania and Texas. The laws and regulations governing these businesses may be, and in some cases have been, challenged in the courts, and could be changed by Congress, state legislatures or regulators at any time. In addition, new regulations could be imposed by federal or state authorities that increase our operating costs or capital requirements or that are otherwise adverse to us. We cannot predict the impact of future developments or changes to the regulatory environment or the impact such developments or changes may have on us. Adverse rulings, legislation or changes in governmental policy on issues material to us could increase our competition, cause us to lose customers to competitors and decrease our revenues, increase our costs and decrease profitability.

 

Legislative or regulatory changes could reduce or eliminate the revenues our rural telephone companies receive from network access charges.

 

A significant portion of our ILECs revenues come from network access charges paid by long distance and other carriers for originating or terminating calls in our ILECs service areas. The amount of network access charge revenues that our ILECs receive is based on interstate rates set by the FCC and intrastate rates set by the ICC, PAPUC and PUCT. The FCC has reformed, and continues to reform, the federal network access charge system, and the states, including Illinois, Pennsylvania and Texas, establish intrastate network access charges.

 

Traditionally, regulators have allowed network access rates to be set higher in rural areas than the actual cost of originating or terminating calls as an implicit means of subsidizing the high cost of providing local service in rural areas. In 2001, the FCC adopted rules reforming the network access charge system for rural carriers, including reductions in per-minute access charges and increases in both universal service fund subsidies and flat-rate, monthly per line charges on end-user customers. Our Illinois rural telephone company’s intrastate network access rates mirror interstate network access rates. Illinois does not provide, however, an explicit subsidy in the form of a universal service fund applicable to our Illinois rural telephone company. As a result, while subsidies from the federal universal service fund have offset Illinois Telephone Operations’ decrease in revenues resulting from the reduction in interstate network access rates, there was not a corresponding offset for the decrease in revenues from the reduction in intrastate network access rates.

 

The FCC is currently considering even more sweeping potential changes in network access charges. Depending on the FCC’s decisions, our current network access charge revenues could be reduced materially, and we do not know whether increases in other revenues, such as federal, Pennsylvania or Texas subsidies and monthly line charges, will be sufficient to offset any such reductions. The ICC, PAPUC and the PUCT also may make changes in our intrastate network access charges, which may also cause reductions in our revenues. To the extent any of our rural telephone companies become subject to competition and competitive telephone companies increase their operations in the areas served by our rural telephone companies, a portion of long distance and other carriers’ network access charges will be paid to our competitors rather than to our companies. In addition, the compensation our companies receive from network access charges could be reduced due to competition from wireless carriers.

 

Our Pennsylvania rural telephone company is regulated for interstate access charge purposes as an average schedule rate of return company, meaning that its interstate access revenues are based upon a statistical formula developed by NECA and approved by the FCC, rather than upon its actual costs. In each of its past two annual revisions of the average schedule formulas, NECA has proposed and the FCC has approved structural changes that will, when they have been fully phased in, reduce our Pennsylvania rural telephone company’s interstate revenues by approximately $3.7 million on an annualized basis. NECA and the FCC may make further changes to the formulas in future years, which could have an additional impact on our Pennsylvania rural telephone company’s revenues. Although our Pennsylvania rural telephone company has the option to become a cost company subject to its own individual cost and demand data studies, this option

would be irrevocable if exercised and we cannot predict at this time whether or when it would be advantageous to make this conversion.

 

On October 23, 2006, Verizon Pennsylvania, Inc., along with a number of its affiliated companies, filed a formal complaint with the PAPUC claiming that our Pennsylvania CLEC’s intrastate switched access rates are in violation of Pennsylvania statute. The provision that Verizon cites in its complaint was enacted as part of Act 183 of 2004 and requires CLEC rates to be no higher than the corresponding incumbent’s rates unless the CLEC can demonstrate that the higher access rates are “cost justified.” Verizon’s original claim requested a refund of $0.5 million from access billings through August 2006. In a letter dated January 30, 2007, Verizon notified our Pennsylvania CLEC that it was revising its complaint to reflect a more current alleged over-billing calculation which resulted in a revised claim of $1.3 million through December 2006, which claim includes amounts from certain affiliates that had not been included in the original calculation. We believe that our CLEC’s switched access rates are permissible, and are in the process of vigorously opposing this complaint. In an Initial Decision dated December 5, 2007, the presiding administrative law judge recommended that the PAPUC sustain Verizon’s complaint. As relief, the ALJ directed that our Pennsylvania CLEC reduce its access rates down to those of the underlying incumbent exchange carrier and provide a refund to Verizon in an amount equal to the amount of access charges collected in excess of the new rate since November 30, 2004, the date Act 183 became effective. We have filed exceptions to the full PAPUC and are awaiting an order.

 

In the event we are not successful in this proceeding, our Pennsylvania CLEC’s operations could be materially adversely impacted by not only the refund sought by Verizon but more importantly by the prospective decreases in access revenues resulting from the change in its intrastate access rates, which would apply to all carriers on a non-discriminatory basis. We preliminarily estimate that the decrease in our annual revenues would be approximately $1.2 million on a static basis (meaning keeping access minutes of use constant) if Verizon prevails completely in its complaint. In addition, other interexchange carriers could file similar claims for refunds. As of December 31, 2007 we have reserved $3.0 million in other liabilities on the balance sheet relating to this complaint.

 

Legislative or regulatory changes could reduce or eliminate the government subsidies we receive.

 

The federal and Pennsylvania and Texas state system of subsidies, from which we derive a significant portion of our revenues, are subject to modification. Our rural telephone companies receive significant federal and state subsidy payments.

 

During the last two years, the FCC has made modifications to the federal universal service fund system that changed the sources of support and the method for determining the level of support recipients of federal universal service fund subsidies receive. The FCC is also currently considering proposals for further changes to the source and amount of contributions to, and eligibility for payments from, the federal universal service fund, and these issues may also be the subject of legislative amendments to the Telecommunications Act.

 

We cannot predict the outcome of any federal or state legislative action or any FCC, PAPUC, PUCT or ICC rulemaking or similar proceedings. If our rural telephone companies do not continue to receive federal and state subsidies, or if these subsidies are reduced, our rural telephone companies will likely have lower revenues and may not be able to operate as profitably as they have historically. In addition, if the number of local access lines that our rural telephone companies serve increases, under the rules governing the federal universal service fund, the rate at which we can recover certain federal universal service fund payments may decrease. This may have an adverse effect on our revenues and profitability.

 

The high costs of regulatory compliance could make it more difficult for us to enter new markets, make acquisitions or change our prices.

 

Regulatory compliance results in significant costs for us and diverts the time and effort of management and our officers away from running our business. In addition, because regulations differ from state to state, we could face significant costs in obtaining information necessary to compete effectively if we try to provide services, such as long distance services, in markets in different states. These information barriers could cause us to incur substantial costs and to encounter significant obstacles and delays in entering these markets.

Compliance costs and information barriers could also affect our ability to evaluate and compete for new opportunities to acquire local access lines or businesses as they arise.

 

Our intrastate services are generally subject to certification, tariff filing and other ongoing state regulatory requirements. Challenges to our tariffs by regulators or third parties or delays in obtaining certifications and regulatory approvals could cause us to incur substantial legal and administrative expenses. If successful, these challenges could adversely affect the rates that we are able to charge to customers, which would negatively affect our revenues. Some states also require advance regulatory approval of mergers, acquisitions, transfers of control, stock issuance, and certain types of debt financing, which can increase our costs and delay our ability to complete some strategic transactions.

 

Legislative and regulatory changes in the telecommunications industry could raise our costs by facilitating greater competition against us and reduce potential revenues.

 

Legislative and regulatory changes in the telecommunications industry could adversely affect our business by facilitating greater competition against us, reducing our revenues or raising our costs. For example, federal or state legislatures or regulatory commissions could impose new requirements relating to standards or quality of service, credit and collection policies, or obligations to provide new or enhanced services such as high-speed access to the Internet or number portability, whereby consumers can keep their telephone number when changing carriers. Any such requirements could increase operating costs or capital requirements.

 

The Telecommunications Act provides for significant changes and increased competition in the telecommunications industry. This federal statute and the related regulations remain subject to judicial review and additional rulemakings of the FCC, as well as to implementing actions by state commissions.

 

Currently, there exists only a small body of law and regulation applicable to access to, or commerce on, the Internet. As the significance of the Internet expands, federal, state and local governments may adopt new rules and regulations or apply existing laws and regulations to the Internet. The FCC is currently reviewing the appropriate regulatory framework governing broadband consumer protections for high speed access to the Internet through telephone and cable providers’ communications networks. The outcome of these proceedings may affect our regulatory obligations and costs and competition for our services which could have a material adverse effect on our revenues.

 

Because we are subject to extensive laws and regulations relating to the protection of the environment, natural resources and worker health and safety, we may face significant liabilities or compliance costs in the future.

 

Our operations and properties are subject to federal, state and local laws and regulations relating to protection of the environment, natural resources and worker health and safety, including laws and regulations governing and creating liability relating to, the management, storage and disposal of hazardous materials, asbestos, petroleum products and other regulated materials. We also are subject to environmental laws and regulations governing air emissions from our fleets of vehicles. As a result, we face several risks, including the following:

 

 

 

As a result of the above, we may face significant liabilities and compliance costs in the future.

 

 

 

In addition to the facilities listed above we own or have the right to use approximately 724 additional properties consisting of equipment at point of presence sites, central offices, remote switching sites and buildings, tower sites, small offices, storage sites and parking lots. Some of the facilities listed above also serve as central office locations.

 

 

PART II

 

Although it is our current intention to pay quarterly dividends at an annual rate of $1.5495 per share for 2008, stockholders may not receive dividends in the future, as a result of any of the following factors:

 

 

The cash requirements of the expected dividend policy are in addition to our other expected cash needs, both of which we expect to be funded with cash flow from operations. In addition, we expect we will have sufficient availability under our revolving credit facility to fund dividend payments in addition to any expected fluctuations in working capital and other cash needs, although we do not intend to borrow under this facility to pay dividends.

 

We believe that our dividend policy will limit, but not preclude, our ability to grow. If we continue paying dividends at the level currently anticipated under our dividend policy, we may not retain a sufficient amount of cash, and may need to seek refinancing, to fund a material expansion of our business, including any significant acquisitions or to pursue growth opportunities requiring capital expenditures significantly beyond our current expectations. In addition, because we expect a significant portion of cash available will be distributed to holders of common stock under our dividend policy, our ability to pursue any material expansion of our business will depend more than it otherwise would on our ability to obtain third-party financing.

 

Additional information required by this Item is incorporated herein by reference to our proxy statement to be issued in connection with the Annual Meeting of our Stockholders to be held on May 6, 2008, which proxy statement will be filed within 120 days of the end of our fiscal year.

 

 

 

 

The following table sets forth a reconciliation of Cash Provided by Operating Activities to Consolidated EBITDA:

 

 

 

integrated high-technology telecommunications business in Western Pennsylvania, providing competitive and local exchange services, long distance and Internet services similar to our Illinois and Texas operations. Unless otherwise noted, no results of operations are included for North Pittsburgh in the discussion that follows and other operating data does not include North Pittsburgh unless otherwise expressly stated.

 

Initial Public Offering

 

On July 27, 2005, we completed our IPO. The IPO consisted of the sale of 6,000,000 shares of common stock newly issued by the Company and 9,666,666 shares of common stock sold by certain of our selling stockholders. The shares of common stock were sold at an initial public offering price of $13.00 per share resulting in net proceeds to us of approximately $67.6 million.

 

We used the net proceeds from the IPO, together with additional borrowings under our credit facilities and cash on hand to:

 

 

Share Repurchase

 

On July 28, 2006, we completed the repurchase of 3,782,379, or 12.7% of the outstanding shares, from Providence Equity for $56.7 million, or $15.00 per share. The repurchase was funded with $17.7 million of cash on hand and $39.0 million of new borrowings under our existing credit facility.

 

The effect of the transaction was an annual increase of $3.0 million of cash flow due to:

 

 

Acquisition of North Pittsburgh and New Credit Facility

 

On December 31, 2007, the Company completed its acquisition of North Pittsburgh Systems, Inc., pursuant to an Agreement and Plan of Merger, dated as of July 1, 2007. At the effective time of the Merger, 80% of the shares of North Pittsburgh common stock converted into the right to receive $25.00 in cash, without interest, per share, for an approximate total of $300.1 million in cash, and each of the remaining shares of North Pittsburgh common stock converted into the right to receive 1.1061947 shares of common stock of the Company, or an approximate total of 3.32 million shares of the Company’s common stock. The total purchase price, including fees, was $346.6 million, net of cash acquired.

 

In connection with the acquisition, the Company entered into a new credit facility that provides for:

 

 

Proceeds from the term loan along with cash on hand were used to:

 

 

Redemption of Senior Notes

 

On February 26, 2008, we provided notice of our intention to call the outstanding senior notes on April 1, 2008. Under terms of the Indenture, the senior notes are callable at the outstanding principal amount plus a redemption premium of 4.875%, or approximately $6.3 million. We anticipate funding the redemption using proceeds from the delayed draw term loan and cash on hand.

 

preparation, we began aggressively marketing our “triple play” bundle, which includes local service, DSL and IPTV, in our key Illinois exchanges in September 2005. In August 2006 we introduced IPTV service in selected Texas markets. As of December 31, 2007, IPTV was available to over 107,000 homes in our markets. Our IPTV subscriber base has grown from 6,954 as of December 31, 2006 to 12,241 as of December 31, 2007. We intend to launch IPTV in our Pennsylvania markets in the second quarter of 2008. In addition to our access line and video initiatives, we intend to continue to integrate best practices across our Illinois, Texas and Pennsylvania regions. These efforts may act to mitigate the financial impact of any access line loss we may experience.

 

Because of our promotional efforts, the number of DSL subscribers we serve grew substantially. We had 66,624, 52,732 and 39,192 DSL lines in service as of December 31, 2007, 2006 and 2005, respectively. Currently over 95% of our rural telephone companies’ local access lines are DSL capable. The penetration rate for DSL lines in service was approximately 45.4% of our primary residential access lines at December 31, 2007.

 

We have also been successful in generating Telephone Operations revenues by bundling combinations of local service, custom calling features, voicemail and Internet access. Our service bundles totaled 45,971, 43,175 and 36,627 at December 31, 2007, 2006 and 2005, respectively.

 

Our plan is to continue to execute our customer retention program by delivering excellent customer service and improving the value of our bundle with DSL and IPTV. However, if these actions fail to mitigate access line loss, or we experience a higher degree of access line loss than we currently expect, it could have an adverse impact on our revenues and earnings.

 

The following sets forth several key metrics as of the end of the periods presented excluding North Pittsburgh:

 

 

In connection with the acquisition of North Pittsburgh, we gained 58,241 ILEC access lines, 43,904 DSL lines, and 68,874 CLEC access line equivalents.

 

Expenses

 

Our primary operating expenses consist of cost of services, selling, general and administrative expenses and depreciation and amortization expenses.

Cost of Services and Products

 

Our cost of services includes the following:

 

 

We have agreements with carriers to provide long distance transport and termination services. These agreements contain various commitments and expire at various times. We believe we will meet all of our commitments in these agreements and believe we will be able to procure services for future periods. We are currently procuring services for future periods, and at this time, the costs and related terms under which we will purchase long distance transport and termination services have not been determined. We do not expect, however, any material adverse affects from any changes in any new service contract.

 

Selling, General and Administrative Expenses

 

In general, selling, general and administrative expenses include the following:

 

 

Our Telephone Operations segment incurs selling, marketing and customer care expenses from its customer service centers and commissioned sales representatives. Our customer service centers are the primary sales channels for residential and business customers with one or two phone lines, whereas commissioned sales representatives provide customized solutions to larger business customers. In addition, we use customer retail centers for various communications needs, including new telephone, Internet and IPTV purchases in Illinois and Texas.

 

Each of our Other Operations businesses primarily uses an independent sales and marketing team comprised of dedicated field sales account managers, management teams and service representatives to execute our sales and marketing strategy.

 

We have operating support and back office systems that are used to enter, schedule, provision and track customer orders, test services and interface with trouble management, inventory, billing, collections and customer care service systems for the local access lines in our operations. We have migrated most key business processes of our Illinois and Texas operations onto single, company-wide systems and platforms. Our objective is to improve profitability by reducing individual company costs through centralization, standardization and sharing of best practices. For the years ended December 31, 2007, 2006 and 2005 we spent $1.2 million, $2.9 million and $7.4 million, respectively, on integration and restructuring expenses (which included projects to integrate our support and back office systems). We successfully completed the integration of our Illinois and Texas billing systems in the third quarter of 2007.

 

Amortization expenses are recognized primarily for our intangible assets considered to have finite useful lives on a straight-line basis. In accordance with Statement of Financial Accounting Standards, or SFAS, No. 142, Goodwill and Other Intangible Assets , goodwill and intangible assets that have indefinite useful lives are not amortized but rather are tested annually for impairment. Because trade names have been determined to have indefinite lives, they are not amortized. Customer relationships are amortized over their useful life, at a weighted average life of approximately 10 years.

 

The following summarizes our revenues and operating expenses on a consolidated basis for the years ended December 31, 2007, 2006 and 2005: