| HUNGARIAN TELEPHONE & CABLE CORP Item 1A Risk Factors In addition to the other information contained in this Report on Form 10-K, the following risk factors should be considered carefully in evaluating our business |
| Our business, financial condition, or results of operations or future prospects could be materially adversely affected by any of these risks |
| Please note that additional risks not presently known to us or that we currently deem immaterial may also impair our business and operations |
| Risks Affecting Our Business We face significant competition due to increased telecommunications industry liberalization and other market forces, which competition could adversely affect our operating results and financial performance |
| We compete in a rapidly evolving and highly competitive market and we expect competition to continue to intensify in both the residential and business markets |
| The recent revisions to Hungary’s telecommunications laws and regulations, to further promote competition and harmonize Hungary’s telecommunications laws with the current European Union framework, have laid the foundation for effective competition in the Hungarian telecommunications marketplace |
| Competitors are no longer hindered by historical barriers to entry |
| Hungarotel’s exclusive rights to provide local wireline telephone services in the Hungarotel Operating Areas have expired |
| The introduction of number portability, carrier selection and carrier pre-selection, network access and local loop unbundling have all contributed to a highly competitive environment |
| ” As a result of these regulatory changes, Hungarotel has faced greater competition in its core local wireline business from cable television companies, wireless providers, ISPs, facilities-based telecommunications service providers using their own networks as well as telecommunications service providers leasing parts of Hungarotel’s networks through government regulated arrangements |
| PanTel also faces intense competition in the domestic and international wholesale markets, the Hungarian business retail market and the residential market outside the Hungarotel Operating Areas |
| With Hungary’s high wireless phone penetration rate, competition from the wireless phone companies has been intense and we anticipate that such competition will continue in the future |
| Such competition has led to, -32- ______________________________________________________________________ [33]Table of Contents and could continue to lead to: price erosion; loss of market share and inability to increase market share; loss of existing customers; more difficulty in retaining existing customers and acquiring new customers; and other competitive pressures that could have a material adverse affect on our results of operations and financial performance |
| In order to compete in this competitive environment, we are seeking to distinguish ourselves from our competitors through numerous initiatives such as expanded product bundling, improved customer service and support, and competitive pricing |
| However, these initiatives are new and unproven |
| We may not have sufficient resources to distinguish our products, services or pricing from those of our competitors |
| Even if successful, these initiatives may not be sufficient to offset our continuing loss of access lines and revenue |
| See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7 of this report for more information regarding trends affecting our access lines |
| If we are not able to stem the loss of access lines or grow other areas of our business to compensate for these losses, our revenue may continue to decline in the Hungarotel Operating Areas |
| Our recent revenue decline is largely attributable to our continued loss of access lines in the Hungarotel Operating Areas, which is the result of increased competition and technology substitution (such as wireless for wireline telephony) |
| We are seeking to improve our competitive position through product bundling, customer service initiatives, competitive pricing and other sales and marketing initiatives |
| If we are not successful, this could result in continued loss of customers, lower market share, lower revenues per customer and lower overall revenue without corresponding cost deductions which will cause a material deterioration to our results of operations and financial condition |
| Our strategy to expand into new markets and introduce new services may not be successful |
| Our strategy to have PanTel offer services to the residential and small business market outside of the Hungarotel Operating Areas requires a capital investment |
| While PanTel has experience in the large and medium-sized business market throughout Hungary, PanTel is entering into a highly competitive residential and small business market outside of the Hungarotel Operating Areas |
| If we are not successful in launching our product offerings or in responding to our competitors’ offerings, our business, results of operations and financial condition could be adversely affected |
| Our failure to increase revenue from the Internet services market may adversely affect our business and results of operations |
| Our strategy includes increasing our market penetration in a growing Internet services market to make up for the loss of business in other services |
| The Hungarian government has been promoting Internet usage throughout Hungary with the goal of making Hungary the logical regional hub for Central and Eastern Europe based on a knowledge-based economy, innovation and high-tech industries |
| We are planning on increasing our revenue from Internet services to offset our decreased revenue from our wireline voice services |
| If Hungary’s Internet usage does not grow as expected, or if our competitors are more successful at obtaining new customers or the competition decreases prices more than we expect, we may not be able to increase our revenue from Internet services as planned, which could have a material adverse affect on our business and results of operations |
| Economic conditions could continue to negatively affect our business and results of operations |
| We are affected by the general economic conditions in Hungary and the rest of Central and Eastern Europe in general, and in the telecommunications industry in particular |
| There are many factors that influence global and regional economies which are outside of our control |
| An economic slowdown -33- ______________________________________________________________________ [34]Table of Contents may affect business investment spending on information technology and telecommunications systems, which could adversely affect our revenue |
| In addition, the lower level of wages in Hungary as compared to Western Europe and the United States has had, and could continue to have, an effect on our business |
| Many residential customers in Hungary can not afford both a wireline phone and a wireless phone |
| A stagnant economy could decrease the number of our customers and decrease our average revenue per customer, which could have a material adverse affect on our business and results of operations and our financial condition |
| We may not be able to adapt to technological changes in the telecommunications marketplace |
| The telecommunications industry is subject to rapidly changing technology which affects customer demands as new products and services are introduced |
| Our future success will be impacted by our ability to anticipate and adopt new technologies as the telecommunications markets evolve |
| The successful deployment of new telecommunications technologies may require significant capital expenditures in excess of contemplated levels |
| There can be no assurance that we will have the capital resources or the ability to obtain such capital to make such investments |
| New technologies may also necessitate us taking some of our existing assets out of our networks which could require substantial write-downs of the carrying value of our assets, resulting in charges to our Statement of Operations |
| Network or system failure could result in lost revenue, increased capital expenditures or a damaged brand name |
| Our technical infrastructure (including our network infrastructure) is vulnerable to damage or interruption from information technology failures, power loss, floods, windstorms, fires, vandalism or other acts of intentional wrongdoing, and other unpredictable events |
| Unanticipated problems at our facilities, network or system failures, hardware or software failures or computer viruses could negatively affect the quality of our services and cause interruptions in service |
| Any of these problems could adversely affect our revenue, require unexpected capital expenditures and damage our business prospects and brand name in the markets that we serve |
| Our IT Systems are critical to our business and a failure of those systems could materially harm our business |
| We depend on our ability to store, retrieve, process and manage a significant amount of information |
| If our IT systems fail to perform as expected, or if we suffer an interruption, malfunction or loss of information processing capabilities, it could have a material adverse effect on our business |
| The loss of key employees could adversely affect us |
| Our operations are managed by a small number of key employees |
| The loss of such key employees could adversely affect our operations |
| There can be no assurance that we will be able to keep all of our key employees or find adequate replacement employees |
| Risks Relating to Regulatory Matters We are subject to substantial government regulation, which could result in adverse consequences for our business and results of operations |
| As summarized elsewhere in this report, we are subject to substantial governmental regulation, which could result in adverse consequences for our business and results of operations |
| The Hungarian government regulates the entire telecommunications marketplace in Hungary including, among other matters: prices of wireline telecommunications services; carrier selection; number portability; our Universal Service obligations and benefits; the terms and conditions upon which we are required to “unbundle” our telecommunications network to allow other telecommunications service providers to use -34- ______________________________________________________________________ [35]Table of Contents our network to compete with us in the provision of telecommunications services; and the terms and conditions upon which we must provide interconnection of our network to the networks of other telecommunications service providers |
| The Hungarian government has designated Hungarotel as a telecommunications service provider with “significant market power” which increases the oversight of its operations |
| Our business and results of operations may be adversely affected by any changes in telecommunications laws or regulations enacted by the Hungarian government |
| ” Hungary has recently joined the European Union and its integration may cause changes in Hungary’s laws, which could result in adverse consequences for our business and results of operations |
| Hungary joined the European Union in 2004 |
| Hungary has recently revised its telecommunications laws to further promote competition and harmonize its telecommunications laws with the current European Union framework |
| Our business and results of operations may be adversely affected by changes in EU laws and regulations which may require Hungary to revise its telecommunications laws in a manner that increases competition, decreases revenue or requires us to expend additional resources |
| Risks Relating to Our Debt Our ability to generate cash depends on many factors beyond our control, and we may not be able to generate sufficient cash to service our debt |
| We have an outstanding secured bank credit facility which is repayable in euros (approximately dlra157 million outstanding as of December 31, 2005) and outstanding notes which are repayable in US dollars which are held by our majority shareholder TDC (dlra25 million outstanding as of December 31, 2005) |
| Our ability to pay or refinance our bank credit facility or the outstanding notes will depend upon our future operating performance, which will be affected by general economic, financial, competitive, regulatory and business factors, some of which may be beyond our control |
| We anticipate that our operating cash flow will be sufficient to meet our future anticipated operating expenses and fund our capital expenditures |
| However, we can not assure you that we will meet our goals regarding revenue, expenses, or cash flow from operations to enable us to pay the required interest and principal payments on our debt or fund our other liquidity needs |
| If we are not able to meet our debt payment obligations, we may be required to: reduce, forego or delay capital expenditures; limit our growth; issue additional debt or equity; sell assets; refinance our debt; or forego business opportunities |
| We can not assure you that any of these actions could be executed on reasonable commercial terms or at all |
| We are subject to currency exchange rate risks |
| Since we generate substantially all of our revenue in Hungarian forints, our ability to repay debt and other liabilities denominated in currencies other than the Hungarian forint can be adversely affected by the weakening of the Hungarian forint against such non-Hungarian currencies |
| For example, the bank credit facility is euro-denominated debt |
| If the Hungarian forint were to weaken against the euro, Hungarotel and PanTel would need a greater amount of Hungarian forints to pay the same amount of euro-denominated debt |
| We evaluate this risk frequently and enter into foreign currency forward contracts, if deemed effective, or purchase foreign currency in advance, to attempt to minimize such risks |
| We are subject to risks resulting from fluctuations in interest rates |
| The interest rates on our bank credit facility and notes are both variable rates tied to current market interest rates |
| An increase in the market interest rates could adversely affect our ability to service our debt |
| To limit the interest rate risk of the euro-denominated bank credit facility, we entered into interest rate swap agreements whereby we exchanged 100prca of our variable interest rate exposure on the euro-denominated debt for a fixed interest rate |
| The swap agreements are in place until 2010 |
| -35- ______________________________________________________________________ [36]Table of Contents Our secured bank credit facility imposes restrictions on our ability to take certain actions and contains financial covenants that we could fail to satisfy |
| Our bank credit facility prohibits us from taking certain actions, without the consent of the banking syndicate |
| For example, there are limitations on our ability to pay dividends, borrow funds, merge, acquire assets or businesses, or dispose assets |
| We can not assure you that the operating and financial restrictions in our bank credit facility will not adversely affect our ability to finance our future operations or capital requirements or engage in other business activities that may be in our interests |
| Our bank credit facility requires us to maintain certain financial ratios |
| Those financial covenants are measured in euros while our operating revenue and expenses are generally in Hungarian forints |
| There can be no assurance that our financial performance will enable us to meet these financial performance tests |
| Our ability to meet these tests may be affected by events beyond our control, including a negative movement in the currency markets |
| We may be required to seek waivers if we do not meet these financial tests |
| We can not assure you that we could obtain such waivers |
| If we did not obtain the waivers, any breach of these financial covenants could result in a default under the bank credit facility and require us to repay the outstanding balance, including interest, of the bank credit facility |
| There can be no assurance that we would have the funds to repay the bank credit facility or have the ability to refinance the bank credit facility |
| If we were unable to repay any amounts owed under the bank credit facility, the banks could take actions to take control of the collateral pledged to the banks as security, which collateral consists of all of our assets, including our parent company’s ownership interests in Hungarotel and PanTel |
| Our secured bank credit facility enumerates certain events which, if they were to occur, could trigger a mandatory prepayment provision, which could require us to make a prepayment on the outstanding balance under the secured bank credit facility |
| Our bank credit facility requires us to make a prepayment on the outstanding balance of the bank credit facility if we take certain actions such as raising debt or equity capital |
| We are also required to make a prepayment if we have any “Excess Cash Flow” (as defined in the bank credit facility) |
| We can not assure you that these mandatory prepayment provisions, if not waived, will not adversely affect our ability to finance our future operations or capital requirements or engage in other business activities that may be in our interests |
| We are also required to repay the entire amounts outstanding under our bank credit facility if TDC, without the consent of the banks holding two-thirds of the bank credit facility loans, either (i) disposes of a certain amount of its shares of the Company or (ii) no longer has the right to appoint the Chairman of our Board of Directors, Chief Executive Officer or Chief Financial Officer (the “Appointment Rights”) |
| However, such mandatory prepayment provision shall not apply if (a) our Total Net Borrowings to EBITDA ratio is less than 2:1 at the end of each of the two fiscal quarters prior to such event, (b) TDC sells all of its shares of the Company to an internationally recognized telecommunications operator with a certain credit rating, or (c) TDC transfers the Appointment Rights to an internationally recognized telecommunications operator with a certain credit rating which telecommunications operator also buys all of TDC’s shares of the Company |
| TDC currently owns approximately 62prca of our outstanding Common Stock |
| TDC was recently acquired by a group of five private equity funds |
| If this mandatory prepayment was triggered, there can be no assurance that we would have the funds to repay the bank credit facility or have the ability to refinance the bank credit facility |
| If we were unable to repay any amounts owed under the bank credit facility, the -36- ______________________________________________________________________ [37]Table of Contents banks could take actions to take control of the collateral pledged to the banks as security, which collateral consists of all of our assets, including our parent company’s ownership interests in Hungarotel and PanTel |
| Risks Relating to Our Reported Financial Results as a US Public Company We are subject to fluctuations in currency exchange rates which could have an adverse effect on our reported financial results |
| As a Delaware incorporated company, we report our financial results in US dollars, our reporting currency, while almost all of our revenue and a substantial portion of our expenses, including capital expenditures, are in Hungarian forints |
| Changes in the Hungarian forint/US dollar exchange rate have an impact on the amounts reported by us in our financial statements when we translate such forint amounts into US dollars for reporting purposes |
| For example, if we had the same amount of revenue in Hungarian forints during two consecutive financial reporting periods and the value of the Hungarian forint appreciates against the US dollar during the second financial reporting period as compared to the first financial reporting period, we would report higher revenue in US dollars during the second financial reporting period even though the amount of revenue in Hungarian forints remained the same during each of the two financial reporting periods |
| Conversely, if the Hungarian forint weakened against the US dollar during the second financial reporting period as compared to the first financial reporting period, we would report lower revenue in US dollars during the second financial reporting period even though the amount of revenue in Hungarian forints remained the same during each of the two financial reporting periods |
| Therefore, fluctuations in the Hungarian forint/US dollar exchange rate can have a material impact on our reported financial results |
| • Subsidiary Debt Denominated in Currency Other than the US dollar - Effect on Balance Sheet |
| If any of our Hungarian subsidiaries hold debt denominated in a currency other than the US dollar, that amount is translated into US dollars at the exchange rate in effect on the balance sheet date |
| Hungarotel and PanTel have debt denominated in currencies other than the US dollar (euros) |
| Therefore, if Hungarotel or PanTel were to hold the same amount of euro-denominated debt on two consecutive balance sheet reporting dates, and if the euro appreciated against the US dollar on the second balance sheet reporting date as compared to the first balance sheet reporting date, we would report more debt in US dollars on our balance sheet, with respect to the euro-denominated debt, even though the amount of euro-denominated debt was the same on both balance sheet reporting dates |
| This increase in debt reported in US dollars due to currency fluctuations would be recorded as a reduction to shareholders’ equity |
| Conversely, if Hungarotel or PanTel were to hold the same amount of euro-denominated debt on two consecutive balance sheet reporting dates, and if the euro depreciated against the US dollar on the second balance sheet reporting date as compared to the first balance sheet reporting date, we would report less debt in US dollars on our balance sheet, with respect to the euro-denominated debt, even though the amount of euro-denominated debt was the same on both balance sheet reporting dates |
| This decrease in debt reported in US dollars due to currency fluctuations would be recorded as an addition to shareholders’ equity |
| • Subsidiary Debt Denominated in Currency Other than the Hungarian Forint - Effect on Statement of Operations |
| - Hungarotel’s and PanTel’s functional currency for accounting purposes is the Hungarian forint |
| Hungarotel and PanTel have debt denominated in currencies other than the Hungarian forint (euros) |
| When Hungarotel or PanTel prepares its balance sheet, each must re-value debt amounts denominated in currencies other than the Hungarian forint into Hungarian forints at the exchange rate in effect at the balance sheet date |
| Therefore, if Hungarotel or PanTel -37- ______________________________________________________________________ [38]Table of Contents were to hold the same amount of euro-denominated debt on two consecutive balance sheet reporting dates, and if the Hungarian forint has appreciated against the euro on the second balance sheet reporting date as compared to the first balance sheet reporting date, Hungarotel or PanTel would report less debt in Hungarian forints on its balance sheet, with respect to the euro-denominated debt, even though the amount of euro-denominated debt was the same on both balance sheet reporting dates |
| The difference in the amount of Hungarian forints reported for the euro-denominated debt for the two periods would be translated back into US dollars at the average Hungarian forint/US dollar exchange rate for the second period and be recorded as a foreign exchange gain for the period on our consolidated Statement of Operations |
| Conversely, if the Hungarian forint depreciated against the euro on the second balance sheet reporting date as compared to the first balance sheet reporting date, Hungarotel would report more debt in Hungarian forints on its balance sheet, with respect to the euro-denominated debt, even though the amount of euro-denominated debt was the same on both balance sheet reporting dates |
| In this case, the difference in the amount of Hungarian forint reported for the euro-denominated debt for the two periods would be translated back into US dollars at the average Hungarian forint/US dollar exchange rate for the second period and be recorded as a foreign exchange loss for the period on our consolidated Statement of Operations |
| As a result of the above, while our reported financial performance may change, a significant portion of such change may be due to currency fluctuations |
| Changes in accounting rules, including the expensing of stock options granted to our employees, could have a material impact on our financial results |
| US generally accepted accounting principles are subject to interpretation by the Financial Accounting Standards Board (“FASB”), the American Institute of Certified Public Accountants, the Public Company Accounting Oversight Board (“PCAOB”), the SEC, and various bodies formed to promulgate and interpret appropriate accounting principles |
| A change in these principles or interpretations could have a significant effect on our reported financial results |
| We currently record any compensation expense associated with stock option grants to employees using the intrinsic value method in accordance with Accounting Principles Board Opinion Nodtta 25 |
| On December 15, 2004, the FASB issued SFAS 123R, Share-Based Payment, which will require us to measure compensation expense for employee stock options using the fair value method beginning the first quarter of fiscal year 2006, which is the quarter ended March 31, 2006 |
| SFAS 123R applies to all outstanding stock options that are not vested at the effective date and grants of new stock options made subsequent to the effective date |
| As a result of SFAS 123R, we will record higher levels of stock based compensation due to differences between the valuation methods of SFAS 123R and APB 25 |
| Our future operating expenses may be adversely affected by changes in our stock price |
| All of our outstanding stock options are subject to variable accounting |
| Under variable accounting, we are required to re-measure the value of the options, and the corresponding compensation expense, at the end of each reporting period until the option is exercised, canceled or expires unexercised |
| As a result, the stock-based compensation expense we recognize in any given period can vary substantially due to changes in the market value of our Common Stock |
| Volatility associated with stock price movements has resulted in compensation benefits when our stock price has declined and compensation expense when our stock price has increased |
| We are unable to predict the future market value of our Common Stock and therefore are unable to predict the compensation expense or benefit that we will record in future periods |
| -38- ______________________________________________________________________ [39]Table of Contents Changes in accounting assumptions or regulations could affect our financial results |
| Changes in accounting assumptions that regulatory agencies, including the SEC, may require or that result from changes in the accounting rules or applications, could result in an impact on our financial results |
| The failure of our internal control over financial reporting could harm our business and financial results |
| Our management is responsible for establishing and maintaining adequate internal control over financial reporting |
| Internal control over financial reporting is a process to provide reasonable assurance regarding the reliability of financial reporting for external purposes in accordance with accounting principles generally accepted in the United States of America |
| Internal control over financial reporting includes maintaining records that in reasonable detail accurately and fairly reflect the Company’s transactions; providing reasonable assurance that transactions are recorded as necessary for preparation of the financial statements; providing reasonable assurance that receipts and expenditures of the Company’s assets are made in accordance with management authorization; and providing reasonable assurance that unauthorized acquisition, use or disposition of the Company assets that could have a material effect on the financial statements would be prevented or detected on a timely basis |
| Because of its inherent limitations, internal control over financial reporting is not intended to provide absolute assurance that a misstatement of the Company’s financial statements would be prevented or detected |
| Any failure to maintain an effective system of internal control over financial reporting could limit our ability to report our financial results accurately and timely or to detect and prevent fraud |
| Risks Relating to Strategic Investments or Acquisitions We may engage in future acquisitions and strategic investments that dilute the ownership percentage of our stockholders and require the use of cash, incur debt or assume contingent liabilities |
| As part of our business strategy, we expect to continue to review opportunities to buy or invest in other businesses or technologies that we believe would complement our current products, expand the breadth of our markets or enhance our technical capabilities, or that may otherwise offer growth opportunities |
| If we buy or invest in other businesses, products or technologies in the future, we could: incur significant unplanned expenses and personnel costs; issue stock, or assume stock option plans that would dilute our current stockholders’ percentage ownership; use cash, which may result in a reduction of our liquidity; incur debt; assume liabilities; and spend resources on unconsummated transactions |
| We may not realize the anticipated benefits of future acquisitions and strategic investments, and the integration of acquisitions may disrupt our business and management |
| We are always reviewing our options with respect to additional acquisitions |
| Any additional acquisitions would expose us to certain post-acquisition execution risks, including the following: • the difficulty of assimilating the operations and personnel of the acquired entity; • the potential disruption to our ongoing business caused by senior management’s focus on the acquisition integration; • our failure to incorporate successfully licensed or acquired technology into our network and product offerings; • the potential loss of our key employees or the key employees of the acquired organization; • the failure to maintain uniform standards, controls, procedures and policies; and -39- ______________________________________________________________________ [40]Table of Contents • the impairment of relationships with employees as a result of changes in management and ownership |
| There can be no assurance that we will be successful in overcoming these risks, and our failure to overcome these risks could have a negative effect on our business, financial condition and results of operations |
| Other Risks Our business is subject to increasingly complex corporate governance, public disclosure, accounting, and tax requirements that have increased both our costs and the risk of noncompliance |
| We are subject to rules and regulations of federal and state government as well as the stock exchange on which our Common Stock is listed |
| These entities, including the PCAOB, the SEC, the Internal Revenue Service and the American Stock Exchange, have issued a significant number of new and increasingly complex requirements and regulations over the course of the last several years and continue to develop additional regulations and requirements in response to laws enacted by the United States Congress, most notably the Sarbanes-Oxley Act of 2002 |
| Our efforts to comply with these requirements have resulted in, and are likely to continue to result in, increased expenses and a diversion of management time and attention from revenue-generating activities to compliance activities |
| We are subject to periodic audits or other reviews by such governmental agencies as well as governmental agencies in Hungary and other countries in Central and Eastern Europe in which we operate |
| The SEC periodically reviews our public company filings |
| Any such examination or review requires management’s time and a diversion of internal resources and, in the event of an unfavorable outcome, may result in additional liabilities or adjustments to our historical financial results |
| We have a majority shareholder who interests may be different from the minority shareholders with respect to some matters |
| TDC owns approximately 62prca of our outstanding common stock |
| Three officers of TDC are on our Board of Directors and two employees from TDC serve as executive officers of the Company |
| TDC has, and will continue to have, directly or indirectly, the power to affect our business through their ability to control all actions that require shareholder approval and through their representatives on our board of directors |
| They are not obligated to provide us with financial support |
| The interests of the majority shareholder and those of the minority shareholders may differ with respect to some matters |
| The low trading volume in our stock and the small “public float” of our stock subjects our common stock to volatile trading |
| One stockholder of the Company, TDC, owns 62prca of our outstanding Common Stock |
| Our Common Stock is traded on the American Stock Exchange |
| There has been, and we expect that there will continue to be, only limited shares of our Common Stock available on the market and limited trading volume for the Common Stock |
| Accordingly, the market price of the Common Stock may not be reflective of its underlying value |
| Limited trading volume can also increase the volatility of the market price of the Common Stock |