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Executives

John Finke – President and CEO

David Christensen – SVP and CFO

Jennifer Spaude – Director, IR

Analysts

[No Q&A session for this event]

Hickory Tech Corporation (HTCO) Q3 2012 Earnings Call November 9, 2012 10:00 AM ET

Operator

Good morning. My name is Lindsay and I will be your conference operator today. At this time, I would like to welcome everyone to the HickoryTech’s Third Quarter 2012 Earnings Conference Call. (Operator Instructions)

Thank you. Jennifer Spaude, Director of Investor Relations and Marketing, you may begin your conference.

Jennifer Spaude

Thank you, Lindsay and good morning. We appreciate you joining us today for HickoryTech’s third quarter 2012 earnings call. I’m Jennifer Spaude and with me today are John Finke, HickoryTech’s President and Chief Executive Officer; and David Christensen, Senior Vice President and Chief Financial Officer. At the conclusion of the prepared remarks, we will open the call up for questions. Please refer to the safe harbor statement shown on slide 2 of our presentation which is also available on the investor relations section of our website at hickorytech.com.

The information in today’s presentation may contain certain statements and predictions that are not historical facts, but are forward-looking in nature. These forward-looking statements are based on current expectations, estimates and projections about the industry in which HickoryTech operates, and management’s beliefs and assumptions as of the time of this call.

Such forward-looking statements are subject to uncertainties. Actual results or outcomes may differ materially from those indicated or suggested by any forward-looking statements, whether as a result of new information, future events or otherwise.

You are cautioned not to place undue reliance on these forward-looking statements made during the conference call. These statements are not guarantees of future performance and involve certain risks, uncertainties and probabilities which are difficult to predict. There are many such risks and uncertainties which could affect the economy, our industry and our company in particular, some or all of which could affect future results.

More information on potential risks and uncertainties is available in the company’s recent filings with the Securities and Exchange Commission, including HickoryTech’s Annual Form 10-K report and Form 10-KA, our Quarterly Form 10-Q and 10-QA reports, and our Form 8-K reports.

In addition, today’s discussion will include certain non-GAAP financial measures. Reconciliations of these non-GAAP measures to the most directly comparable GAAP measures are available in our presentation and in our earnings release.

All participants are advised that the audio of this conference call is being broadcast and is also being recorded for playback purposes. Following management’s discussion, we will open the call to the Q&A session.

At this time, I’d like to turn the call over to John Finke.

John Finke

Thank you, Jennifer and good morning everyone. I appreciate you joining us today as we discuss HickoryTech’s third quarter 2012 earnings. I will begin my remarks with comments on our overall results and provide an update on our IdeaOne integration progress. David will provide a detailed review of our financials and the recent restatement we filed regarding the accounting for our interest rate swap agreements. We filed our restated documents this morning and the financial impact was the same as the estimates in the 8-K released two weeks ago which announced this restatement.

Year to date we are on track to achieve our 2012 objectives. Our business fiber and data services continued to deliver solid revenue growth offsetting declines in our legacy telecom services. Total operating revenues of $45.8 million grew 1% year over year. Fiber and data segment revenue grew 36% from a year ago and telecom segment revenue declined 12%. Clearly our fiber and data services are the driving force behind our diversification strategy and our continued emphasis on growing our business services.

Consolidated operating income totaled $4.6 million, down 28% year over year and net income totaled $1.7 million, down 18% for the same period. The quarter’s lower earnings are attributed primarily to a larger decline in the telecom segment, specifically in network access and local service revenue, an increase in depreciation associated with the acquisition of IdeaOne and overall operating expense increase in our growth lines of business.

EBITDA totaled $11.4 million in the third quarter and $34.1 million for the nine months ended September 30, 2012. While EBITDA declined in the quarter, EBITDA increased 3% on year to date basis. Overall growth in our fiber and data segment is helping to offset telecom profitable decline. It is important to note that despite declines in profitability the telecom segment still produces solid free cash flow.

Now turning to the fiber and data segment which now includes the IdeaOne operations. Fiber and data revenue of $15.7 million grew 36% from a year ago. Excluding IdeaOne operation, we grew fiber and data revenue 8% in the third quarter and 10% year to date. We attribute this growth to the success we continued to experience in our commercial, enterprise and wholesale customer segments. We’re focused on our core minutes of the markets of the Twin cities Duluth and Rochester, as well as West Des Moines, Iowa and Fargo, North Dakota.

We have a solid backlog of orders in our fiber and data business and we are excited about the targeted fourth quarter business sales promotion which is focused on driving pre-qualified on-net services at competitive prices within these markets. The demand for greater bandwidth and high capacity data network connection is driving revenue in Ethernet, dedicated internet and transport services.

The IdeaOne Fargo market integration is on track to be completed by year end. You may recall that we closed on this transaction in March. We converted the financial systems in July and the billing system conversion took place earlier this month. We are rebranding this market as Enventis and this effort is already underway.

We’ve maintained the strong local presence in Fargo and recently, we were awarded a 10-year contract with the West Fargo school district to provide wide area network connectivity to the district. The $1 million contract expands the existing relationship IdeaOne had with the school district which includes 15 existing locations and the new school which will be in operation next year.

Our leadership team remains in place and is active in the Fargo market as well as in Northern Minnesota. The Fargo market is already delivering value as we secured new business based on our expanded footprint. We continue to identify revenue opportunities and operational cost savings as we combine the operations. We expect the acquisition to be accretive on a free cash flow basis by the end of the first year of operation. Our Greater Minnesota broadband collaborative project remains on schedule. With the completion of construction on the first phase of the project, a 184 mile fiber build from Minneapolis-St. Paul to Duluth and to Prairie, Wisconsin. We’re now focused on the second long-haul route. This fiber build is from Brainerd, Minnesota to Moorhead, Minnesota and will also connect with our network in Fargo. Construction along this route is underway and the entire project is scheduled to be complete in August of 2013. We successfully completed a federal program officer review in September and received favorable feedback on our Btop (ph) project as well as the progress on our construction.

Now turning to our equipment segment, revenue for this business unit totalled $15 million, down 9% year-over-year. Revenue on equipment and hardware sales varies quarter to quarter and year-to-date equipment segment revenue is up 17%. Heading into the fourth quarter, we have high order activity and our focus on increasing professional services revenue which is recurring higher margin revenue. Our support services revenue totaled $1.1 million in the third quarter.

Enventis achieved the Cisco master managed services certification in September. This certification highlights our position as a market leader in managed and hosted services and has to our credentials as one of the most experienced Cisco Gold master unified communication partners in the upper Midwest. Our Cisco expertise is a key differentiator in helping us cross-sell network and professional services across our entire customer base and align sales incentives to focus on selling both network services and equipment.

We’ve experienced a solid demand for our UC contact center and data networking services which drives both hardware sales and professional services. Our equipment business is on track to finish the year strong with a solid backlog of orders. Business and broadband revenue account for 76% of our total revenue. Looking specifically at our business product lines, we believe overall and over the long term they will continue to deliver excellent results towards meeting our strategic objectives. It’s the strong level of diversification that defines the transformation of HicktoryTech into a leading fiber and data and networking provider serving the upper Midwest.

Now turning to our telecom segment, third quarter revenue totaled $15.7 million, down 12% from a year ago. Telecom results reflect the third consecutive quarter of larger declines in networking access and local service revenue. Local service revenue was down 12% reflecting the continued trend of access line losses and changes due to regulatory reform. Network access revenue was down 15%. These declines are higher than we have experienced in previous years and Dave will provide more details on the factors triggering this level of decline in 2012.

Broadband revenue totaled $4.9 million, down 5% year-over-year which is a reflection of our mature market and increased competition. Our new customer bundles which were launched in July have been received very well and are proving to be very competitive. The new bundles offer both new and existing customers an excellent value to maintain services, less in churn or for new customers to choose HickoryTech as their service provider. Of those choosing our new bundles, approximately 70% are existing customers and 30% are new subscribers.

The new plans feature simple discounts which are highly customizable and offer deeper discounts for one or two year agreement. 84% of bundle subscribers are choosing a three-year agreement. We are in the process of upgrading our digital TV middleware which will bring wholesale – which will bring whole home DDR services and other benefits making our services more competitive in the marketplace.

On the business front, within our telecom service area, we are pleased to have recently secured a two-year contract extension to provide voice, data and video conferencing services to SOCRATES, the consortium of 69 schools and libraries across south central Minnesota. The initial $4 million three year contract has been extended through 2015. Given that our telecom markets are mature, we remain focused on developing programs to ensure customer retention and target consumer promotions that drove loyalty.

We are leading with our differentiators, our local customers support and our strong connection to the communities we serve. Telecom expenses were down 3% as we worked to moderate our spending in the segment, and as I mentioned earlier, despite the decline in telecom revenues and profitability, the telecom segment still provides steady consistent cash flows for our company.

At this time, I will turn the call over to David Christensen who will discuss our recent restatement and provide financial details on our third-quarter results.

David Christensen

Thank you, John. Let me begin with a note of our restatement. Two weeks ago, we announced our need to restate earnings for several prior periods. Today we filed amendments to those prior documents with the SEC, thus completing the restatement. The restatement we announced in late October was related to accounting for interest rate swaps under financial accounting standards board FASB ASC 815 derivatives and hedging.

Prior to that announcement, we along with our registered public accounting firm Grant Thornton discussed the accounting for interest rate swap agreements and concluded the changes in the fair value of interest rate swaps should have been reported as non-cash interest charges within the statement of operations. This conclusion was based on the documentation requirement at the inception of the interest rate swap agreements as well as on an ongoing basis.

We have previously recorded the changes in market values of our interest rate swap agreements within accumulated other comprehensive income. The restatement affected interest expense, taxes, net income, earnings per share and certain lines in the equity section of the balance sheet. The restatement did not affect cash flow, operating income, EBITDA, or the company’s ability to pay dividend. Finally the restatement does not affect the cash flow moving into our interest expense and does not reduce the benefits the interest rate swap provides us in managing our exposure to interest rate fluctuations.

As John mentioned, consolidated third quarter revenue was $45.8 million, a 1% increase over last year. Our nine month year to date revenue is $136.6 million and is up 10% over last year. Equipment sales which is revenue from non-recurring equipment or fiber transactions is the primary factor for both the low increase in the third quarter and the higher increase in the year-to-date results.

Equipment revenue is cyclical and tends to vary quarter to quarter. The rest of our revenue approximately 71% of our total is service revenue which has grown 6% over last year for both the quarter and year-to-date, This growth is net of the declines we incurred in our telecom segment.

The 36% growth in our fiber and data segment for the quarter and the 31% growth in the first nine months is the main driver of our overall revenue increase. We experienced a 10% organic growth in fiber and data revenue for the nine months ended September 30, 2012 before the addition of the acquired IdeaOne. This revenue growth is net of any customer price reductions as they migrate from our traditional TDM network to a more IT based network connection, a progression that allows them to benefit from pricing economy.

When this organic growth is combined with a seven month revenue impact from owning IdeaOne, it gives us the combined 31% revenue growth in this segment year to date. Fiber and data segment operating expenses and operational capabilities have grown as evidenced by a 38% increase in costs for the third quarter and 31% increase year to date. These growth rates are in line with the revenue increases and driven in part by the acquisition of IdeaOne.

We have continued to invest in the Fargo market and throughout our regional network to take advantage of growth opportunities in this segment. We’ve also added sales and sales engineering resources to support our growth in the fiber and data segment. We spent $6.4 million in capital expenditures in the third quarter for this segment and $12 million in CapEx year to date, levels that are significantly higher than last year for the quarter and for the year-to-date. The addition of Fargo operations and the success based capital expenditures supporting fiber and data growth and expansion are the primary drivers for the increase in this segment’s CapEx.

Our equipment segment has experienced period of significant growth such as the 37% increase in revenue over the first half of 2012, followed by period such as the 9% decline in this third quarter. That’s the nature of this line of business. We have a year to date increase of 17% in total equipment revenue for the nine-months ended September 30 2012. Our equipment business has an exceptional reputation in our market. We have a robust backlog and we feel very good about the future of this business line.

We understand the peaks and plateaus this line of business can pose financially from quarter to quarter and we focus on the longer term. Our telecom segment revenue was down 12% in the third quarter and year to date it fell 9%. Network access revenue declined 15% for the quarter and 16% year to date. We along with other telecom companies have experienced diminishing access lines and minutes of use on our network for many years, as well as a reduction of the rates we’re allowed to charge for network access. That has led to gradual network access revenue decline.

For the past three years, these declines were between 3% and 7% annually. This year we are feeling the impact of access reform in addition to the historic decline. The higher level of decline this year is as a result of three main factors. First, the expiration of interstate infrastructure support reimbursements. Second, we canceled service to a conference call service provider due to new access rules, further reducing the minutes of use and business access lines. And third, the initial impact of industry wide access reform regulation.

Beginning in the third quarter, additional access rate changes went into effect in part to begin to reduce the difference between interstate and state rates. This provides less incentive for inter-exchange carriers to report minutes in another jurisdiction really to reduce costs.

August 2012 marked the first month support teams from the new Connect America Fund or CAF were received by telecoms which is the mechanism now used for companies to recover some of the lower revenue from inter-exchange carriers resulting from access reform. This new CAF is expected to help stabilize the access revenue decline and make it more predictable over the long run. We expect to see this impact take effect over the next several quarters.

Telecom local service declines which are down 12% for the quarter and 9% for nine months year to date are related to the nationwide trend common to all the wireline providers, the challenge of holding local phone customers on our reliable network. The pace of decline we are experiencing in 2012 is higher than we have seen in the last couple of years. This pace was heightened by the one-time loss of business line we experienced when we canceled service to a conference call provider and we also experienced more local service churn at this offline (ph) months, including some broadband churn.

The new competitive bundles which John mentioned are focused on both retention and sales of local and broadband services. We achieved 3% reductions in telecom operating costs in the third quarter and also year to date. While we continue to invest in telecom business, we are very aware and focused on maintaining healthy operating net cash flow from this important legacy business.

Our overall 28% decline in operating income this quarter has several contributing factors, including declines in the telecom business and in the equipment business. The fact that our EBITDA for the nine months of $34.1 million is 3% higher than last year yet the operating income is lower points to depreciation as another cost. We have additional depreciation for IdeaOne’s network which was valued at fair value when we reported our $28 million acquisition in the first quarter. And we have the ongoing organic influence on depreciation from the CapEx associated with our multi-year network expansion.

Our interest expense for the third quarter was $1.6 million. With our recently changed accounting method of recording the fair value changes and interest rate swap agreements as non-cash interest charges within this interest expense. In the third quarter, we recorded additional non-cash interest expense of $131,000. For the comparable period last year, the non-cash interest charge from the fair value of the interest rate swap agreements was $1,393,000.

On a year to date basis, the non-cash interest charge added into interest expense was $295,000. And from the same period last year the added non-cash interest charge was $1.629 million. With both regard to the non-cash charges within interest expense, the interest expense as depicted as cash paid for interest which we explain at the bottom of our statement of cash flows in our 10-K, shows that for the nine months ended September 30, 2012, we paid $4.5 million in interest. And in the comparative period last year, we paid $3.3 million of interest.

The increase is the combined effect of the extra $22 million borrowing for the IdeaOne acquisition and higher interest rate margins paid to bank as a result of our refinancing last August. Even at $1.5 million average quarterly interest payment this year, we have effective interest cost of approximately 4.2% on an annualized basis this year compared with 4.1% for 2011.

Our debt to EBITDA leverage is less than 3 to 1 and we are in full compliance with our debt agreement. Our debt agreement has a term that runs through 2016 and we are fortunate to have such a great source of capital. We were pleased to receive the prompt waiver of any implied breach caused by our recent financial restatement. That waiver was for our representation of the bank group that we follow generally accepted accounting principles which was remedied both by the bank waiver and with our filings today.

Current maturity and the long term debt classifications of debt on our balance sheet totaled $137.2 million as of September 30, 2012. That is $4.3 million less than last quarter and represents a $16.9 million increase from the $120.2 million level at the beginning of 2012. The increase is made up of the funds borrowed to purchase IdeaOne. Our voluntary third quarter debt paydown illustrates our confidence in the future of net cash flow of our business. Further details of our third quarter are contained in the SEC Form 10-Q which will be filed later today.

We are on track to achieve our business plan objectives. We have not changed the basic revenue, EBITDA or CapEx guidance for 2012 and we remain committed to the building shareholder value prospects of our business plan and focus on the long run. Our fiscal 2012 guidance has only minor changes in it to the forecasted year end debt due to our recent voluntary debt paydown and changes to net income and earnings per share guidance to allow for a wide range of potential interest rate levels now that non-cash fair value changes in the interest rate swap agreements are recorded in the income statement. The details are provided in our earnings release and on the presentation accompanying this call.

Please note that the fiscal guidance includes IdeaOne for 10 months starting March 1 of this year. I will just end by saying our nine months year to date 2012 has been successful financially and is in line with our financial targets. And year to date we have been successful operationally because we closed on IdeaOne and we are continuing profitably and our entire fiber and data segment continues on to its clear path.

With that, I would like to turn the call back over to John Finke. John?

John Finke

Thank you, David. In summary, as we approach the final quarter of 2012, we are on track to achieve our objective and our fiscal guidance. Our team of 500 employees is working hard to deliver results and complete the integration of our Fargo operations. We are focused on growing our business services and leveraging the strong fiber and data growth trends as business customers transition to next generation data services.

Our legacy telecom operations are mature and declining but continue to produce solid cash flow. We continue to use free cash flows of our business to achieve our strategic objectives. Our ability to invest, pay down our debt and increase our shareholder dividend in the third quarter can be attributed to the strong free cash flow generated by our operations.

We are confident in our business plan and we are well positioned to continue to deliver results and deliver on our strategies as we drive shareholder value through a combination of growth and a strong vigilance (ph). We have a strong balance sheet, we have growth trends in key strategic product lines. We have a very high level of recurring services revenue. We have a healthy dividend with approximately 5% yield. We have strong cash flow and we have the ability to generate cash to fund future growth opportunities.

We appreciate your continued support of HickoryTech and thank you for joining us on the call today.

At this time, we’d be happy to take any questions. Lindsay, you may initiate them now.

Question-and-Answer Session

Operator

(Operator Instructions) At this time there are no questions.

John Finke

Thank you, Lindsay. I appreciate it. If you joined us after the call began or like a replay of the call, it will be posted on our website at hickorytech.com later today. The telephone replay of this call will be available at noon.

Thank you again for joining us today and we look forward to our next call. And also to remind you that if you have any further questions, please don’t hesitate to give Jennifer, David, or myself a call. Thanks again. Have a great day.

Operator

This concludes today’s conference call. You may now disconnect.

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