| D&E COMMUNICATIONS INC section titled “Item 1A Risk Factors” and elsewhere in this document could affect our future results and could cause results to differ materially from those expressed in these forward-looking statements |
| You are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this document |
| All subsequent written and oral forward-looking statements attributable to us are expressly qualified in their entirety by the cautionary statements contained or referred to in this report |
| We do not undertake any obligation to release publicly any revisions to these forward-looking statements to reflect events or circumstances after the date of this document or to reflect the occurrence of unanticipated events |
| Business Overview We are a provider of integrated communications services to residential and business customers in markets throughout the eastern half of Pennsylvania |
| We have operated as a rural local exchange carrier (“RLEC”) in parts of Lancaster, Berks, Lebanon, Chester, Montgomery, Lehigh, Union and Northumberland counties in Pennsylvania since the early 1900s and were among the first to deploy a 100prca digitally switched network |
| In 1998, we began operating as a competitive local exchange carrier (“CLEC”) and currently operate in the Lancaster, Reading, State College, Pottstown, Williamsport, Altoona and Harrisburg, Pennsylvania areas, which we refer to as our “edge-out” markets |
| Today, we offer our customers a comprehensive package of communications services, including local and long distance telephone services, high-speed data, or broadband, services, Internet access services and integrated voice and data network solutions throughout our territory |
| Additionally, in the State College and Lewisburg areas, we also provide video services |
| Our reporting segments are RLEC, CLEC, Internet Services and Systems Integration |
| As of December 31, 2005, we served 134cmam698 RLEC access lines, 40cmam796 CLEC access lines, 19cmam795 digital subscriber line (“DSL”) subscribers, 7cmam959 dial-up internet access subscribers, 6cmam630 video subscribers and 952 web-hosting customers |
| For the year ended December 31, 2005, we generated revenue of dlra176dtta2 million, operating income of dlra22dtta7 million and a net income of dlra13dtta7 million |
| Historically, we have derived a majority of our revenues from the regulated RLEC segments |
| Our CLEC focuses primarily on businesses, and revenue is derived primarily from local telephone service, network access charges, enhanced telephone services, private line service and long distance service revenue |
| Our Internet Services revenue is derived from broadband and dial-up Internet access services, in addition to web-hosting services and our new Voice over Internet Protocol (“VoIP”) service |
| Our Systems Integration revenue is derived from sales of services and equipment that support the design, implementation and maintenance of local and wide area networks and telecommunications systems |
| The following graphs represent fiscal year segment revenues and operating income |
| 3 ______________________________________________________________________ [28]Table of Contents LOGO LOGO 4 ______________________________________________________________________ [29]Table of Contents We own a one-third interest in EuroTel, LLC, which owns 100prca of Pennecom BV, a Netherlands company |
| We presently maintain a minority interest in these ventures |
| Pennecom continues to pursue legal action that it initiated in July 2002 in the United States District Court for the Southern District of Item 1A Risk Factors The convergence of voice and data communications technologies could eliminate our competitive advantages and may, in fact, put us at a competitive disadvantage |
| We may experience increased competitive pressures, which could have a negative effect on our revenues and earnings |
| The convergence of voice and data communication technologies is changing the communications industry |
| For several years, telephone and cable companies have been able to provide data transmission, with telephone companies having the advantage in voice and cable companies having the advantage in video |
| Technology is reducing those advantages |
| The development of VoIP is changing voice communication to a packet data transmission process |
| This enables cable companies, as well as ISPs and new start-ups who require minimal capital investment, to compete with telephone companies for voice services and phone features like voicemail and unified communications |
| These developments have placed our core telephone business at risk, although also enabling us to compete in the provision of cable TV services |
| Adding to the complexity of the competitive environment, wireless offerings in voice and data are becoming increasingly competitive; and technology has been developed that could enable electric power transmission companies to compete in the communications industry in the future |
| Service offerings of telephone, cable and electric power companies in voice, data and video may be similar, while wireless is a significant provider in voice and data |
| It is basic policy of the FCC and the Pennsylvania Public Utility Commission (“PUC”) to encourage competition in the communications industry |
| The limited suspension that we held until January 2003 from certain interconnection requirements of the Telecommunications Act of 1996 has been discontinued, although legislation enacted in Pennsylvania in the fourth quarter of 2004 provided a continued limited suspension to our Buffalo Valley RLEC through December 31, 2008 |
| These developments mean that two of our RLECs could be required to allow competitors to have access to our customers by our competitors seeking the removal of our rural exemption, entering our territory and using our facilities through interconnection agreements to provide local services |
| Local cable TV companies may use their own facilities and apply to be licensed as a facilities-based CLEC within our franchise territory in order to attempt to qualify for number portability |
| This would enable our existing telephone customers to switch to VoIP services provided by the cable TV companies and still retain the same telephone numbers, thus making the transfer of local telephone services to VoIP far more convenient to the customer |
| Service Electric Telephone Company, LLC, filed on September 2, 2005 with the PUC to be a facilities-based CLEC competitor in our Conestoga RLEC territory |
| In addition, CORE Communications, Inc (“CORE”) filed an amended application on August 19, 2005 with the PUC to be a facilities-based CLEC providing service in our RLEC territories |
| On January 25, 2006, CORE served our three RLECs with their Petition for Arbitration |
| Included in Appendix 2 of their filing is a request seeking a termination of the rural exemption for the limited purpose of permitting the interconnection standards to apply to any direct interconnection between our three RLECs and CORE We are actively engaged in these filings and will be working with both CLECs to develop interconnection agreements to be filed with the PUC In areas served by our CLEC, the incumbent carrier, Verizon, enjoys certain business advantages, including its size, financial resources, brand recognition and network connection to virtually all of our customers and potential customers in those areas |
| Similarly, in areas where we do or may provide video services, the incumbent cable operators enjoy certain business advantages, including their size, financial resources, brand recognition, and ownership of or superior access to programming |
| As an integrated communications provider, we face competition from: • competitive local exchange carriers, including TelCove, Commonwealth Telephone Enterprises, Choice One and XO Communications; • wireless service providers, including Cingular Wireless, Verizon Wireless, Sprint Nextel, Immix and T-Mobile Wireless; 24 ______________________________________________________________________ [49]Table of Contents • internet service providers, including AOL, EarthLink and MSN; • cable television companies, including Adelphia, Comcast, Pencor Services, Atlantic Broadband LLC, Service Electric and CATV Service, Inc |
| ; • voice over Internet protocol (“VoIP”) providers, including Vonage, AT&T and Verizon; • providers of communications services, such as long distance services, including AT&T, Sprint Nextel and Verizon Communications; • systems integration providers, including Morefield, Ecomm, IntelliMark and Weidenhammer Systems Corp |
| ; and • electric power companies as possible competitors in the future |
| Many of our competitors are, or are affiliated with, major communications companies |
| These competitors have substantially greater financial and marketing resources and greater name recognition and more established relationships with a larger base of current and potential customers than we |
| Accordingly, it may be more difficult to compete against these large communications providers |
| In addition, we cannot assure that we will be able to achieve or maintain adequate technology to remain competitive |
| Our continued addition of fiber to enhance our broadband capacity may be more difficult as a result of our indebtedness than for our competitors |
| Accordingly, it may be difficult to compete in any of our markets |
| We are subject to a complex and uncertain regulatory environment that may require us to alter our business plans |
| The United States communications industry is subject to federal, state and local regulations that are continually evolving |
| As new communications laws and regulations are issued, we may be required to modify our business plans or operations, and we may not be able to do so in a cost-effective manner |
| Federal and state regulatory trends toward a more competitive market place through reduced competitive entry standards are likely to have negative effects on our business and our ability to compete |
| In this regard, the regulatory environment governing ILEC operations has been and will likely continue to be very liberal in its approach to promoting competition and network access, which may increase the likelihood of new competitors offering similar services in our service areas |
| The introduction of new competitors could have a negative effect on our RLEC operating results, yet at the same time present operating benefits to our CLEC business |
| Prices for RLEC’s interstate services, consisting primarily of subscriber line charges and access charges for interstate and international toll calls, are regulated by the FCC based on the “average schedule” formulas proposed by NECA Removal of the RLECs from the NECA average schedules could result in a significant revenue loss |
| Changes in the average schedule formula amounts developed by NECA and implemented annually in July could have a negative effect on the RLEC’s future revenues |
| NECA filed their annual updated formulas with the FCC to be effective July 1, 2006 |
| This update proposes major reductions to settlements received by larger RLECs, including our three RLECs |
| It also proposed a two-year transition for implementing the new calculations |
| Based on our evaluation we estimate the impact, excluding any transition period, would be approximately a dlra1 million reduction in 2006 network access revenues for the six-month period beginning July 1, 2006, or an annual decrease of dlra2 million |
| It is estimated that approval of the proposed transition plan to phase in new settlement calculations over a longer period could reduce the 2006 impact by as much as 50prca to 75prca |
| The FCC has requested comment from interested parties on NECA’s filing |
| We will not know until June 2006 whether the FCC accepts the revised calculations of NECA or whether the FCC will accept the two-year transition of the reduced settlement amounts |
| Our RLECs held a limited suspension from certain interconnection requirements with competitors, which expired in 2003 |
| The suspension had protected our RLEC markets by excluding us from requirements to allow competitors to have access to our customers by relying upon our facilities |
| Since the Pennsylvania Public Utility 25 ______________________________________________________________________ [50]Table of Contents Act, as amended in November 2004, provides a suspension only to RLECs that have under 50cmam000 lines and which have agreed to provide universal broadband availability by December 31, 2008, two of our three RLECs may see competitors seeking to remove our rural exemption for the purposes of entering our territory and using our services and facilities through interconnection agreements to provide competitive services |
| The introduction of new competitors could result in the loss of customers and have a negative effect on our revenues and earnings |
| Although our two RLECs have lost their suspension from certain interconnection requirements, changes at the federal level as noted below have provided some relief permitting our RLECs to offer only certain services, affording them a greater ability to recover their investment costs |
| The PUC is currently considering changes in intrastate switched access rates and intrastate USF reform for ILECs in Pennsylvania |
| The proceeding, which began in December 2004, addresses the rates that our RLECs charge to long distance carriers for intrastate toll calls that originate or terminate on our RLECs’ local telephone lines |
| Our RLECs also receive funding from the Pennsylvania USF, which could be affected by the PUC’s investigation |
| At this time, we cannot predict either the timing or the outcome of the PUC’s proceeding |
| The FCC has made and will continue to make regulatory changes that will affect both our RLEC and CLEC operations |
| On December 15, 2004, the FCC adopted rules limiting ILEC unbundling obligations in order to provide incentives for both ILECs and CLECs to invest in the telecommunications market in a way that best allows for innovation and sustainable competition |
| The new rules eliminate mass market switching as an unbundled network element and limit the availability of high-capacity loops and dedicated interoffice transport as unbundled network elements to CLECs |
| While beneficial to our RLECs, our CLEC interconnects with and uses other telephone companies’ networks to access certain of their customers in order to provide service, such as voice, and data communications and DSL Our CLEC depends, in certain circumstances, upon the technology and capabilities of other telephone companies as well as the quality, availability and maintenance of the facilities of those telephone companies |
| We must also maintain efficient procedures for ordering, provisioning, maintaining and repairing facilities from these other telephone companies |
| We may not be able to obtain facilities and services of satisfactory quality from other telephone companies, or on satisfactory terms and conditions, in which case we may experience delays in the growth of our CLEC networks and the degradation of the quality of our service to customers |
| The new rules may have an adverse impact on our CLEC because it purchases unbundled switching from ILECs |
| Although Verizon has indicated that they will continue to offer unbundled switching on a commercial contract basis, our CLEC will receive less favorable terms and conditions in the commercial contract than they received under the prior FCC mandated contracts |
| The FCC, on February 10, 2005, initiated a proceeding to develop a unified intercarrier compensation regime |
| This proceeding will affect our RLECs, CLECs, long distance and VoIP operations |
| The FCC is considering various plans that have been submitted to the FCC and has solicited comments from the public concerning those proposals |
| Most, if not all of these proposals, if adopted would affect the intercarrier compensation revenues and expenses as well as the USF funding that our RLECs receive |
| The rule changes that result from this proceeding could have a material effect on our revenues, expenses and earnings |
| Until the FCC adopts a specific proposal, it is impossible to predict how changes will affect our company |
| The Supreme Court has upheld an FCC ruling that broadband cable modem service provided by cable operators is properly classified as an information service rather than a telecommunications service |
| In response to the Court’s action, on September 23, 2005, the FCC released a Report and Order in which it determined that the provision by telephone companies of wireline broadband services, such as DSL, constitutes an information service, rather than a telecommunications service |
| Previous to this ruling, FCC policies and rules required facilities-based telephone company providers of DSL to offer the wireline transmission component of DSL separately to competitors on a common carrier basis |
| The FCC’s recent ruling eliminated this requirement to share such transmission capacity with competitors, subject to a one year transition period wherein existing offerings of such transmission capacity must be maintained, on a “grandfathered” basis, to purchasers unaffiliated with the telephone company |
| The FCC ruled that while facilities-based telephone companies are not required to offer broadband wireline transmission capacity to their competitors, they are permitted to do so if 26 ______________________________________________________________________ [51]Table of Contents they choose, and may make such offerings on either a common carrier or a non-common carrier basis |
| The FCC’s ruling appears at this time to be deregulatory and to be intended to put facilities-based telephone company providers of DSL in regulatory position similar to that of cable TV providers of cable modem service |
| However, the ruling also provides that it does not alter the rights of competitors under Section 251 of the Communications Act to purchase “unbundled network elements” including the purchase of unbundled loops to provide their own DSL service |
| It is not possible at this time to predict how the FCC’s recent action will affect the Company, including the impact on the competitive position of the Company in the provision of DSL services, and the impact on access charge revenue settlements with NECA The FCC has yet to significantly regulate VoIP offerings, maintaining regulatory uncertainty while placing VoIP services at a regulatory advantage over our RLEC legacy telephone services |
| Currently, two recent FCC rulings have defined the regulatory status of VoIP as an information service subject to minimal regulation by the FCC rather than as a telephone service subject to state commission regulation |
| The FCC has issued a Notice of Proposed Rulemaking to broadly investigate the appropriate regulatory treatment of VoIP services |
| It is unknown at this time when the FCC will act on this proposal or what effects any changes may have on the results of our operations or financial conditions |
| The FCC has ordered strict requirements for the provision of 911 services by VoIP providers |
| All interconnected VoIP providers must notify customers regarding the provisions of 911 service and certify to the FCC that existing customers have been informed and that they acknowledged receipt of such information |
| Our ISP is in full compliance with the FCC requirements and we are working to make 911 service available everywhere we wish to offer the service |
| We are still investigating the cost to provide 911 connectivity in all potential locations |
| In addition to regulation of 911 service, on September 23, 2005, the FCC issued a Report and Order holding that the requirements to make networks available for electronic surveillance by law enforcement agencies under the federal Communications Assistance for Law Enforcement Act (“CALEA”) applies to facilities-based broadband Internet access providers and a broad category of VoIP providers |
| It is not possible at this time to predict how the FCC’s recent action will affect us |
| While it may be easier for us to comply with new CALEA requirements than other VoIP providers, the FCC left to a future Order, the task of defining the specific capabilities that carriers will have to provide to law enforcement agencies, and the method for recovering costs for providing those capabilities |
| In addition, the FCC issued a Notice of Proposed Rulemaking seeking comment as to whether small and rural providers of facilities-based broadband Internet access services should be exempt from CALEA requirements |
| The FCC has also enacted changes to certain technical rules that would foster broadband deployment using the capabilities of the nation’s power grid |
| All of these developments may result in an even more highly competitive environment in which utility companies are very likely to be in direct competition with telephone companies and cable TV operators in many locations |
| This development could cause telephone companies to lose their competitive edge in their territories and, consequently, result in significant inroads into their core telephone/voice business |
| Our indebtedness could restrict our operations |
| As of December 31, 2005, we had approximately dlra215dtta5 million of total indebtedness, including current maturities |
| We refinanced our indebtedness in March 2004 and further amended our credit facility in November 2004 |
| The effect of the refinancing was to lower the interest rates on our indebtedness, provide greater flexibility in our financial covenants and spread out the amortization of principal |
| The refinancing also lifted restrictions on the expansion of our CLEC edge-out market and eliminated the requirement of the prior loan agreement that excess cash flow be applied to prepayments of principal |
| This new structure, pursued to manage our balance sheet in order to better achieve our business plan, decreases the risks associated with our indebtedness |
| However, our indebtedness could still restrict our operations because we will use a substantial portion of our cash flow from operations, if any, to pay principal and interest on our indebtedness, which will reduce the funds available for working capital, capital expenditures, acquisitions and other general corporate purposes |
| 27 ______________________________________________________________________ [52]Table of Contents Additionally, our level of indebtedness may make us more vulnerable to economic or industry downturns and competitive pressures |
| The agreements governing our indebtedness contain covenants imposing financial and operating restrictions on our business |
| These restrictions may limit our ability to take advantage of potential business opportunities as they arise and adversely affect the conduct of our business |
| These covenants place restrictions on our ability and the ability of our subsidiaries to, among other things: • incur more indebtedness; • pay dividends over dlra10 million annual limit, redeem or repurchase our stock or make other distributions; • make acquisitions or investments; • use assets as security in other transactions; • enter into transactions with affiliates; • merge or consolidate with others; • dispose of assets or use asset sale proceeds; • create liens on our assets; and • extend credit |
| The Systems Integration Segment could be affected by the concentration of business among a few major customers |
| The sale of equipment and services in the Systems Integration business is dependent upon the willingness of companies to invest in improvements in their information and communications systems |
| This business is more concentrated among a few major customers than other segments of our business and may be affected by the economic conditions in our customers’ business sectors |
| We have continuing involvement in the Conestoga Wireless segment after its sale, which may adversely affect the continuing operations of the business |
| In connection with the acquisition of Conestoga, we committed to a plan to sell the assets of Conestoga’s wireless segment |
| We have continuing involvement after the sale as a result of our continued guarantees on cell site leases |
| This obligation could restrict our operations by reducing the funds available for working capital, capital expenditures, acquisitions and other general corporate purposes |