<PAGE>
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 8-K
CURRENT REPORT
Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
Date of Report (Date of earliest event reported) January 26, 1999
FRONTIER CORPORATION
(Exact name of registrant as specified in its charter)
New York 1-4166 16-0613330
(State or other (Commission (IRS Employer
jurisdiction of File Number) Identification No.)
incorporation)
180 South Clinton Avenue, Rochester, New York 14646
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code (716) 777-1000
Item 5 Other Events
- ------ ------------
Frontier Corporation reports its Management's Discussion of Results of
Operations and Analysis of Financial Condition and its audited consolidated
financial statements and notes to those financial statements for the years ended
December 31, 1998, 1997 and 1996.
Such financial information is attached hereto as Exhibit 99 and
incorporated herein by reference.
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf of the
undersigned hereunto duly authorized.
Frontier Corporation
(Registrant)
Dated: January 25, 1999 By: /s/ Rolla P. Huff
-----------------------------
Rolla P. Huff
Executive Vice President and
Chief Financial Officer
<PAGE>
EXHIBIT INDEX
Exhibit Number Description
- -------------- ------------------
23 Consent of Accountants Filed herewith
(PriceWaterhouseCoopers LLP)
27 Financial Data Schedule Filed herewith
99 Financial Information Filed herewith
<PAGE>
EXHIBIT 23
Consent of Independent Accountants
We hereby consent to the incorporation by reference in the Prospectus
constituting part of the Registration Statements on Form S-3 (File Nos.
33-64307, 333-23229 and 333-57137), Form S-4 (File No. 33-91250) and in the
Registration Statements on Forms S-8 (File Nos. 33-67430, 33-54511, 33-67432,
33-54519, 33-67324, 33-51331, 33-51885, 33-52025, 33-59579, 33-61855, 333-04803,
333-48755 and 333-49657) of Frontier Corporation of our report dated January 25,
1999, appearing on page 20 of Form 8-K of Frontier Corporation dated January 25,
1999.
PricewaterhouseCoopers LLP
Rochester, New York
January 25, 1999
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM FRONTIER
CORPORATION'S FINANCIAL STATEMENTS FOR THE YEAR ENDED DECEMBER 31, 1998 AND IS
QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<CIK> 0000084567
<NAME> FRONTIER CORPORATION
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-END> DEC-31-1998
<CASH> 85,143
<SECURITIES> 0
<RECEIVABLES> 460,680
<ALLOWANCES> 37,956
<INVENTORY> 9,924
<CURRENT-ASSETS> 566,674
<PP&E> 3,205,451
<DEPRECIATION> 1,527,892
<TOTAL-ASSETS> 3,058,743
<CURRENT-LIABILITIES> 567,697
<BONDS> 1,350,821
0
18,770
<COMMON> 171,636
<OTHER-SE> 827,848
<TOTAL-LIABILITY-AND-EQUITY> 3,058,743
<SALES> 0
<TOTAL-REVENUES> 2,593,558
<CGS> 0
<TOTAL-COSTS> 2,276,162
<OTHER-EXPENSES> (45,025)
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 55,318
<INCOME-PRETAX> 307,103
<INCOME-TAX> 129,560
<INCOME-CONTINUING> 177,543
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> (1,755)
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<EPS-PRIMARY> 1.02
<EPS-DILUTED> 1.01
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<PAGE>
EXHIBIT 99
Management's Discussion of Results of Operations and
Analysis of Financial Condition
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The information presented in this Management's Discussion of Results of
Operations and Analysis of Financial Condition should be read in conjunction
with the consolidated financial statements and accompanying notes of Frontier
Corporation (the "Company" or "Frontier") for the three years ended December 31,
1998. The matters discussed throughout this report, except for historical
financial results contained herein, may be forward-looking in nature or
"forward-looking statements." Actual results may differ materially from the
forecasts or projections presented. Forward-looking statements are identified by
such words as "expects," "anticipates," "believes," "intends," "plans" and
variations of such words and similar expressions. The Company believes its
primary risk factors include, but are not limited to: changes in the overall
economy, the nature and pace of technological change, the number and size of
competitors in Frontier's markets, the increasing competitiveness of the
business, changes in law and regulatory policy, our ability to respond to
technological changes in the telecommunications industry, the mix of products
and services offered in the Company's markets and risks associated with
acquisitions. Any forward-looking statements in this report should be evaluated
in light of these important risk factors. For additional disclosure regarding
risk factors refer to the Company's Annual Report on Form 10-K for the year
ended December 31, 1997.
- --------------------------------------------------------------------------------
DESCRIPTION OF THE BUSINESS
Frontier Corporation provides integrated telecommunications services
including Internet IP and data applications, long distance, local telephone and
wireless to business, carrier and targeted residential customers nationwide and
in certain international countries. Following is a description of the Company's
principal lines of business:
Integrated Services
Through its Integrated Services segment, the Company is one of the nation's
largest long distance companies. This segment provides domestic and
international voice, data products, video and audio communications, digital
distribution services, Internet service and other communications products to
primarily small to mid-size business customers, carrier customers and targeted
consumer markets. Results for this segment also include competitive local
exchange carrier ("CLEC") services, currently available in 32 states, plus
Washington D.C., providing Frontier with the ability to offer integrated local
and long distance telephone service to approximately 71% of the United States.
Local Communications Services
The Company's Local Communications Services operation is one of the largest
local exchange service providers in the United States. This segment includes the
Company's local telephone operations, consisting of 34 telephone operating
subsidiaries in 13 states. Also included in this segment are the revenues and
expenses of Frontier Communications of Rochester, Inc., a competitive
telecommunications company formed on January 1, 1995. Frontier Telephone of
Rochester, Inc. led the telecommunications industry by being the first to open
its local market to competition in 1995 under the Open Market Plan.
Consequently, the Local Communications Services segment includes both wholesale
and retail local service provided in the Rochester, New York market. After four
years of operating in a
<PAGE>
competitive marketplace, the Rochester local exchange carrier retains a market
share of approximately 98% of wholesale, and approximately 96% of retail local
service access lines in the Rochester, New York operating territory.
Corporate Operations and Other
Corporate Operations is comprised of expenses traditionally associated with
a holding company, including executive and board of directors' expenses,
corporate finance and treasury, investor relations, corporate planning, legal
services and business development. The Other category includes Frontier Network
Systems Corp. ("FNSC"). FNSC markets and installs telecommunications systems and
equipment. This segment has also included wireless operations of Minnesota
Southern Cellular Telephone Company ("Minnesota RSA No. 10") and the Company's
69.5% interest in South Alabama Cellular Communications Partnership RSAs No. 4
and No. 6 ("Alabama RSAs No. 4 and No. 6"). The sale of Minnesota RSA No. 10 was
finalized April 30, 1998. The Alabama interest was sold in January 1997.
Telecommunications Law
The Telecommunications Act of 1996 was enacted on February 8, 1996. This
landmark legislation significantly modified the Communications Act of 1934 and
established a framework for increased competition in the Local and Integrated
Services' segments of the Company's business. The Company views this legislation
as favorable to its operations because Frontier has been able to enter new
markets to provide local service as a CLEC, as well as derive other benefits
from the elimination of barriers to competition. In addition to its established
local telephone and long distance base, Frontier has been authorized to provide
competitive local services in 33 states, plus Washington D.C, as of December 31,
1998. The Telecommunications Act incorporated many aspects of the Open Market
Plan initiated by the Company in Rochester, New York in 1993 and implemented in
1995. The Company believes its experience in providing integrated services and
its experience with the Rochester, New York Open Market Plan provides it with a
competitive advantage.
The Telecommunications Act has been substantially implemented by the
Federal Communications Commission ("FCC"). In late 1996, the FCC released a
First Report and Order (the "First Report and Order") establishing guidelines to
promote local competition affecting the Company and all other competitors in
local telecommunications markets. On July 18, 1997, the U.S. Circuit Court of
Appeals for the Eighth Circuit reversed portions of the First Report and Order
that provided for pricing based primarily on forward-looking, rather than
historical costs, which would have provided the FCC with substantially more
authority over the compliance by local telephone companies with provisions of
the Telecommunications Act. On January 22, 1998, the same court issued a mandate
compelling adherence to the decision. On January 23, 1998, the U.S. Supreme
Court agreed to review this case. The case was argued on October 13, 1998. On
January 25, 1999, the Court reversed the Eighth Circuit Court's decision and
reinstated the rules.
2
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The Act also requires the FCC to restructure the manner in which universal
service support payments are established and distributed. On May 7, 1997, the
Commission substantially adopted the recommendation of a Federal-State Joint
Board released on November 8, 1996 with respect to universal service. The FCC's
order increased the amount of support to be dedicated to universal service
programs. The Commission has released numerous subsequent orders that have
modified its original decisions. These actions are subject to reconsideration
and appeal. On May 16, 1997, the Commission adopted an order that substantially
modified the structure by which local exchange carriers are compensated for
access to and use of their networks. This order was implemented effective
January 1, 1998. In general, this order encouraged the recovery of some costs
that had previously been recovered in usage-based charges to be recovered in
fixed charges. Both of these orders are subject to the possibility of Commission
modification in light of market impacts. The Federal-State Joint Board issued a
recommendation on November 23, 1998, outlining options for future high cost
recovery and that could result in significant changes in the current
relationship between carriers. This recommendation is currently being reviewed
by the FCC. Any decision is subject to modification and review.
On October 9, 1997, the FCC ordered carriers who receive "dial around"
calls from payphones (certain calls sent without coins, such as 800 or other
calls with special access codes) to compensate payphone owners at the rate of
28.4 cents per completed call. The per-call compensation rate became effective
retroactive to October 7, 1997. The FCC is still considering how it will address
the payphone operator compensation issue for a preceding eleven month period.
The Company has pursued challenges to the FCC order. However, the Company has
also taken action to assess a surcharge to recover the amount of the
compensation ordered and related costs or to allocate responsibility for the
surcharge where it believes that is an appropriate course. This is believed to
be consistent with the action taken by other long distance providers that handle
similar calls through payphones. Some payphone providers have initiated
proceedings seeking payphone compensation. The Company cannot predict the
ultimate outcome of any of these proceedings.
The Company's entry into the Internet distribution business through its
Frontier GlobalCenter, Inc. subsidiary ("GlobalCenter") has led it to accelerate
its development of additional Internet related products including the provision
of certain information or communications offerings over the Internet. Some
parties have relied on the Telecommunications Act and other provisions of law to
seek the relief of specific regulatory cost and other burdens in some of these
services. As these services develop, these issues will be resolved, and a
decision that causes access charges and universal service costs to be collected
and paid during the course of their provision could drive up the price and make
them less attractive.
Competitive Response To Changes in Telecommunications Law
Since the enactment of the Telecommunications Act of 1996, a number of
fundamental changes in the business have occurred. Many companies in the
industry, particularly among the largest companies, have announced or completed
corporate
3
<PAGE>
consolidations or other acquisitions, partnerships or organizational
transactions. As a result, a number of these competitors may be substantially
larger in size and may possess financial resources substantially greater than
Frontier's. This trend toward consolidation is expected to continue. There is
ongoing regulatory activity at both the federal and state levels to implement
the Telecommunications Act, and to put in place mechanisms to govern and to deal
with new business relationships. If some of the more recently announced mergers
are permitted to go forward, these firms will have greater ability to impact the
provision of access and other services to the Company and could affect
competition in one or more of the Company's markets.
As new technological and business opportunities emerge, the pace of
innovation and business activity will likely accelerate. New business
relationships are developing and this can be expected to continue. These
relationships are partially the result of provisions in the law that require new
forms of pricing agreements between facilities-based carriers and resellers, new
interconnection agreements, and arrangements that replace long-standing tariff
filing mechanisms. Many interconnection and resale agreements have been entered
into between incumbent local exchange carriers and other firms. However, in the
regions served by the Bell Operating Companies, there continue to be large
segments of customers who cannot obtain basic local services from competitors of
the incumbent Bell Operating Company. The new law promotes broader competition
among incumbent companies in traditional telecommunications lines of business
and across such lines of business. While such competition is growing, the
Company believes that the local telephone market has not yet achieved the level
of competition anticipated at the time of the enactment of the
Telecommunications Act. At some point, there will be sufficient competition and
other actions taken within given states such that one or more of the Bell
Operating Companies will be able to justify entry into the interLATA long
distance business within their own territory. Such an event is likely to have
direct impacts on both the local telephone market and the long distance market
in that state, and indirect impacts elsewhere.
Frontier anticipated that public policy would continue to evolve in favor
of greater competition. As a result, the Company has been positioning itself to
confront a marketplace with numerous new competitors in each of its targeted
business segments. This includes the development of sales, marketing, new
products, provisioning, customer service, billing and information technology
capabilities that are necessary to compete aggressively and successfully.
Part of this activity has involved an analysis of the merits of owning
additional amounts of long distance facilities. Ownership of facilities can
provide a number of benefits, including the advantages of lower unit costs, new
strategic pricing opportunities and the ability to offer new or unique services.
Completion of the Company's nationwide Optronics network in 1999 will provide
the Company with the infrastructure necessary to meet the increasing demands for
bandwidth capacity and connectivity from both a wholesale and retail basis. The
Optronics network will also result in reduced costs and unparalleled
reliability. Frontier is installing Nortel DMS-500 switching systems in
strategic locations across the country that will connect to the Optronics
network. These switches will provide Frontier the ability to offer combined
local and long distance
4
<PAGE>
telecommunications services to its customers through a single, cost-effective
switching platform and will enable Frontier to accelerate offerings of its CLEC
services. In the fourth quarter of 1997, Frontier introduced a nationwide frame
relay product. This product complements the Company's voice services business
with a portfolio of additional data services products. In addition, the
acquisition of GlobalCenter, a provider of Internet, data and digital
distribution services, completed in February 1998, further enhances Frontier's
data product capability. The combined technology of the Optronics network, DMS-
500 switches, frame relay and enhanced data service comprises a substantial part
of the Company's strategic infrastructure that has made Frontier a nationwide,
facilities-based provider of local, long distance and data services.
The Company's customer base has been segmented to provide better focus for
its sales efforts. Frontier targets four major customer segments: business
customers, where Frontier offers customized products for vertical industry
segments; wholesale carrier customers, which includes long distance resellers as
well as Internet Service Providers ("ISPs"), CLECs and international
telecommunications companies; selected data and Internet segments; and targeted
consumer markets. Marketing efforts have been centralized. Frontier anticipates
that brand awareness and product development will be critical to successful
marketing in the future telecommunications marketplace. The Company committed
resources in 1998 to diversify and improve its product lines and increase brand
awareness, which is expected to continue into 1999.
Strategic Developments
In the fourth quarter of 1997, the Company announced a restructuring plan
designed to focus the Company on its core business. The restructuring plan
included exiting certain non-strategic businesses; phasing out low margin,
price-sensitive long distance consumer products; and targeting actions to reduce
costs. In connection with these actions, a post-tax charge of $54.7 million was
recorded in the fourth quarter of 1997, primarily associated with a workforce
reduction, program cancellations, the exiting of certain product lines and
miscellaneous asset and lease impairments. During 1997, the Company reduced its
workforce by approximately 700 positions or 8%. These cost cutting measures were
partially offset in 1998 by investments in sales and customer service, an
acceleration of competitive local service expansion and increased product
development costs. Frontier continues to redeploy its resources to respond
quickly to opportunities to provide superior product offerings and customer
service in its core business.
The Company's strategy has been defined and actions have been taken to move
toward the goal of becoming a market-driven business. During the fourth quarter
of 1997, the Company began to divest certain nonstrategic assets, which has
allowed for the
5
<PAGE>
redirection of resources into more strategic assets and operations. These
actions included the sale of a portion of the Company's retail prepaid calling
card business to SmarTalk Teleservices Inc. in December 1997 and the sale of the
Minnesota and Alabama facilities-based cellular businesses in 1998 and 1997 as
well as the sale of certain other nonstrategic assets during 1998. The Company
continues to evaluate the strategic value of other assets and additional sales
are expected from time to time.
Construction of the nationwide Optronics network, which commenced in the
fourth quarter of 1996, is near completion. The Company's service capacity and
network reliability is increasing significantly as the Optronics network is put
into service. The Company made a commitment to extend this network in 1998, and
that extension is expected to be completed in late 1999. The combined technology
of the Optronics network and the DMS-500 switches will enable the Company to
expand its ability to provide integrated local and long distance services
nationwide. In 1998, the Company added ATM and IP capabilities to the Optronics
network, which will provide greater speed and service for data products. In the
fourth quarter of 1997, the Company also introduced a nationwide frame relay
product. This product will complement the Company's voice services business with
a portfolio of additional data services products. This technology will make
Frontier a nationwide facilities based provider of integrated local, long
distance and data services.
Consolidated Results of Operations
Consolidated revenues in 1998 were $2.6 billion, a $218.7 million or 9.2%,
increase from 1997. Revenues in 1997 were $2.4 billion, a $213.7 million or 8.3%
decrease from 1996. The most significant growth in 1998 continues to be
generated by the Integrated Services Segment's Carrier Services business.
Carrier Services' revenues grew $220.7 million or 52.5% over 1997. Carrier
Services' revenue normalized for the effect of a major carrier customer's
one-plus traffic grew $23.0 million or 6.2% over 1996. The growth in Carrier
Services reflects a growing and diverse base of telecommunications customers,
such as Level 3 Communications. The Company's agreement with Level 3
Communications provides them with additional bandwidth for IP-based applications
and is expected to generate $195.0 million in incremental revenue for the
Company over the five year term of the agreement. The decrease in 1997 revenue
is primarily attributed to the migration of the Company's major carrier
customer's one-plus traffic from the Frontier network, a process that was
essentially completed by the end of 1996.
Normalized for other charges, total costs and expenses were $2.3 billion in
1998, $2.1 billion in 1997, and $2.2 billion in 1996. This resulted in an
operating income before other charges increase of 20.2% in 1998, as compared
with a decrease of 38.2% in 1997. Operating margins, before other charges, were
12.5%, 11.4%, and 16.8% during 1998, 1997 and 1996, respectively.
Operating results in 1998 continue to be positively impacted by revenue
growth in several areas including Carrier, Data and CLEC services which
are all included in the Integrated Services segment. The downturn in operating
income and operating margins for 1997 was attributable to the migration of the
Company's largest long distance carrier customer discussed above as well as a
higher level of primarily network expenses in the Integrated Services segment.
6
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Expenses in 1998 were driven primarily by an increase in service costs in
the Local segment as well as a higher cost of access in the Integrated Services
segment due to growth in Carrier Services, a historically lower margin product.
These increases are offset by improvements in selling, general and
administrative expenses as a percent of revenue, in part resulting from the
restructuring plans announced in the fourth quarter of 1997, which entailed
exiting of the Company's prepaid business, the phase down of the Integrated
Services residential consumer base, a refocusing of the Company's core product
offerings, and centralization of marketing efforts.
Diluted earnings per share were $1.01, $0.18, and $1.13 for the years ended
1998, 1997 and 1996, respectively. Excluding the impact of nonrecurring other
charges discussed below, normalized diluted net income applicable to common
stock amounted to $176.8 million, $137.0 million, and $238.9 million in 1998,
1997 and 1996, respectively. Diluted earnings per share, normalized for
nonrecurring adjustments, were $1.02, $0.81, and $1.43 for the three years,
representing an increase of 25.9% for 1998 and a decrease of 43.4% for 1997.
Nonrecurring Adjustments
Consolidated results for the years 1998 through 1996 were impacted by a
number of nonrecurring adjustments. Net income for these years, normalized for
nonrecurring adjustments, is summarized in the following chart and succeeding
narrative.
<TABLE>
<CAPTION>
(In thousands of dollars, except per share data)
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1998 1997 1996
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<S> <C> <C> <C>
Diluted income applicable to common stock $175,143 $ 30,782 $189,365
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Adjustments, Net of taxes:
Other charges 5,797 117,464 42,670
Gain on sale of assets (5,922) (11,243) (3,029)
Adoption of new accounting standards 1,755 --- 8,018
Work stoppage preparation costs --- --- 1,861
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Total adjustments $ 1,630 $106,221 $ 49,520
- ----------------------------------------------------------------------------------------------------------
Normalized income applicable
to common stock $176,773 $137,003 $238,885
==========================================================================================================
Diluted earnings per share $ 1.01 $ 0.18 $ 1.13
Total adjustments 0.01 0.63 0.30
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Normalized diluted earnings per share $ 1.02 $ 0.81 $ 1.43
==========================================================================================================
</TABLE>
1. Other Charges
During 1998, the Company recorded an after-tax charge of $5.8 million (net
of taxes of $0.7 million) associated with the acquisition of GlobalCenter. These
charges included investment banker, legal fees and other direct costs and were
subsequently liquidated in the second quarter of 1998.
7
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In March 1997, the Company recorded a $62.8 million charge, net of a tax
benefit of $33.8 million, primarily related to the write-off of certain network
costs no longer required for the Company's long distance traffic volumes. As a
result of the decline in long distance traffic, an evaluation of the existing
network was performed and facilities deemed no longer necessary to support the
Company's revenue and traffic levels were identified.
In the fourth quarter of 1997, Frontier recorded a $54.7 million charge,
net of a tax benefit of $32.1 million. This charge was primarily associated with
a restructuring and refocusing of the business which included a workforce
reduction, program cancellations, the exiting of certain product lines and
miscellaneous asset and lease impairments.
Operating results for 1996 included a $42.7 million charge, net of a tax
benefit of $25.0 million, resulting from the curtailment of certain Company
pension plans, a one-time charge associated with the Company's conference
calling product line and the write-off of in-process product development costs.
The pension curtailment comprises $17.3 million of the total post-tax charge and
is a result of the Company's efforts to standardize pension benefits. The
one-time charge associated with the Company's conference calling product line
($13.1 million, post-tax) primarily reflected an adjustment to write-off
nonrecoverable product development costs relating to proprietary software. The
write-off of in-process product development costs ($12.3 million, post-tax)
related to the 1996 GlobalCenter merger with GCIS, an Internet management
services company.
2. Gain on Sale of Assets
During November 1998, the Company sold certain non-strategic investments.
The sales resulted in an after tax gain of $3.0 million.
In April 1998, the Company completed the sale of Minnesota RSA No. 10, a
wholly owned cellular partnership, and certain other properties. The sale of
these properties resulted in a combined after-tax gain of $2.9 million, or $.02
per share. The income taxes in these transactions of $12.3 million are primarily
driven by a low tax basis in the Minnesota RSA No. 10 investment which was
acquired in a tax free stock transaction and resulted in nondeductible goodwill.
Gain on sale of assets in 1997 reflects the sale of the Company's 69.5% equity
interest in the South Alabama Cellular Communications Partnership which resulted
in a post-tax gain of $11.2 million ($18.8 million pre-tax).
In 1996, Frontier sold its minority investment in a Canadian long distance
company ($5.0 million pre-tax gain, $3.0 million post-tax).
3. Adoption of New Accounting Standards
The Company adopted Statement of Position 98-5, "Reporting on the Costs of
Start-Up Activities." ("SOP 98-5") during 1998. The cumulative effect of
adopting SOP 98-5 was an after-tax charge of $1.8 million, net of applicable
income taxes of $0.8 million or
8
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$.01 per share. The charge is primarily attributed to unamortized start-up costs
related to product development costs associated with new business ventures.
Additionally in 1996, the Company recorded an $8.0 million charge, net of a
tax benefit of $4.3 million, for the adoption of Financial Accounting Standards
Board ("FAS") 121, "Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to be Disposed Of." The assets held for disposal consisted
principally of telephone switching equipment in the Local Communications segment
as a result of a central office switch consolidation project in Frontier's New
York markets.
4. Work Stoppage Preparation Costs
During the first quarter of 1996, operating costs increased $1.9 million,
net of applicable income taxes of $0.9 million, at the Company's largest
telephone subsidiary due to high labor and related expenses in connection with a
union contract negotiation that was substantively settled during 1997.
Results of Segment Operations
Integrated Services
Revenues were $1.9 billion, $1.7 billion, and $1.9 billion in 1998, 1997
and 1996, respectively, representing an 11.8% increase in 1998 and a 12.3%
decrease in 1997. The increase in revenue from 1997 to 1998 is attributed to a
growing base of carrier customers, CLEC services and data revenue. Revenue
increases are being offset from exiting the prepaid business and the de-emphasis
of selected consumer programs. The decrease in revenue from 1996 to 1997 is
attributable primarily to the migration of the one-plus long distance traffic of
the Company's major carrier customer from the Frontier network as discussed
below. Normalized for the effect of this major carrier customer's one-plus
traffic, Integrated Services' revenue grew approximately 5% in 1997.
Carrier Services' revenue grew 52.5% in 1998 and 6.2% in 1997, normalized
for the effect of the major carrier customer's one-plus traffic in 1997. These
increases are driven by both an increase in the customer base as well as higher
levels of switched and dedicated traffic. As the optronics network is completed,
the Company anticipates further fiber capacity sales, swaps and exchanges such
as the Level 3 Communications contract which includes a minimum commitment of
$195.0 million over a five year contract term.
In 1996, the Company renegotiated its contract with its then largest
carrier customer as the customer was planning to install its own long distance
switching capacity and diversify its traffic distribution to one or more
additional carriers. Revenue from this carrier comprised approximately 4% of
Frontier's Integrated Services revenue in 1998 as contrasted with 6% and 21% in
1997 and 1996, respectively. The loss of this customer's one-plus traffic
contributed to lower operating income in 1997 due to lower overall traffic
levels resulting in a higher level of fixed network costs than required by the
remaining volume of business carried by the Company.
9
<PAGE>
CLEC revenue growth was 107.2% for the year ended 1998. Frontier provides
local service as a CLEC on both a resale and facility basis with a focus on
providing integrated local, long distance and data services. At year end 1998,
the Company was providing local services as a CLEC together with a complete
range of long distance products in 32 states, plus Washington, D. C. Most of
that coverage was provided via resale of services of incumbent local exchange
carriers. Within that footprint, CLEC service also was provided initially from
Frontier's own switches in New York, Boston and Minneapolis. Since then,
Frontier expanded its coverage to approximately two-thirds of the United States
and turned up facilities-based service in a total of thirteen metropolitan areas
at the end of 1998. The Company anticipates providing facilities-based service
in a total of thirty-eight metropolitan areas by the end of 1999.
Facilities-based service is being offered in cities that are on the Company's
Optronics network, which will provide Frontier with the opportunity to expand
its offerings of combined local and long distance services into additional
markets, control access costs, and leverage the Optronics network. As of the end
of 1998, Frontier is serving in excess of 208,000 CLEC ANIs, or access lines as
compared to 100,000 CLEC ANIs at the end of 1997. Frontier's objective is to
have the capability to offer local services in 33 states, plus Washington D.C.,
covering 74% of the United States by the end of 1999.
Data Services' revenue was $97.6 million, $22.4 million and $12.9 million
in 1998, 1997 and 1996, respectively, which led to increases of 335.7% in 1998
and 73.6% in 1997. The continued integration and growth of GlobalCenter largely
led to the year over year increase. In general, growth in Data Services' revenue
was driven by dedicated Internet, national frame relay and web hosting.
GlobalCenter's major digital distribution service customers include Yahoo!,
Motley Fool, and USA Today among others.
Cost of access as a percentage of revenues was 64.0% in 1998, 64.1% in
1997, and 63.7% in 1996. The 1998 percentage has remained constant as compared
to 1997 due to increased Carrier Services' traffic, which has lower margins,
offset by network migration, favorable 1998 access rate reductions and a shift
in the international traffic mix. Construction delays of the Optronics network
impacted the level of savings expected during 1998. The higher cost of access
percentages reported for 1997 compared to 1996 was driven by the growth and mix
of international traffic and a higher proportion of fixed network costs than
would have been required for the volume of minutes actually carried by the
Company's network during these periods. Cost of access in 1997 was also impacted
by increased costs related to the public payphone compensation order. In
September 1996, an FCC ruling established a "per call compensation plan" that
provides payphone service providers with compensation for calls completed using
their payphones. The FCC substantially increased these charges in October 1997.
In 1997, the Company began assessing a surcharge to its payphone users in order
to recover the amount of compensation and related costs ordered by the FCC.
Construction of the Company's Optronics network as originally announced in
1996, was on schedule through the first half of 1998. However, delays in the
completion of a small number of segments have moved the expected completion date
of the network into the first half of 1999. Cost benefits are expected to be
realized as the SONET rings are closed, traffic is migrated, and redundant
leased costs are eliminated. The Company has further enhanced its Optronics
network by expanding its
10
<PAGE>
geographic coverage. Through swap agreements with Enron Communications and WTCI,
Frontier will add approximately 4,000 additional route miles in the western half
of the United States. These agreements will also provide the Company with
additional redundant SONET rings, further enhancing the reliability and
performance of the network. In addition, in July 1998, Frontier entered into an
agreement with Williams Communications to construct an extension of Frontier's
Optronics network into the southeast United States. In aggregate, the Company's
Optronics network will have 20,000 route miles. As of December 31, 1998,
approximately 74% of the original 13,000 route mile Optronics network is
carrying traffic. Construction of the Optronics network and the continuing
network integration efforts are expected to reduce future network costs as well
as provide new revenue opportunities for the Company.
Selling, general and administrative costs ("SG&A"), as a percentage of
revenues, was 25.3% in 1998, 27.9% in 1997 and 19.8% in 1996. The 1998 decrease,
as a percentage of revenues, is largely due to increased Carrier Services'
revenue which carries lower SG&A costs as well as cost controls and a change in
the revenue mix away from consumer businesses. The 1997 increase as a percentage
of revenues is principally due to the decrease in revenues without corresponding
proportional cost decreases. During the last half of 1996 and continuing through
1998, the Company intensified its investment in the sales and marketing areas
with the intent of providing the Company with the resources necessary to expand
into new markets, attract and retain new customers and provide superior customer
service.
Depreciation and amortization increased by $11.3 million and $14.5 million
in 1998 and 1997, respectively due primarily to the impact of the Optronics
network.
Operating income for Integrated Services, excluding nonrecurring charges,
increased 153.0% in 1998 and decreased 84.6% in 1997. Operating margin was 4.8%
in 1998, 2.1% in 1997, and 12.1% in 1996. The Company anticipates improved
operating margins during 1999 as higher revenue levels are achieved, higher cost
routes are removed from the network, the Optronics network is completed and
additional operating efficiencies are introduced. The growth in revenue is
expected to be driven by expanded sales in the Company's targeted markets, and
the introduction of new products and services, and the maintenance of superior
customer service. The Company's calling card services agreement with U S WEST
began contributing to operating results in the second quarter of 1997 and has
continued to grow throughout 1998. The agreement provides U S WEST the ability
to offer calling card services to its customers and is expected to generate in
excess of $50 million in incremental revenue for the Company over the 30 month
term of the agreement.
Local Communications Services
In addition to consistent profitability and strong cash flows, the local
communications companies have been successful in marketing and selling
integrated services to their customers. Local Communications' revenues were
$701.9 million in 1998, $667.1 million in 1997, and $643.0 million in 1996,
representing increases of 5.2% and 3.7%, respectively over the prior years.
Revenue growth in each year was driven by the
11
<PAGE>
introduction of new products and features such as voice mail, caller ID and call
waiting, and a higher demand for services such as second lines. Revenue growth
in 1998 and 1997 was also influenced by an increased demand for Internet
services and dedicated traffic growth. The growth in revenue is partially offset
by the elimination of the surcharge on wholesale, flat rate local measured
service, as ordered by the New York State Public Service Commission ("NYSPSC")
in 1996, an increase in the discount to wholesale providers in the Rochester, NY
market from 5% to 17%, also ordered by the NYSPSC, and a $1.5 million annual
rate reduction as stipulated by the Open Market Plan for the Company's
subsidiary, Frontier Telephone of Rochester, Inc. ("FTR"). Total access lines
increased 3.5% and 2.3% and minutes of use increased 3.4% and 5.3% in 1998 and
1997, respectively.
Costs and expenses for the local communications segment, excluding
nonrecurring charges, were $334.6 million in 1998, up slightly over 1997, but
down as a percent of revenue. The increase in costs and expenses in 1998 is
attributable to service quality improvement efforts during the year in response
to continued scrutiny by the NYSPSC and the assessment of a two million dollar
service penalty at FTR. Service penalty assessments in 1999 could range up to $7
million if certain service metrics are not obtained. FTR met or exceeded these
service requirements in the fourth quarter of 1998. Costs are also up due to
increased depreciation expense, higher operating costs for repair and
maintenance and an increase in customer service costs due to access line growth.
A portion of the repair and maintenance increase was caused by severe flooding
and ice storms during the first half of 1998 as well as a severe windstorm
during the third quarter at certain local properties. Costs and expenses for
1997 compared to 1996 were relatively consistent. During 1996, the Rochester
telephone operation experienced increased costs and expenses related to
incremental labor expenses resulting from work stoppage preparation costs. These
expenses, which were incurred in connection with contract negotiations with the
Communications Workers of America ("CWA" or "Union"), were necessary to ensure
continued high standards of customer service levels in the event of a work
stoppage or slowdown. The contract negotiations resulted in an agreement which
expired at the end of 1998. A new three year agreement became effective on
January 3, 1999. The result of these agreements provide several operational
improvements and a more consistent alignment of benefits. Operating margins,
excluding nonrecurring items, were 36.2% in 1998, 36.3% in 1997, 33.5% in 1996.
This positive result is reflective of the continuing effort in maintaining
operating efficiencies and consistent revenue growth.
The Rochester, New York local communications subsidiary completed its
fourth year of operations under the Open Market Plan in December 1998. The Open
Market Plan promotes telecommunications competition in the Rochester, New York
marketplace by providing for (1) interconnection of competing local networks
including reciprocal compensation for terminating traffic, (2) equal access to
network databases, (3) access to local telephone numbers, (4) service provider
telephone number portability, and (5) certain wholesale discounts to resellers
of local services. The Open Market Plan has undergone some modifications in
light of the Telecommunications Act and other regulatory action of the NYSPSC.
The Company believes that it has successfully maintained its competitiveness in
the Rochester marketplace, as the Company's subsidiary still provides
approximately 98% of the services in the wholesale market and approximately 96%
of retail local services in the market.
12
<PAGE>
Corporate Operations and Other
This segment includes the operations of FNSC and expenses traditionally
associated with a holding company, including executive and board of directors'
expenses, corporate finance and treasury, investor relations, corporate
planning, legal services and business development. Formerly, the wireless
operations from Minnesota RSA No. 10 and the Company's 69.5% interest in Alabama
RSAs No. 4 and No. 6 were included in this segment. The sale of the Company's
interest in Alabama RSAs No. 4 and No. 6 was finalized January 31, 1997 and on
April 30, 1998, the Company sold Minnesota RSA No. 10. The sale of wireless
properties is a result of the Company's strategic decision to divest non-core
assets. Wireless products, as a part of Frontier's integrated services, are
offered to Frontier customers nationwide on a resale basis.
In February 1997, the Company completed its purchase of R.G. Data
Incorporated (renamed FNSC). FNSC was a privately held upstate New York based
computer and data networking equipment and services company. A total of 110,526
shares of Frontier common stock held in treasury were reissued in exchange for
all of the shares of FNSC. The treasury shares were acquired through open market
purchases. FNSC's operations are consolidated with FNS for reporting purposes.
Other Income Statement Items
Interest Expense
Interest expense was $55.3 million in 1998, an increase of $7.1 million or
14.7% over 1997. Interest expense was $48.2 million in 1997, an increase of $4.9
million or 11.4% over 1996. The overall increase in interest expense in both
periods is the result of higher levels of debt outstanding primarily
attributable to the Company's capital program. The amount of interest expense
capitalized increased $18.2 million and $7.2 million in 1998 and 1997,
respectively, also as a result of increased capital spending.
Equity Earnings from Unconsolidated Wireless Interests
The Company's minority interests in wireless operations and its 50%
interest in the Frontier Cellular joint venture with Bell Atlantic are accounted
for using the equity method. This method of accounting results in the Company's
proportionate share of earnings being reflected in a single line item below
operating income.
Equity earnings from the Company's interests in wireless partnerships were
$16.7 million in 1998, $12.0 million in 1997, and $9.0 million in 1996. The
increase in equity earnings during 1998 and 1997 is attributable to increased
customers, primarily at Frontier Cellular, and usage, as well as improved
operating efficiencies as compared to 1996.
Income Taxes
The effective tax rate was 42.2% in 1998 versus 58.1% in 1997 and 41.8% in
1996. The increase in the effective tax rate for 1997 is attributable to the
nonrecurring charges
13
<PAGE>
recorded by the Company, combined with the effect of recording additional
valuation allowance for net operating loss deferred tax assets at GlobalCenter
prior to the pooling of interests transaction. Use of the preacquisition net
operating losses are limited by tax laws and the realization of these losses is
uncertain at this time.
Financial Condition
Review of Cash Flow Activity
Cash provided from operations in 1998 amounted to $434.2 million as
compared to $255.8 million in 1997 and $397.2 million in 1996. The increase in
cash flow from operations is largely attributable to the increased operating
income in the Integrated Services' segment during 1998. The accounts receivable
allowance increase in 1998 is primarily due to revenue volume increases and a
higher mix of carrier customers with larger account balances.
Earnings before interest, taxes, depreciation and amortization ("EBITDA")
is a common measurement of a company's ability to generate operating cash flow.
EBITDA should be used as a supplement to, not in place of, cash from operating
activities. The Company's EBITDA was $549.7 million, $482.1 million, and $626.9
million before other charges in 1998, 1997 and 1996, respectively.
Cash used for investing activities was $597.6 million, $292.6 million, and
$333.3 million in 1998, 1997 and 1996, respectively. Capital expenditures
continue to be the largest recurring use of the Company's investing funds.
Capital spending amounted to $646.9 million, $365.1 million, and $311.9 million
in 1998, 1997 and 1996, respectively. The Company's total capital investment for
1998 was $696.4 million, including the $136.9 million accrued for the Company's
new optronics network and other capital programs. The $136.9 million obligation
at December 31, 1998 is a non-cash transaction that is treated as debt in the
Company's capital structure as the Company intends to finance this obligation
through available credit facilities and unused commitments extending beyond one
year. The increase in the 1998 capital program was due to long distance switch
enhancements, additional investments intended to improve service at FTR,
continued product enhancements and construction costs for the optronics network.
Cash utilized in 1998 for investing activities was partially funded by the
proceeds received from the sale of Minnesota RSA No. 10 and the sale of other
certain nonstrategic investments.
Cash flows from financing activities amounted to inflows of $222.3 million
and $25.7 million in 1998 and 1997, respectively, compared with an outflow of
$58.0 million in 1996. The net inflow of cash is the result of increased
borrowings during 1998 and 1997 driven by the Company's capital program. The
Company's largest recurring financing activities are the payment of common and
preferred dividends which totaled $151.8 million, $143.6 million, and $138.7
million in 1998, 1997 and 1996, respectively.
Liquidity and Capital Resources
The Company has a number of financing vehicles in place to ensure adequate
liquidity in meeting its anticipated cash needs. Frontier has a commercial paper
program of $350 million which is fully backed by committed revolving credit
agreements. In
14
<PAGE>
November 1998, the Company established combined revolving credit agreements of
$475 million which will serve as backup to the Company's commercial paper
program. These facilities replaced the Company's existing $350 million credit
facility which was due to expire in August 2000. At December 31, 1998, total
borrowings and amounts available under these lines of credit were $197.7 million
and $277.3 million, respectively. In September 1998, the Company completed a
$200.0 million public offering of 6.00% Dealer remarketable securities
("Drs.SM") which mature in 2013. In December 1997, the Company entered into an
interest rate hedge agreement that effectively converts $200.0 million of the
Company's fixed-rate debt into a floating rate, based on an index rate plus
2.88%. The agreement expires in May 2004 and caps the floating rate the Company
pays at 7.25% through November 1999 and 9.00% through May 2004. In May 1997, the
Company completed a $300.0 million public offering of 7.25% Notes which mature
in 2004. In December 1997, the Company issued $100.0 million, 6.25% Pass-Through
Asset Trust Securities ("PATS") due in 1999. The PATS securities were sold
pursuant to Rule 144A under the Securities Act, and not under the shelf
registration. Proceeds from these offerings were used to finance a portion of
the nationwide optronics network and to pay down commercial paper borrowings.
At December 31, 1998, aggregate debt maturities amounted to $9.5 million
for 1999, $16.9 million for 2000 and $273.4 million for 2001. The debt to total
capital ratio at December 31, 1998 increased to 57.2%, as compared to 49.2% in
the prior year and 39.1% in 1996. Pre-tax interest coverage, which measures the
Company's ability to cover its financing costs, was 4.7 times in 1998 and 1997
versus 8.7 times in 1996 (excluding nonrecurring charges for all years).
In May 1997, Duff and Phelps revised its rating on the Company's long-term
debt from "A" to "A-", reflecting concern about the recent performance of the
Company's Integrated Services operations, increased capital spending levels and
rising uncertainty in the Integrated Services business. Standard & Poor's
affirmed its "A" rating of the Company, although it revised its rating "outlook"
from stable to negative. Rating outlooks serve as an assessment of long-term
trends or risks, normally for periods covering one to three years, that have
less certain credit implications, and are not necessarily a precursor to future
rating changes. Moody's and Fitch affirmed their ratings of "A3" and "A",
respectively. The Company does not anticipate that the revised rating or rating
"outlook" will have a material impact on the future cost of borrowing.
Total gross expenditures for property, plant and equipment in 1999 are
anticipated to be consistent with 1998. The Company anticipates financing its
capital program through a combination of internally generated cash from
operations and external borrowings.
Under the Company's Open Market Plan, dividend payments to the parent
company are temporarily prohibited until FTR receives clearance from the NYSPSC
that service requirements are being met. Cash restricted for dividend payments
by FTR as of December 31, 1998 was approximately $53.0 million.
15
<PAGE>
In December 1998, the Company's Board of Directors declared a quarterly
dividend on common stock of $0.2225 per share, payable February 1, 1999, to
shareholders of record on January 15, 1999.
Year 2000 Issues
The Company's Year 2000 ("Year 2K") project is intended to address
potential processing errors in computer programs that use two digits (rather
than four) to define the applicable year. The Company's assessment of Year 2K
issues is essentially complete. Disclosure is warranted because the issues, if
unresolved by the Company and by the many unaffiliated carriers and other firms
with whom the Company interconnects its networks or does business, could have
impacts that are material. The Company addresses Year 2K issues in four areas:
State of Readiness. Frontier has developed plans to assess and remediate
------------------
key internally-developed computer systems so they will be Year 2K compliant in
advance of December 31, 1999 and has implemented those plans to a significant
degree. The plans encompass all operating properties as well as Frontier's
corporate headquarters. These include both information technology ("IT") and
non-IT compliance. The plans cover the review, and either modification, or
replacement, where necessary, of portions of the Company's computer
applications, telecommunications networks, telecommunications equipment and
building facility equipment that directly connect the Company's business with
customers, suppliers and service providers. Implementation of the plan began in
1996 and the Company believes that substantially all of its internally-developed
IT systems are now compliant. Final assessments and remediation are expected to
be substantially complete by midyear 1999, leaving the remainder of 1999 for
additional system testing, carrier interoperability testing and other
remediation. These plans involve capital expenditures for new software and
hardware, as well as costs to modify existing software. Initially, work with IT
systems was given priority over work with non-IT systems, but the Company is
comprehensively reviewing its non-IT Year 2K readiness as well, including
communications with third parties who supply or maintain non-IT systems or
significant non-IT subsystems.
Costs. To date, the Company has committed approximately $7.5 million to
-----
Year 2K issues, and anticipates that it will spend an additional $3.0 to $4.6
million during 1999. This includes costs directly related to Year 2K assessment
and remediation and the replacement of non-compliant systems, including
acceleration of replacement of non-compliant systems due to Year 2K issues. A
substantial portion of the total amount has been used for third party assistance
in assessment and remediation. The source of these funds is cash generated from
operations. The Year 2K projects have not caused the Company to forego or defer,
to any material degree, other critical IT projects. To date, the costs of
addressing potential Year 2K problems are not considered material to the
Company's financial condition, results of operations or cash flows and have been
consistent with planned expenditures, and future costs are not expected to be
material in such respects.
16
<PAGE>
Risks. The Company is engaged primarily in telecommunications lines of
-----
business, and therefore connects directly and indirectly with thousands of other
carriers, inside and outside the United States. These connections are made
through switching offices of the Company and the other carriers. The switching
offices were manufactured by and often maintained by third parties. While many
other carriers have announced plans to engage independently in Year 2K
assessment and remediation for their networks, there is a risk that some
carriers (particularly smaller carriers and carriers outside the United States)
will not address or resolve Year 2K issues, and that telecommunications will
therefore be affected. If this were to occur, it is likely that the Company
would be affected only to the same degree as the other carriers in the
telecommunications industry. A Year 2K failure in the network of smaller
carriers would not be likely to have a significant impact on telecommunications
generally, or on the Company. However, addressing these risks is outside the
Company's control. In addition, the Company is unable at this time to assess the
degree to which the manufacturers of switches and similar equipment have
completed their assessment and remediation of such equipment and its associated
software with respect to any other carriers. The majority of the Company's
switches are manufactured and supported by entities with a broad base of
similarly situated customers, and who have a vested interest in assuring that
their products will not be affected by Year 2K events, and if affected, will be
remedied promptly. The Company has initiated an inquiry with its primary vendors
and continues to engage in discussions related to Year 2K compliance with many
of them. Another risk to the Company arises with respect to the timely
completion of Year 2K remediation for the processing that occurs in the
Company's IT and non-IT systems. If the Company or its vendors are unable to
resolve such processing issues in a timely manner, it could pose independent
risks to the Company's business that could be material. Accordingly, the Company
has devoted resources it believes to be adequate to resolve all significant
identified Year 2K issues in a timely manner, and has undertaken plans to make
information available to customers and others related to its Year 2K activities.
Consistent with the practice of other carriers, the Company generally has
declined to provide Year 2K compliance warranties or other Year 2K-related
contractual promises to customers or other persons. In addition, the Company is
engaged in communications with third party equipment and software vendors and
suppliers of services to verify their Year 2K readiness, and plans to engage in
internetwork testing with other carriers during 1999. Since the Company's own
optronics network, including the recently announced southeast expansion, is
expected to be substantially deployed before December 31, 1999, the Company
anticipates that the impact of other carriers who may experience business
interruptions would be lessened, and such interruptions are not currently
expected to have material adverse impacts on the Company.
Contingency Plans. The Company consistently monitors the progress of its
-----------------
Year 2K program. The Company currently anticipates that it will resolve its Year
2K issues before the end of 1999, with the exception of any issues that involve
other carriers or suppliers and are outside of its control. During 1999, the
Company will also monitor efforts undertaken through regulatory agencies and
industry groups to assure that Year 2K preparations are completed in a timely
manner. The Company has begun to evaluate whether there are areas for which
contingency plans are appropriate (but has not identified any such areas to
date). Any need for contingency planning will be identified over the next two
quarters. Contingency plans (if necessary) will be developed for
17
<PAGE>
critical systems if conversion or replacement projects fall behind schedule, or
if internetwork testing should identify significant risk issues, or if broader
industry concerns emerge that management concludes require such action.
New Accounting Pronouncements
The Financial Accounting Standards Board ("FASB") issued FAS 130,
"Reporting Comprehensive Income," effective for fiscal years beginning after
December 15, 1997. This statement establishes standards for reporting and
displaying of comprehensive income and its components in a full-set of
general-purpose financial statements. Comprehensive income is defined as "the
change in equity of a company during a period from transactions and other events
and circumstances from nonowner sources." This statement requires reporting by
major components and as a single total, the change in net assets during the
period from non-shareholder sources. The Company adopted FAS 130 in the first
quarter of 1998. Adoption of this standard does not have a material impact on
Frontier.
The Company has adopted the provisions of FAS 131, " Disclosures about
Segments of an Enterprise and Related Information," effective December 31, 1998.
This statement establishes annual and interim reporting standards for an
enterprise's business segments and related disclosures about its products,
services, geographic areas and major customers. Adoption of this statement did
not impact the Company's consolidated financial position, results of operations
or cash flows.
In April 1998, the American Institute of Certified Public Accountants
issued SOP 98-5 which requires that start-up costs be expensed as incurred. The
Company adopted the provisions of SOP 98-5 in 1998. Accordingly, $1.8 million,
net of applicable income taxes of $.8 million of unamortized start-up costs at
December 31, 1997, have been expensed in the accompanying Consolidated
Statements of Income and is reported as cumulative effect of a change in
accounting principle. These start-up costs are primarily related to product
development costs associated with new business ventures.
The Company adopted FAS 128, "Earnings Per Share," effective December 31,
1997. This statement simplifies the standards for computing earnings per share
previously found in Accounting Principles Board Opinion No. 15, "Earnings Per
Share", and makes them comparable to international earnings per share ("EPS")
standards. FAS 128 requires dual presentation of basic and diluted EPS on the
face of the income statement and requires a reconciliation of the numerator and
denominator of the basic EPS computation to the numerator and denominator of the
diluted EPS calculation. Basic EPS excludes the effect of common stock
equivalents and is computed by dividing income available to common shareholders
by the weighted average of common shares outstanding for the period. Diluted EPS
reflects the potential dilution that could result if securities or other
contracts to issue common stock were exercised or converted into common stock.
The impact on EPS resulting from the adoption of FAS 128 was not material.
18
<PAGE>
The FASB issued FAS 133, "Accounting for Derivative Instruments and Hedging
Activities" effective for fiscal years beginning after June 15, 1999. This
statement standardizes the accounting for derivatives and hedging activities and
requires that all derivatives be recognized in the statement of financial
position as either assets or liabilities at fair value. Changes in the fair
value of derivatives that do not meet the hedge accounting criteria are to be
reported in earnings. Adoption of this standard is not expected to have a
material effect on the Company's financial position, results of operations or
cash flows.
19
<PAGE>
Report of Independent Accountants
To the Board of Directors and
Shareholders of Frontier Corporation
In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of income, shareholders' equity and cash flows present
fairly, in all material respects, the financial position of Frontier Corporation
and its subsidiaries at December 31, 1998, 1997, and 1996, and the results of
their operations and their cash flows for the years then ended in conformity
with generally accepted accounting principles. These financial statements are
the responsibility of the Company's management; our responsibility is to express
an opinion on these financial statements based on our audits. We conducted our
audits of these statements in accordance with generally accepted auditing
standards which require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements, assessing the
accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for the opinion expressed above.
As discussed in Note 12 to the financial statements, during 1998 the Company
adopted the provisions of Statement of Position 98-5, "Reporting on the Costs of
Start-Up Activities."
As discussed in Note 12 to the financial statements, during 1996 the Company
adopted the provisions of Statement of Financial Accounting Standards No. 121,
"Accounting for the Impairment of Long-Lived Assets and Long-Lived Assets to be
Disposed Of."
PricewaterhouseCoopers LLP
January 25, 1999
Rochester, New York
<PAGE>
Report of Management
The integrity and objectivity of the accompanying financial information is
the responsibility of the management of Frontier Corporation.
The financial statements report on management's accountability for
corporate operations and assets. To this end management maintains a highly
developed system of internal controls and procedures designed to provide
reasonable assurance that the Company's assets are protected and that all
transactions are accounted for in conformity with generally accepted accounting
principles. The system includes documented policies and guidelines, augmented by
a comprehensive program of internal and independent audits conducted to monitor
overall accuracy of financial information and compliance with established
procedures.
PricewaterhouseCoopers LLP, an independent accounting firm, provides an
objective assessment of the degree to which management meets its responsibility
for financial reporting. They regularly evaluate the system of internal
accounting controls and perform such tests and other procedures they consider
necessary to express an opinion that the financial statements present fairly the
financial position of the Company.
Rolla P. Huff
Executive Vice President and Chief Financial Officer
Frontier Corporation
January 25, 1999
Report of Audit
Committee
The Audit Committee of the Board of Directors is comprised of three
independent directors who are not officers or employees of the corporation. The
committee oversees the Company's financial reporting process on behalf of the
Board of Directors. The Audit Committee recommends to the Board of Directors the
election of the independent accountants and ratification by the shareholders.
The committee also meets regularly with management, the independent accountants
and internal auditors to review accounting, auditing, internal accounting
controls, pending litigation and financial reporting matters. As a matter of
policy, the internal auditors and independent accountants have unrestricted
access to the Audit Committee.
Jairo A. Estrada
Chairman, Audit Committee
Frontier Corporation
January 25, 1999
<PAGE>
BUSINESS SEGMENT INFORMATION
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------------------------------------------------------
In thousands of dollars Years Ended December 31, 1998 1997 1996
- -----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Integrated Services:
Revenue
Commercial $ 981,977 $ 924,779 $ 938,030
Consumer 239,782 267,689 241,311
Carrier 641,361 420,670 702,590
Exited business-Prepaid - 53,362 19,278
- -----------------------------------------------------------------------------------------------------------------------------------
Total Revenue 1,863,120 1,666,500 1,901,209
Cost of Access 1,191,760 1,067,985 1,210,343
- -----------------------------------------------------------------------------------------------------------------------------------
Gross Margin 671,360 598,515 690,866
Selling, General and Administrative Expense 471,625 464,236 376,600
Depreciation and Amortization 110,097 98,844 84,336
- -----------------------------------------------------------------------------------------------------------------------------------
Operating Income:
Operating Income Before Other Charges 89,638 35,435 229,930
Other Charges (6,528) (175,856) (39,756)
- -----------------------------------------------------------------------------------------------------------------------------------
Total Operating Income (Loss) $ 83,110 $ (140,421) $ 190,174
Capital Expenditures $ 487,403 $ 316,901 $ 189,604
Total Assets $1,740,320 $1,327,651 $1,059,951
- -----------------------------------------------------------------------------------------------------------------------------------
Local Communications Services:
Revenue $ 701,935 $ 667,078 $ 643,013
Costs and Expenses 334,642 314,503 325,025
Depreciation and Amortization 112,925 110,104 102,350
- -----------------------------------------------------------------------------------------------------------------------------------
Operating Income:
Operating Income Before Other Charges 254,368 242,471 215,638
Other Charges - (4,174) (23,100)
- -----------------------------------------------------------------------------------------------------------------------------------
Total Operating Income $ 254,368 $ 238,297 $ 192,538
Capital Expenditures $ 153,901 $ 108,782 $ 101,342
Total Assets $1,033,655 $ 931,438 $ 941,629
- -----------------------------------------------------------------------------------------------------------------------------------
Corporate Operations and Other:
Revenue $ 28,503 $ 41,231 $ 44,297
Costs and Expenses 45,801 46,011 49,612
Depreciation and Amortization 2,784 3,584 4,274
- -----------------------------------------------------------------------------------------------------------------------------------
Operating Loss:
Operating Loss Before Other Charges (20,082) (8,364) (9,589)
Other Charges - (3,354) (4,900)
- -----------------------------------------------------------------------------------------------------------------------------------
Total Operating Loss $ (20,082) $ (11,718) $ (14,489)
Capital Expenditures $ 55,128 $ 27,305 $ 22,554
Total Assets $ 284,768 $ 228,831 $ 227,812
- -----------------------------------------------------------------------------------------------------------------------------------
Consolidated:
Revenue $2,593,558 $2,374,809 $2,588,519
Costs and Expenses 2,043,828 1,892,735 1,961,580
Depreciation and Amortization 225,806 212,532 190,960
- -----------------------------------------------------------------------------------------------------------------------------------
Operating Income:
Operating Income Before Other Charges 323,924 269,542 435,979
Other Charges (6,528) (183,384) (67,756)
- -----------------------------------------------------------------------------------------------------------------------------------
Total Operating Income $ 317,396 $ 86,158 $ 368,223
Capital Expenditures $ 696,432 $ 452,988 $ 313,500
Total Assets $3,058,743 $2,487,920 $2,229,392
- -----------------------------------------------------------------------------------------------------------------------------------
</TABLE>
See accompanying Notes to Consolidated Financial Statements.
22
<PAGE>
CONSOLIDATED STATEMENTS OF INCOME
<TABLE>
<CAPTION>
- -------------------------------------------------------------------------------------------------------------------------------
In thousands of dollars, except per share data Years Ended December 31, 1998 1997 1996
- -------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Revenue
Integrated Services $ 1,863,120 $1,666,500 $ 1,901,209
Local Communications 701,935 667,078 643,013
Corporate Operations and Other 28,503 41,231 44,297
- -------------------------------------------------------------------------------------------------------------------------------
Total Revenue 2,593,558 2,374,809 2,588,519
Costs and Expenses
Operating expenses 1,982,008 1,834,239 1,911,553
Depreciation and amortization 225,806 212,532 190,960
Taxes other than income taxes 61,820 58,496 50,027
Other charges 6,528 183,384 67,756
- -------------------------------------------------------------------------------------------------------------------------------
Total Costs and Expenses 2,276,162 2,288,651 2,220,296
- -------------------------------------------------------------------------------------------------------------------------------
Operating Income 317,396 86,158 368,223
Interest expense 55,318 48,239 43,312
Other income:
Gain on sale of assets 20,378 18,765 4,976
Equity earnings from unconsolidated wireless interests 16,711 12,019 9,011
Interest income 5,084 3,659 2,363
Other income (expense) 2,852 3,627 (500)
- -------------------------------------------------------------------------------------------------------------------------------
Income Before Taxes and Cumulative Effect of
Changes in Accounting Principles 307,103 75,989 340,761
Income tax expense 129,560 44,188 142,556
- -------------------------------------------------------------------------------------------------------------------------------
Income Before Cumulative Effect of Changes in
Accounting Principles 177,543 31,801 198,205
Cumulative effect of changes in accounting principles (1,755) - (8,018)
- -------------------------------------------------------------------------------------------------------------------------------
Consolidated Net Income 175,788 31,801 190,187
Dividends on preferred stock (1,005) (1,019) (1,182)
- -------------------------------------------------------------------------------------------------------------------------------
Basic Income Applicable to Common Stock $ 174,783 $ 30,782 $ 189,005
Diluted earnings adjustment 360 - 360
- -------------------------------------------------------------------------------------------------------------------------------
Diluted Income Applicable to Common Stock $ 175,143 $ 30,782 $ 189,365
- -------------------------------------------------------------------------------------------------------------------------------
Basic Earnings Per Common Share
Income before cumulative effect of changes in
accounting principles $ 1.03 $ .18 $ 1.19
Cumulative effect of changes in accounting principles (.01) - (.05)
- -------------------------------------------------------------------------------------------------------------------------------
Basic Earnings Per Common Share $ 1.02 $ .18 $ 1.14
Average Shares Outstanding 170,626 168,975 165,234
- -------------------------------------------------------------------------------------------------------------------------------
Diluted Earnings Per Common Share
Income before cumulative effect of changes in
accounting principles $ 1.02 $ .18 $ 1.18
Cumulative effect of changes in accounting principles (.01) - (.05)
- -------------------------------------------------------------------------------------------------------------------------------
Diluted Earnings Per Common Share $ 1.01 $ .18 $ 1.13
Average Shares Outstanding 173,941 169,967 167,508
- -------------------------------------------------------------------------------------------------------------------------------
</TABLE>
See accompanying Notes to Consolidated Financial Statements.
23
<PAGE>
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------------------------------------------------------
In thousands of dollars, except share data December 31, 1998 1997 1996
- -----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
ASSETS
Current Assets
Cash and cash equivalents $ 85,143 $ 26,302 $ 37,411
Accounts receivable (less allowance for uncollectibles
of $37,956, $25,100 and $31,519, respectively) 422,724 380,324 365,486
Materials and supplies 9,924 12,312 13,421
Deferred income taxes 13,320 33,948 30,617
Prepayments and other 35,563 37,419 30,826
- -----------------------------------------------------------------------------------------------------------------------------------
Total Current Assets 566,674 490,305 477,761
Property, plant and equipment, net 1,677,559 1,046,884 975,982
Goodwill and customer base, net 484,015 517,754 538,296
Deferred and other assets 330,495 432,977 237,353
- -----------------------------------------------------------------------------------------------------------------------------------
Total Assets $ 3,058,743 $ 2,487,920 $ 2,229,392
- -----------------------------------------------------------------------------------------------------------------------------------
LIABILITIES AND SHAREHOLDERS' EQUITY
Current Liabilities
Accounts payable $ 449,041 $ 343,606 $ 326,938
Dividends payable 38,508 36,798 35,966
Debt due within one year 9,466 6,443 7,929
Taxes accrued 26,128 16,023 34,968
Other liabilities 44,554 90,108 18,596
- -----------------------------------------------------------------------------------------------------------------------------------
Total Current Liabilities 567,697 492,978 424,397
Long-term debt 1,350,821 934,681 677,570
Deferred income taxes 40,046 10,927 2,542
Deferred employee benefits obligation 81,925 74,965 57,573
- -----------------------------------------------------------------------------------------------------------------------------------
Total Liabilities 2,040,489 1,513,551 1,162,082
- -----------------------------------------------------------------------------------------------------------------------------------
Shareholders' Equity
Preferred stock 18,770 20,126 22,611
Common stock, par value $1.00, authorized 300,000,000 shares;
171,635,518 shares, 170,503,300 shares, and 168,649,955
shares issued in 1998, 1997, and 1996 171,636 170,503 168,649
Capital in excess of par value 578,946 550,423 523,011
Retained earnings 274,870 253,042 365,651
Accumulated other comprehensive income:
Minimum pension liability adjustment and other (4,249) (2,546) (1,076)
- -----------------------------------------------------------------------------------------------------------------------------------
1,039,973 991,548 1,078,846
Less-
Treasury stock, 10,849 shares in 1998 and 1997
and 6,375 shares in 1996, at cost 231 231 147
Unearned compensation 21,488 16,948 11,389
- -----------------------------------------------------------------------------------------------------------------------------------
Total Shareholders' Equity 1,018,254 974,369 1,067,310
- -----------------------------------------------------------------------------------------------------------------------------------
Total Liabilities and Shareholders' Equity $ 3,058,743 $ 2,487,920 $ 2,229,392
- -----------------------------------------------------------------------------------------------------------------------------------
</TABLE>
See accompanying Notes to Consolidated Financial Statements.
24
<PAGE>
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
- ---------------------------------------------------------------------------------------------------------------------------------
In thousands of dollars Years Ended December 31, 1998 1997 1996
- ---------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Operating Activities
Net income $ 175,788 $ 31,801 $ 190,187
- --------------------------------------------------------------------------------------------------------------------------------
Adjustments to reconcile net income to net cash
provided by operating activities:
Other charges 6,528 183,384 67,756
Cumulative effect of changes in accounting principles 2,564 - 12,396
Depreciation and amortization 225,806 212,532 190,960
Gain on sale of assets (20,378) (18,765) (4,976)
Equity earnings from unconsolidated wireless interests (16,711) (12,019) (9,011)
Other, net 6,768 4,474 92
Changes in operating assets and liabilities, exclusive of impacts of
dispositions and acquisitions:
(Increase) decrease in accounts receivable (43,388) (26,057) 36,137
Decrease (increase) in material and supplies 2,183 (1,315) (1,378)
Decrease (increase) in prepayments and other current assets 1,779 (7,047) (2,295)
Increase in deferred and other assets (32,896) (7,646) (12,970)
Increase (decrease) in accounts payable 85,717 3,482 (77,532)
(Decrease) increase in taxes accrued and other current liabilities (15,589) (120,416) 1,582
Increase (decrease) in deferred employee benefits obligation 5,916 8,323 (1,298)
Increase in deferred income taxes 50,113 5,054 7,545
- ---------------------------------------------------------------------------------------------------------------------------------
Total adjustments 258,412 223,984 207,008
- ---------------------------------------------------------------------------------------------------------------------------------
Net cash provided by operating activities 434,200 255,785 397,195
- ---------------------------------------------------------------------------------------------------------------------------------
Investing Activities
Expenditures for property, plant and equipment (629,815) (286,947) (249,231)
Deposits for capital projects (17,060) (78,109) (62,694)
Proceeds from asset sales 49,216 67,889 13,841
Investment in cellular partnerships 29 4,524 (29,422)
Purchase of companies, net of cash acquired - - (5,791)
- ---------------------------------------------------------------------------------------------------------------------------------
Net cash used in investing activities (597,630) (292,643) (333,297)
- ---------------------------------------------------------------------------------------------------------------------------------
Financing Activities
Proceeds from issuance of long-term debt 380,910 401,450 58,335
Repayments of debt (13,840) (236,386) (15,120)
Dividends paid (151,812) (143,638) (138,697)
Issuance of common stock 8,433 9,289 33,407
Other financing activities (1,420) (4,966) 4,103
- ---------------------------------------------------------------------------------------------------------------------------------
Net cash provided by (used in) financing activities 222,271 25,749 (57,972)
- ---------------------------------------------------------------------------------------------------------------------------------
Net Increase (Decrease) in Cash and Cash Equivalents 58,841 (11,109) 5,926
Cash and Cash Equivalents at Beginning of Year 26,302 37,411 31,485
- ---------------------------------------------------------------------------------------------------------------------------------
Cash and Cash Equivalents at End of Year $ 85,143 $ 26,302 $ 37,411
=================================================================================================================================
</TABLE>
See accompanying Notes to Consolidated Financial Statements.
25
<PAGE>
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
<TABLE>
<CAPTION>
- ------------------------------------------------------------------------------------------------------------------------------------
Accumulated
Capital In Other
Preferred Common Excess of Retained Comprehensive Treasury Unearned
In thousands of dollars Stock Stock Par Earnings Income Stock Compensation Total
- ------------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Balance, January 1, 1996 $22,769 $160,754 $418,848 $317,575 $ (842) $(147) $ (6,511) $912,446
Comprehensive Income:
Net income 190,187 190,187
Minimum pension liability adjustment and
other (net of tax of $261) (234) (234)
-------
Comprehensive Income 189,953
-------
Acquisitions 1,645 19,984 21,629
Redemptions (158) 53 (105)
Exercise of stock options 5,482 27,355 32,837
Exercise of warrants 87 131 218
Restricted stock plan activity, net 100 4,089 (4,878) (689)
Tax benefit from exercise of stock options 48,531 48,531
Common and preferred dividends (141,416) (141,416)
Equity offering of pooled subsidiary 574 3,675 4,249
Other 7 345 (695) (343)
- ------------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1996 $22,611 $168,649 $523,011 $365,651 $(1,076) $(147) $(11,389) $1,067,310
Comprehensive Income:
Net income 31,801 31,801
Minimum pension liability adjustment
and other (net of tax of $868) (1,470) (1,470)
------
Comprehensive Income 30,331
------
Acquisitions 616 8,146 2,384 11,146
Redemptions (2,485) (13) (2,498)
Exercise of stock options 162 752 914
Exercise of warrants 44 65 109
Restricted stock plan activity, net 190 3,933 (2,556) 1,567
Incentive stock plan, net 4,964 (3,003) 1,961
Tax benefit from exercise
of stock options 982 982
Common and preferred dividends (144,470) (144,470)
Purchases for acquisition (2,468) (2,468)
Equity offering of pooled subsidiary 813 8,215 9,028
Other 29 368 60 457
- ------------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1997 $20,126 $170,503 $550,423 $253,042 $(2,546) $(231) $(16,948) $974,369
Comprehensive Income:
Net income 175,788 175,788
Minimum pension liability
adjustment and
other (net of tax of $365) (1,703) (1,703)
-------
Comprehensive Income 174,085
-------
Redemptions (1,356) (102) (1,458)
Exercise of stock options 548 7,885 8,433
Restricted stock plan activity, net 344 15,847 (5,380) 10,811
Incentive stock plan, net 840 840
Tax benefit from exercise
of stock options 4,505 4,505
Common and preferred dividends (153,522) (153,522)
Other 241 388 (438) 191
- ------------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1998 $18,770 $171,636 $578,946 $274,870 $(4,249) $(231) $(21,488) $1,018,254
- ------------------------------------------------------------------------------------------------------------------------------------
</TABLE>
See accompanying Notes to Consolidated Financial Statements.
26
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
1. Summary of Significant Accounting Policies
Description of Business and Organization-Frontier Corporation
("Frontier" or "the Company"), headquartered in Rochester, New York,
is a leading provider of integrated telecommunications services,
including Internet IP and data applications, long distance, local
telephone and wireless, to more than two million business, carrier and
targeted residential customers nationwide, in Canada and the United
Kingdom. It is one of the largest long distance carriers and local
exchange service providers in the United States. The Company provides
domestic and international voice, data products and video and audio
communications, digital distribution services, Internet service and
other communications products to primarily small to mid-sized business
customers and targeted consumer markets.
Consolidation-The consolidated financial information includes the
accounts of Frontier and its majority-owned subsidiaries after
elimination of all significant intercompany transactions. Investments
in entities in which the Company does not have a controlling interest
are accounted for using the equity method.
Preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the
date of the financial statements, and the reported amounts of revenues
and expenses during the reporting period. Actual results could differ
from those estimates.
Materials and Supplies-Materials and supplies are stated at the
lower of cost or market, based on weighted average unit cost.
Property, Plant and Equipment-The investment in property, plant
and equipment is recorded at cost. Improvements that significantly add
to productive capacity or extend useful life are capitalized.
Maintenance and repairs are expensed as incurred. The Company's
provision for depreciation of property, plant and equipment is based
on the straight-line method using estimated service lives of the
various classes of plant. The range of service lives for buildings is
10 to 40 years. The range of service lives for local and fiber service
lines is 12 to 25 years, central office equipment and switching
facilities is 3 to 20 years, station equipment is 10 to 21 years and
for office equipment and other is 2 to 20 years.
The cost of depreciable telephone property units (assets of the
Local Communications segment) retired, plus removal costs, less
salvage is charged to accumulated depreciation. When non-telephone
property, plant and equipment is retired or sold, the resulting gain
or loss is recognized currently as an element of other income.
Goodwill and Customer Base-The excess of the cost of companies
purchased over the net assets acquired is amortized using a
straight-line basis over 7 to 40 years. The purchase price of customer
bases acquired is amortized using a straight-line basis over
principally 5 to 7 years. Accumulated amortization is $142.8 million,
$131.6 million, and $106.5 million at the end of 1998, 1997 and 1996,
respectively.
Investment in Cellular Partnerships-Financial results for the
Company's cellular joint venture with Bell Atlantic Corporation have
been reported using the equity method of accounting. Accordingly,
Frontier's 50% share of the joint venture's earnings is reflected in
the "Other income" section of the Consolidated Statements of Income.
The partnership investment balances of $83.5 million in 1998, $69.3
million in 1997, and $58.6 million in 1996 are included in "Deferred
and other assets" in the Consolidated Balance Sheets.
Impairment of Long-Lived Assets-In the event that facts and
circumstances indicate that the carrying amount of a long-lived asset
may be impaired, an evaluation of recoverability would be performed.
If an evaluation is required, the estimated future undiscounted cash
flows associated with the asset are compared to the asset's carrying
amount to determine if a write-down to market value or discounted cash
flow is required.
Accounts Payable-Accounts payable includes trade accounts payable
and an estimated accrual for long distance cost of access.
Fair Value of Financial Instruments-Cash and cash equivalents are
valued at their carrying amounts, which are reasonable estimates of
fair value. The fair value of long-term debt is estimated using rates
currently available to the Company for debt with similar terms and
maturities. The fair value of all other financial instruments
approximates cost as stated.
Federal Income Taxes-Deferred tax assets and liabilities are
determined based on differences between the financial reporting and
tax basis of assets and liabilities and are measured using the enacted
tax rates and laws that are anticipated to be in effect when those
differences are expected to reverse. Income tax benefits of tax
27
<PAGE>
deductions related to common stock transactions with the Company's
stock option plans are recorded directly to capital in excess of par
value.
The Company provides a valuation allowance for its deferred tax
assets when it is more likely than not that some portion or all of the
deferred tax assets will not be realized.
Revenue Recognition-Customers are billed as of monthly cycle
dates. Revenue is recognized as service is provided net of an estimate
for uncollectible accounts.
Fiber Exchange Agreements-In connection with its optronics
network expansion, the company has entered into various agreements to
sell or exchange fiber usage rights. Sales of fiber usage rights are
recorded as unearned revenue. Revenue is recognized over the terms of
the related agreements. Non-monetary exchanges of fiber usage rights
(swaps of fiber usage with other long distance carriers) are recorded
at the cost of the asset transferred or, if applicable, the fair value
of the asset received.
Market Risk Disclosure-As of December 31, 1998, the Company does
not have any significant concentration of business transacted with a
particular customer, supplier or lender that could, if suddenly
eliminated, severely impact its operations. However, a portion of the
Company's revenues is derived from services provided to others in the
telecommunications industry, mainly resellers of long distance
telecommunications service. Accordingly, the Company periodically
performs ongoing credit evaluations of its larger customers' financial
condition to limit credit risk to the extent possible.
The Company is also exposed to market risk from changes in
interest rates on long-term debt obligations that impact the fair
value of these obligations. The Company's policy is to manage interest
rates through the use of a combination of fixed and variable rate
debt, and to periodically use interest rate swaps to manage its risk
profile.
Cash Flows-For purposes of the Statements of Cash Flows, the
Company considers all highly liquid investments with an original
maturity of three months or less to be cash equivalents.
The tax benefit realized from the exercise of stock options of
$4.5 million, $1.0 million, and $48.5 million for 1998, 1997 and 1996,
respectively, is reflected as an adjustment to capital in excess of
par value and taxes accrued.
Actual interest paid was $53.8 million in 1998, $59.6 million in
1997, and $49.7 million in 1996. Actual income taxes paid were $64.2
million in 1998, $61.3 million in 1997, and $70.1 million in 1996.
Interest costs associated with the construction of capital assets,
including the nationwide optronics network project, are capitalized.
Total amounts capitalized during 1998, 1997 and 1996 were $18.2
million, $13.4 million, and $6.2 million, respectively.
Reclassifications-Certain reclassifications have been made to
previously reported balances for 1996 and 1997 to conform to the 1998
presentation.
- --------------------------------------------------------------------------------
2. Acquisitions, Mergers and Divestitures
Acquisitions and Mergers
------------------------
On February 27, 1998, the Company acquired GlobalCenter Inc.
(renamed "Frontier GlobalCenter, Inc." or "GlobalCenter"), a leading
provider in digital distribution, Internet and data services
headquartered in Sunnyvale, California. Under the terms of the merger
agreement, the Company acquired all of the outstanding shares of
GlobalCenter. The total shares issued by the Company to effect the
merger were 6.4 million. At the time of the merger, GlobalCenter had
1.1 million stock options and warrants outstanding as converted into
Frontier equivalents. This transaction was accounted for using the
pooling of interests method of accounting and, accordingly, historical
information has been restated to include GlobalCenter.
28
<PAGE>
<TABLE>
<CAPTION>
Combined and separate results of Frontier Corporation and GlobalCenter were as follows:
------------------------------------------------------------------------------------------------------------
Frontier
In Millions Corporation GlobalCenter Combined
------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
One month ended January 31, 1998
Revenues $ 205.5 $ 2.5 $ 208.0
Net income (loss) $ 14.7 $ (1.0) $ 13.7
------------------------------------------------------------------------------------------------------------
Year ended December 31, 1997
Revenues $ 2,352.9 $ 21.9 $ 2,374.8
Net income (loss) $ 54.6 $ (22.8) $ 31.8
------------------------------------------------------------------------------------------------------------
Year ended December 31, 1996
Revenues $ 2,575.6 $ 12.9 $ 2,588.5
Net income (loss) $ 209.9 $ (19.7) $ 190.2
------------------------------------------------------------------------------------------------------------
</TABLE>
In November 1997, the Company, through GlobalCenter, acquired
Voyager Networks, Inc. ("Voyager"), a New York City-based provider of
content management and distribution services. The Company issued .6
million shares of Frontier equivalent common stock in exchange for all
of Voyager's issued and outstanding shares of common stock.
Additionally, .1 million outstanding options for common stock of
Voyager, as converted into Frontier equivalents, were assumed by the
Company in connection with the acquisition. This transaction was
accounted for as a purchase.
In May 1997, the Company, through GlobalCenter, merged with ISI,
Inc. ("ISI"), a Sunnyvale, California-based provider of web hosting
and digital distribution services. The Company issued 1.7 million
shares of Frontier equivalent common stock in exchange for all of
ISI's issued and outstanding voting stock. Additionally, .1 million
outstanding options for common stock of ISI, as converted into
Frontier equivalents, were assumed by the Company in connection with
the merger. The ISI merger was accounted for as a pooling of interests
and, accordingly, the Company's consolidated financial statements have
been restated for all periods prior to the merger to include the
accounts and operations of ISI.
In February 1997, the Company completed its purchase of R.G. Data
Incorporated (renamed "Frontier Network Systems Corp." or "FNSC"), a
privately held upstate New York based computer and data networking
equipment and services company. A total of 110,526 shares of Frontier
common stock held in treasury were reissued in exchange for all of the
shares of R. G. Data Incorporated. The treasury shares were acquired
through open market purchases. This transaction was accounted for as a
purchase.
In December 1996, the Company, through GlobalCenter, merged with
GCIS, Inc. ("GCIS"), a Sunnyvale, California-based provider of
business Internet management services. The Company issued 1.6 million
shares of Frontier equivalent common stock in exchange for all of the
issued and outstanding voting stock of GCIS. Additionally, .1 million
outstanding options for the common stock of GCIS, as converted into
Frontier equivalents, were assumed by the Company in connection with
the merger. This transaction was accounted for as a purchase.
In March 1996, the Company acquired a 55 percent interest in the
New York RSA No. 3 Cellular Partnership ("RSA No. 3"). RSA No. 3 is a
provider of cellular mobile telephone service in the New York State
Rural Service Area No. 3, which encompasses much of the Southern Tier
area of New York State. The Company's interest in RSA No. 3 is managed
by Frontier Cellular, a 50/50 owned joint venture with Bell Atlantic,
and the operating results are reported using the equity method of
accounting. The Company paid $25.3 million in cash for its interest in
RSA No. 3.
Divestitures
------------
During November 1998, the Company sold certain non-strategic
investments. The sales resulted in an after-tax gain of $3.0 million.
In April 1998, the Company completed the sale of Minnesota
Southern Cellular Telephone Company ("Minnesota RSA No. 10"), a wholly
owned cellular partnership, and certain other properties. The sale of
these properties resulted in a combined pre-tax gain of $15.2 million
and an after-tax gain of $2.9 million. The income tax effect on these
gains of $12.3 million is primarily impacted by the sale of Minnesota
RSA No. 10 which resulted in nondeductible goodwill.
On December 9, 1997, the Company completed the sale of a portion
of its retail prepaid calling card business to SmarTalk Teleservices
Inc. for $36.6 million. The net proceeds from this sale were offset by
costs necessary to phase out the remainder of the Company's prepaid
business.
29
<PAGE>
On January 31, 1997, the Company completed the sale of its 69.5%
equity interest in the South Alabama Cellular Communications
Partnership. The sale resulted in a pre-tax gain of $18.8 million.
- --------------------------------------------------------------------------------
3 . Other Charges
In the first quarter of 1998, the Company recorded a pre-tax
charge of $6.5 million associated with the acquisition of
GlobalCenter. These charges included investment banker, legal fees and
other direct costs and were subsequently liquidated in 1998.
In October 1997, the Company recorded a pre-tax charge of $86.8
million consisting of a restructuring charge of $43.0 million and a
provision for asset and lease impairments of $43.8 million. The
restructuring charge was primarily associated with a workforce
reduction, program cancellations and the exiting of certain product
lines. During 1997, the Company reduced its work force by
approximately 700 positions, or 8%, and the restructuring charge of
$43.0 million was subsequently liquidated during 1998. The provision
for asset and lease impairments primarily relates to long term assets
and certain lease obligations the Company is in the process of
disposing of, or exiting.
In March 1997, the Company recorded a $96.6 million pre-tax
charge primarily related to the write-off of certain leased network
facilities no longer required as a result of the migration of the
Company's major carrier customer's one-plus traffic volume to other
networks and the Company's overall network integration efforts. The
Company completed the decommissioning of these redundant facilities
during the first quarter of 1998.
In December 1996, the Company, through GlobalCenter, recorded a
pre-tax charge of $18.9 million related to the write-off of in-process
product development costs associated with the 1996 merger with GCIS,
an Internet management services company.
In November 1996, the Company recorded a $48.8 million pre-tax
charge. This charge included $28.0 million for the curtailment of
certain Company pension plans and a $20.8 million charge primarily to
write-off unrecoverable product development costs for its conference
calling product line.
- --------------------------------------------------------------------------------
4. Property, Plant and Equipment
<TABLE>
<CAPTION>
Major classes of property, plant, and equipment are summarized below:
------------------------------------------------------------------------------------------------------
In thousands of dollars At December 31, 1998 1997 1996
------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Land and buildings $ 111,948 $ 117,750 $ 116,876
Local and fiber service lines 857,699 817,645 795,855
Central office equipment 677,380 614,021 580,217
Station equipment 43,293 40,608 38,770
Switching facilities and optronics network 720,019 412,067 390,779
Office equipment and other 370,959 266,223 233,737
Plant under construction 424,153 171,756 126,140
Less: Accumulated Depreciation 1,527,892 1,393,186 1,306,392
-----------------------------------------------------------------------------------------------------
$1,677,559 $1,046,884 $ 975,982
------------------------------------------------------------------------------------------------------
</TABLE>
Depreciation expense was $189.8 million, $167.7 million and
$147.6 million for the years ending December 31, 1998, 1997 and 1996,
respectively.
30
<PAGE>
- --------------------------------------------------------------------------------
5. Long-Term Debt
<TABLE>
<CAPTION>
------------------------------------------------------------------------------------------------------
In thousands of dollars At December 31, 1998 1997 1996
------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Frontier Communications of Minnesota, Inc.
Senior Notes, 7.61%, due 2003 $35,000 $35,000 $35,000
Rural Utilities Service Debt,
2%-9% due 1999 to 2026 50,313 53,239 64,654
------------------------------------------------------------------------------------------------------
85,313 (a) 88,239 99,654
------------------------------------------------------------------------------------------------------
Debentures
10.46% convertible, due 2008 5,300 (b) 5,300 5,300
9%, due 2021 100,000 100,000 100,000
------------------------------------------------------------------------------------------------------
105,300 105,300 105,300
------------------------------------------------------------------------------------------------------
9% Senior Subordinated Notes, due 2003 - (c) 3,061 3,180
Medium-term notes, 7.51% - 9.3%, due 2000 to 2004 219,000 219,000 219,000
8.25% Notes, due 2011 - 2,225 2,600
7.25% Notes, due 2004 300,000 300,000 (d) -
6.25% 12-2 Putable Notes ("PATS"), due 1999 100,000 100,000 (e) -
6.00% 15-5 Putable Notes, due 2013 200,000 (f) - -
Revolving Credit Agreements 197,719 (g) 21,705 248,570
Capitalized lease obligations 12,519 8,795 9,051
Other debt 136,914 (h) 92,888 996
-----------------------------------------------------------------------------------------------------
Sub-total 1,356,765 (i) 941,213 688,351
Less: Discount/(Premium) on long-term debt (3,522) 89 2,852
Current portion of long-term debt 9,466 6,443 7,929
------------------------------------------------------------------------------------------------------
Total Long-Term Debt $1,350,821 $934,681 $677,570
------------------------------------------------------------------------------------------------------
</TABLE>
(a) Certain assets of the Local Communications Services' segment are
pledged as security.
(b) The debenture is convertible into common stock at any time after
October 26, 1998 at $10.5375 per share. A total of 502,966 shares
of common stock are reserved for such conversion.
(c) The Company exercised its option to call the remaining balance of
its 9% 2003 Senior Subordinated Notes in May 1998.
(d) In December 1997, the Company entered into an interest rate hedge
agreement that effectively converts $200.0 million of the
Company's 7.25% fixed-rate notes due May 2004 into a floating
rate based on a "basket" London Interbank Offered Rate ("LIBOR")
index rate plus 2.88%. The agreement expires in May 2004 and caps
the floating rate the Company pays at 7.25% through November 1999
and 9.00% through May 2004. Interest expense and the related cash
flows under the agreement are accounted for on an accrual basis.
The Company periodically enters into such agreements to balance
its floating rate and fixed rate obligations to insulate against
interest rate risk and maximize savings.
(e) The Company issued $100.0 million face value of putable notes in
December, 1997 as a 144A offering. These notes have an initial
maturity of two years, at which time the notes will be either put
back to the Company for redemption or effectively remarketed by
the trust as 10 year debt, depending on the interest rate
environment at that time. In the event that the notes are put
back for redemption in 1999, the Company intends to finance this
obligation through available credit facilities and unused
commitments extending beyond one year; therefore, the obligation
is classified as long-term debt.
(f) The Company issued $200.0 million face value of putable notes in
September 1998. These notes may be put back to the Company in
October 2003, depending on the interest rate environment at that
time.
(g) The Company has credit facilities totaling $475.0 million which
are available through commercial paper borrowings or through
draws under Revolving Credit Agreements. At December 31, 1998,
the Company had outstanding $197.7 million in commercial paper
issuances. Commercial paper is classified as long-term debt as
the Company intends to refinance the debt through continued
short-term borrowing or available credit facilities with unused
commitments extending beyond one year. The Company
31
<PAGE>
established a $275.0 million three-year revolving credit facility
and a $200 million 364 day facility in November 1998 with a group
of ten commercial banks. The Agreements are unsecured and have
commitment fees of .09 percent per year on the entire commitment,
with interest on amounts drawn down based upon LIBOR plus .16
percent.
(h) This amount includes the Company's obligation to pay $136.9
million related to its optronics network build ($57.9 million)
and other capital initiatives ($79.0 million), which is
classified as long-term as the Company intends to finance this
obligation through available credit facilities and unused
commitments extending beyond one year.
(i) In accordance with FAS 107, "Disclosures about Fair Value of
Financial Instruments," the Company estimates that the fair value
of the debt, based on rates currently available to the Company
for debt with similar terms and remaining maturities, is $1.41
billion, as compared to the carrying value of $1.36 billion.
At December 31, 1998, aggregate debt maturities were:
<TABLE>
<CAPTION>
--------------------------------------------------------------------------------------------------------
In thousands of dollars 1999 2000 2001 2002 2003
--------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
$9,466 $16,942 $273,355 $43,249 $37,991
--------------------------------------------------------------------------------------------------------
</TABLE>
- --------------------------------------------------------------------------------
6. Income Taxes
<TABLE>
<CAPTION>
The provision for income taxes consists of the following:
------------------------------------------------------------------------------------------------------
In thousands of dollars Years Ended December 31, 1998 1997 1996
------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Federal:
Current $ 64,057 $24,189 $114,402
Deferred 47,144 11,101 5,996
------------------------------------------------------------------------------------------------------
111,201 35,290 120,398
------------------------------------------------------------------------------------------------------
State:
Current 11,327 11,234 19,757
Deferred 7,032 (2,336) 2,401
------------------------------------------------------------------------------------------------------
18,359 8,898 22,158
------------------------------------------------------------------------------------------------------
Total income taxes $129,560 $44,188 $142,556
------------------------------------------------------------------------------------------------------
</TABLE>
The reconciliation of the federal statutory income tax rate with
the effective income tax rate reflected in the financial statements is
as follows:
<TABLE>
<CAPTION>
-----------------------------------------------------------------------------------------------------
In thousands of dollars Years Ended December 31, 1998 1997 1996
-----------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Federal income tax expense
at statutory rate 35.0% 35.0% 35.0%
State income tax (net of
federal benefit) 3.9 7.6 4.2
Net operating loss
carryforwards (1.1) 4.7 (1.0)
Research and development costs - - 1.9
Goodwill amortization 3.4 7.0 1.3
Other 1.0 3.8 .4
-----------------------------------------------------------------------------------------------------
Total income tax 42.2% 58.1% 41.8%
-----------------------------------------------------------------------------------------------------
</TABLE>
32
<PAGE>
<TABLE>
<CAPTION>
Deferred tax liabilities (assets) are comprised of the following at December 31:
-----------------------------------------------------------------------------------------------------
In thousands of dollars 1998 1997 1996
-----------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Accelerated depreciation $121,038 $ 111,657 $ 87,612
Research and development costs 9,376 4,712 1,447
Other 36,924 19,206 21,468
-----------------------------------------------------------------------------------------------------
Gross deferred tax liabilities 167,338 135,575 110,527
-----------------------------------------------------------------------------------------------------
Basis adjustment - purchased
telephone companies (25,296) (23,120) (25,477)
Employee benefits obligation (15,498) (13,509) (11,136)
Net operating loss carryforwards (54,589) (56,494) (46,066)
Acquisition related and other charges (20,255) (46,944) (27,630)
Bad debt expense (3,486) (4,463) (11,232)
Other (40,927) (36,972) (38,127)
-----------------------------------------------------------------------------------------------------
Gross deferred tax assets (160,051) (181,502) (159,668)
Valuation allowance 19,439 22,906 21,066
-----------------------------------------------------------------------------------------------------
Total deferred tax assets (140,612) (158,596) (138,602)
-----------------------------------------------------------------------------------------------------
Net deferred tax liabilities (assets) $ 26,726 $ (23,021) $ (28,075)
-----------------------------------------------------------------------------------------------------
</TABLE>
Certain of the Company's acquired subsidiaries have tax net
operating losses and alternative tax net operating loss carryforwards
("NOLs") which can be utilized annually to offset separate company
future taxable income. Under the provisions of Internal Revenue Code
Section 382, the utilization of carryforwards is presently limited.
The Company's NOLs begin to expire in 2004. As a result of the annual
limitation and the difficulty in predicting their utilization beyond a
period of three years, the Company has established valuation
allowances for the NOL carryforwards. Because certain of the NOL
carryforwards were acquired in purchase acquisitions and the related
valuation allowance was recorded using purchase accounting, $7.0
million of this valuation allowance, if subsequently recognized, would
be allocated to reduce goodwill.
- --------------------------------------------------------------------------------
7. Service Pensions and Benefits
The Company has contributory and noncontributory plans providing
for service pensions and certain death benefits for substantially all
employees. In 1995 and 1996, defined benefit plans sponsored by the
Company were frozen. On an annual basis, contributions are remitted to
the trustees to ensure proper funding of the plans.
The majority of the Company's pension plans have plan assets that
exceed accumulated benefit obligations. There are certain plans,
however, with accumulated benefit obligations which exceed plan
assets. The following tables summarize the funded status of the
Company's pension plans and the related amounts that are primarily
included in "Deferred and other assets" in the Consolidated Balance
Sheets.
33
<PAGE>
<TABLE>
<CAPTION>
---------------------------------------------------------------------------------------------------------
In thousands of dollars 1998 1997 1996
---------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Change in Benefit Obligation
Benefit obligation at beginning of year $487,702 $437,954 $409,563
Service cost 162 1,551 6,487
Interest cost 32,820 32,983 30,100
Actuarial loss (gain) 14,663 35,947 (5,692)
Benefits paid (36,085) (28,413) (22,110)
Curtailments - 737 19,606
Special termination benefits - 6,943 -
---------------------------------------------------------------------------------------------------------
Benefit obligation at end of year $499,262 $487,702 $437,954
---------------------------------------------------------------------------------------------------------
Change in Plan Assets
Fair value of plan assets at beginning of year $550,866 $493,894 $451,024
Actual return on plan assets 73,667 83,775 63,806
Employer contribution 2,000 1,610 1,174
Benefits paid (36,085) (28,413) (22,110)
---------------------------------------------------------------------------------------------------------
Fair value of plan assets at end of year $590,448 $550,866 $493,894
---------------------------------------------------------------------------------------------------------
Funded status 91,186 63,164 55,940
Unrecognized net transition asset (1,479) (1,801) (2,837)
Unrecognized prior service cost 9,916 10,556 11,097
Unrecognized net gain (66,702) (57,616) (52,354)
Adjustment required to recognize
minimum liability (5,632) (4,588) (2,109)
---------------------------------------------------------------------------------------------------------
Prepaid benefit cost, net $ 27,289 $ 9,715 $ 9,737
---------------------------------------------------------------------------------------------------------
<CAPTION>
The net periodic pension cost consists of the following:
---------------------------------------------------------------------------------------------------------
In thousands of dollars Years Ended December 31, 1998 1997 1996
---------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Service cost $ 162 $ 1,551 $ 6,487
Interest cost on projected
benefit obligation 32,820 32,983 30,100
Expected return on plan assets (47,174) (83,775) (63,807)
Net amortization and deferral (4,110) 40,715 25,723
Amount expensed due to
curtailment - 6,943 28,000
--------------------------------------------------------------------------------------------------------
Net periodic pension (benefit) cost $(18,302) $ (1,583) $26,503
--------------------------------------------------------------------------------------------------------
<CAPTION>
The following rates and assumptions were used to calculate the projected benefit obligation:
<S> <C> <C> <C>
Years Ended December 31, 1998 1997 1996
--------------------------------------------------------------------------------------------------------
Weighted average discount rate 6.8% 7.0% 7.5%
Rate of salary increase 5.0% 5.0% 5.0%
Expected return on plan assets 9.5% 9.5% 9.0%
--------------------------------------------------------------------------------------------------------
</TABLE>
The projected benefit obligation and accumulated benefit
obligation for the pension plans with accumulated benefit obligations
in excess of plan assets were $25.8 million and $25.2 million,
respectively, as of December 31, 1998, $24.6 million and $24.1
million, respectively, as of December 31, 1997, and $14.9 million and
$13.8 million, respectively, as of December 31, 1996. As of December
31, 1998, 1997 and 1996, the fair value of plan assets for pension
plans with accumulated benefit obligations in excess of plan assets
was zero.
34
<PAGE>
The Company's funding policy is to make contributions for pension
benefits based on actuarial computations which reflect the long-term
nature of the pension plan. However, under FAS 87, "Employers'
Accounting for Pensions," the development of the projected benefit
obligation essentially is computed for financial reporting purposes
and may differ from the actuarial determination for funding due to
varying assumptions and methods of computation. The Company changed
its assumptions used in 1998 and 1997. These changes in assumptions
did not have a material effect on pension expense in the respective
years.
In 1997, the Company recognized a curtailment loss of $6.9
million related to the restructuring of the workforce. In 1996, the
Company recognized a curtailment loss of $28.0 million reflecting the
enhancement and freezing of defined benefit plans sponsored by
Frontier Corporation, primarily for certain bargaining unit employees.
The Company also sponsors a number of defined contribution plans.
The most significant plan covers non-bargaining employees, who can
elect to make contributions through payroll deduction. Effective
January 1, 1996, the Company provides a contribution of .5 percent of
gross compensation in common stock for every employee eligible to
participate in the plan. The common stock used for matching
contributions is purchased on the open market by the plan's trustee.
The Company also provides 100% matching contributions in its common
stock up to three percent of gross compensation, and may, at the
discretion of the Management Benefit Committee, provide additional
matching contributions based upon Frontier's financial results. The
total cost recognized for all defined contribution plans was $9.7
million for 1998, $8.8 million for 1997, and $8.4 million for 1996.
- --------------------------------------------------------------------------------
8. Postretirement Benefits Other Than Pensions
The Company provides health care and life insurance benefits to
most employees. Plan assets consist principally of life insurance
policies and money market instruments. In adopting FAS 106,
"Employers' Accounting for Postretirement Benefits Other Than
Pensions", the Company elected to defer the recognition of the accrued
obligation of $125.0 million over a period of twenty years. During
1996, the Company amended its health care benefits plan to cap the
cost absorbed by the Company for health care and life insurance for
its bargaining unit employees who retire after December 31, 1996. The
effect of this amendment was to reduce the December 31, 1996
accumulated postretirement obligation by $11.2 million. Additionally,
during 1996, special termination benefits were offered to certain
employees with 25 years of service or more who were already entitled
to reduced or full retirement benefits and who voluntarily terminated
their employment with the Company prior to December 31, 1996.
<TABLE>
<CAPTION>
The status of the plans is as follows:
--------------------------------------------------------------------------------------------------------------
December 31, 1998 1998 1997 1996
--------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Change in Benefit Obligation
Benefit obligation at beginning of year $ 118,587 $ 104,273 $ 110,394
Service cost 671 755 642
Interest cost 8,080 7,734 7,735
Amendments 412 (2,810) (11,191)
Actuarial loss 9,473 15,676 2,560
Special termination benefit - - 360
Benefits paid (7,473) (7,041) (6,227)
--------------------------------------------------------------------------------------------------------------
Benefit obligation at end of year $ 129,750 $ 118,587 $ 104,273
--------------------------------------------------------------------------------------------------------------
Change in Plan Assets
Fair value of plan assets at beginning of year $ 5,039 $ 5,322 $ 5,716
Actual return on plan assets 79 360 (120)
Employer contribution 6,786 6,398 5,953
Benefits paid (7,473) (7,041) (6,227)
--------------------------------------------------------------------------------------------------------------
Fair value of plan assets at end of year $ 4,431 $ 5,039 $ 5,322
--------------------------------------------------------------------------------------------------------------
Funded status $(125,319) $(113,548) $ (98,951)
Unrecognized transition obligation 73,292 78,586 84,764
Unrecognized prior service cost 1,516 1,262 90
Unrecognized net loss (gain) 2,196 (8,958) (24,235)
--------------------------------------------------------------------------------------------------------------
Accrued benefit cost $ (48,315) $ (42,658) $ (38,332)
-------------------------------------------------------------------------------------------------------------
</TABLE>
35
<PAGE>
<TABLE>
<CAPTION>
The components of the estimated postretirement benefit cost are as follows:
-------------------------------------------------------------------------------------------------------------
In thousands of dollars Years Ended December 31, 1998 1997 1996
-------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Service cost $ 671 $ 755 $ 642
Interest on accumulated
postretirement benefit obligation 8,080 7,734 7,735
Amortization of transition obligation 5,294 5,276 5,512
Return on plan assets (447) (476) (457)
Amortization of prior service cost 165 217 69
Amortization of gains and losses (1,259) (1,891) (2,024)
Special termination benefit - - 360
-------------------------------------------------------------------------------------------------------------
Net postretirement benefit cost $12,504 $11,615 $11,837
-------------------------------------------------------------------------------------------------------------
<CAPTION>
The following assumptions were used to value the postretirement benefit obligation:
-------------------------------------------------------------------------------------------------------------
Years Ended December 31, 1998 1997 1996
-------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Weighted average discount rate 6.8% 7.0% 7.5%
Expected return on plan assets 9.5% 9.5% 9.0%
Rate of salary increase 5.0% 5.0% 5.0%
Assumed rate of increase in cost
of covered health care benefits 6.4% 6.6% 7.1%
-------------------------------------------------------------------------------------------------------------
</TABLE>
Increases in health care costs were assumed to decline
consistently to a rate of 5.0% by 2006 and remain at that level
thereafter. If the health care cost trend rates were increased by one
percentage point, the accumulated postretirement benefit health care
obligation as of December 31, 1998 would increase by $10.0 million
while the sum of the service and interest cost components of the net
postretirement benefit health care cost for 1998 would increase by $.7
million. If the health care cost trend rates were decreased by one
percentage point, the accumulated postretirement benefit health care
obligations as of December 31, 1998 would decrease by $9.4 million
while the sum of the service and interest cost components of the net
postretirement benefit health care cost for 1998 would decrease by $.7
million.
The Company changed its assumptions used in 1998 and 1997 for the
weighted average discount rate. This change in assumption did not have
a material effect on the 1998 or 1997 postretirement expense.
36
<PAGE>
- --------------------------------------------------------------------------------
9. Earnings Per Share
The Company adopted the provisions of FAS 128, "Earnings Per
Share" effective December 31, 1997. This statement simplifies the
standards for computing earnings per share previously found in
Accounting Principles Board ("APB") Opinion No. 15, "Earnings Per
Share", and makes them comparable to international earnings per share
("EPS") standards. Basic EPS excludes the effect of common stock
equivalents and is computed by dividing income available to common
shareholders by the weighted average of common shares outstanding for
the period. Diluted EPS reflects the potential dilution that could
result if securities or other contracts to issue common stock were
exercised or converted into common stock. Historical earnings per
share have been restated to conform with the provisions of FAS 128.
<TABLE>
<CAPTION>
In thousands of dollars, except per share data
- --------------------------------------------------------------------------------------------------------------------
Years Ended December 31, 1998 1997 1996
- --------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Basic Earnings Per Share
Income Applicable to Common Stock $174,783 $ 30,782 $189,005
Average Common Shares Outstanding 170,626 168,975 165,234
-------- -------- --------
Basic Earnings Per Common Share $1.02 $0.18 $1.14
======== ======== ========
Diluted Earnings Per Share
Income Applicable to Common Stock $174,783 $ 30,782 $189,005
Interest Expense on Convertible Debentures (1) 360 - 360
-------- -------- --------
$175,143 $ 30,782 $189,365
======== ======== ========
Average Common Shares Outstanding 170,626 168,975 165,234
Options and Warrants 2,812 992 1,771
Convertible Debentures (1) 503 - 503
-------- -------- --------
173,941 169,967 167,508
======== ======== ========
Diluted Earnings Per Common Share $1.01 $0.18 $1.13
======== ======== ========
(1) Convertible debentures are anti-dilutive in 1997.
</TABLE>
- --------------------------------------------------------------------------------
10. Stock Option Plans and Other Common Stock Transactions
The Company has stock option plans for its directors, executives
and certain employees. The exercise price for all plans is the fair
market value of the stock on the date of the grant. The options expire
ten years from the date of the grant. The options vest over a period
from one to three years. The maximum number of shares which may be
granted under the executive plan is limited to one percent of the
number of issued shares, including treasury shares, of the Company's
common stock during any calendar year. The maximum number of shares
which may be granted under the employee plan is a total of 8,000,000
shares over a 10 year period. The maximum number of shares which may
be granted under the directors plan is 1,000,000 shares. In connection
with the GlobalCenter merger, the Company assumed all the outstanding
options of GlobalCenter. The plans provide for discretionary grants of
stock options which are subject to the passage of time and continued
employment restrictions.
37
<PAGE>
<TABLE>
<CAPTION>
Information with respect to options under the above plans follows:
-----------------------------------------------------------------------------------------------------
Weighted Average
Shares Exercise Price
-----------------------------------------------------------------------------------------------------
<S> <C> <C>
Outstanding at January 1, 1996 8,441,386 $11.24
Granted in 1996 3,165,878 $30.02
Cancelled in 1996 (800,329) $28.26
Exercised in 1996 (5,481,681) $5.99
-----------------------------------------------------------------------------------------------------
Outstanding at December 31, 1996 5,325,254 $25.25
Granted in 1997 4,679,587 $17.83
Cancelled in 1997 (1,529,340) $23.77
Exercised in 1997 (162,421) $5.58
-----------------------------------------------------------------------------------------------------
Outstanding at December 31, 1997 8,313,080 $21.49
Granted in 1998 4,884,020 $27.23
Cancelled in 1998 (855,618) $23.55
Exercised in 1998 (547,467) $13.76
-----------------------------------------------------------------------------------------------------
Outstanding at December 31, 1998 11,794,015 $24.24
-----------------------------------------------------------------------------------------------------
</TABLE>
At December 31, 1998, 5,466,372 shares were available for future
grant.
The Company applies APB Opinion No. 25, "Accounting for Stock
Issued to Employees", and related interpretations in accounting for
its plans. Accordingly, no compensation expense has been recognized
for its stock-based compensation plans other than for restricted stock
awards and for GlobalCenter stock options issued with an exercise
price below fair market value. During 1997, the Company recorded
deferred compensation of $5.0 million related to the majority of these
options which represents the difference between the exercise price of
the options and the fair market value at the time of issuance. As of
December 31, 1998 and 1997, the Company recognized related
compensation expense of $0.8 million and $2.0 million. The remaining
balance will continue to be amortized over the four year term of these
options.
During 1996 the Company adopted the disclosure requirements of
FAS 123, "Accounting for Stock-Based Compensation". In accordance with
FAS 123, the Company has elected not to recognize compensation cost
related to stock options with exercise prices equal to the market
price at the date of issuance. If the Company had elected to recognize
compensation cost based on the fair value of the options at grant date
as prescribed by FAS 123, the following results would have occurred
using the Black-Scholes option valuation model:
<TABLE>
<CAPTION>
----------------------------------------------------------------------------------------------------------
In thousands of dollars, except per share data
Years Ended December 31, 1998 1997 1996
----------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Post-Tax Compensation Cost $ 14,038 $12,049 $ 5,358
Pro Forma Net Income $161,750 $19,752 $184,829
Pro Forma Basic EPS $ 0.95 $ 0.11 $ 1.11
Pro Forma Diluted EPS $ 0.93 $ 0.11 $ 1.10
Fair Value of Options Granted $ 7.77 $ 5.85 $ 8.50
Volatility 33.9% 33.2% 28.4%
Dividend Yield 3.3% 3.5% 3.0%
Risk-Free Interest Rates 4.2% to 6.7% 5.7% to 6.7% 5.5% to 7.0%
----------------------------------------------------------------------------------------------------------
</TABLE>
Due to the difference in vesting requirements in each of the
plans, the expected lives of the options range from 5 to 7 years.
Forfeitures are recognized as they occur.
38
<PAGE>
<TABLE>
<CAPTION>
Options Outstanding
-------------------
----------------------------------------------------------------------------------------------
Weighted
Average Weighted
Range Of Remaining Average
Exercise Number Contractual Exercise
Prices Outstanding Life Price
----------------------------------------------------------------------------------------------
<S> <C> <C> <C>
$1 - $5 630,512 7.79 $2.23
$12 - $20 1,278,981 7.23 $17.37
$21 - $50 9,884,522 8.25 $26.53
----------------------------------------------------------------------------------------------
<CAPTION>
Options Exercisable
-------------------
----------------------------------------------------------------------------------------------
Weighted
Range Of Average
Exercise Number Exercise
Prices Exercisable Price
----------------------------------------------------------------------------------------------
<S> <C> <C>
$1 - $5 178,241 $3.46
$12 - $20 683,285 $17.23
$21 - $50 3,124,776 $27.36
----------------------------------------------------------------------------------------------
</TABLE>
Restricted Stock Plan
The Company has 691,669 shares of common stock outstanding as of
December 31, 1998 under its Management Stock Incentive Plan. The stock
issued under this plan ("Restricted Stock") is subject to the
achievement of certain performance goals, the passage of time and
continued employment restrictions. Participants in the plan may earn,
without cost to them, Frontier common stock over three years.
Shareholders' equity reflects unearned compensation for the unvested
stock awarded. During 1998, the Company recognized related
compensation expense of $5.9 million, net of cancellations, and $1.6
million during 1997. The Company did not recognize compensation
expense for restricted stock granted prior to 1997 as the market price
of the common stock was significantly below the vesting prices.
39
<PAGE>
11. Preferred Stock
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
-------------------------------------------------------------------------------------------------------------
In thousands of dollars, except share data December 31, 1998 1997 1996
-------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Frontier Corporation-850,000 shares authorized;
par value $100
5.00% Series-redeemable at $101 per share
Shares outstanding 95,276 100,000 100,000
Amount outstanding $ 9,527 $ 10,000 $ 10,000
5.65% Series-redeemable at $101 per share
Shares outstanding 48,219 50,000 50,000
Amount outstanding $ 4,822 $ 5,000 $ 5,000
4.60% Series-redeemable at $101 per share
Shares outstanding 41,514 48,500 48,500
Amount outstanding $ 4,151 $ 4,850 $ 4,850
Frontier Communications of New York, Inc.
40,000 shares authorized; par value $100
5.875% Series A-redeemable at par
Shares outstanding - - 18,694
Amount outstanding - - $ 1,869
7.80% Series B-redeemable at $100.80-$105.00 per share
Shares outstanding - - 6,160
Amount outstanding - - $ 616
Frontier Communications of AuSable Valley, Inc.
4,000 shares authorized; par value $100
5.50% Series-redeemable at par
Shares outstanding 2,702 2,754 2,754
Amount outstanding $ 270 $ 276 $ 276
-------------------------------------------------------------------------------------------------------------
Total shares outstanding 187,711 201,254 226,108
Total amount outstanding $ 18,770 $ 20,126 $ 22,611
-------------------------------------------------------------------------------------------------------------
</TABLE>
Effective January 1, 1997, the Company redeemed all of the
outstanding preferred stock of its wholly-owned subsidiary, Frontier
Communications of New York, Inc. at approximately par value.
At the special meeting in December 1994, Frontier shareholders
authorized 4,000,000 shares of a new class of preferred stock, having
a par value of $100.00 per share and designated as Class A Preferred
Stock. This class of stock will rank junior to the cumulative
preferred stock as to dividends and distributions, and upon the
liquidation, dissolution or winding up of the Company. As of December
31, 1998, no shares of this class have been issued.
On April 9, 1995, the Board of Directors adopted a Shareholders'
Rights Plan (the "Plan"). This Plan provides for a dividend
distribution on each outstanding common share of a right to purchase
one one-hundredth of a share of Series A Junior Participating Class A
Preferred Stock. The rights are designed to protect shareholders in
the event of an unsolicited offer or initiative to acquire Frontier
which the Board does not believe is fair to shareholders. The rights
become exercisable under certain circumstances to purchase Frontier
common stock at one-half market value.
40
<PAGE>
- --------------------------------------------------------------------------------
12. New Accounting Pronouncements
The Company adopted the provisions of FAS 130, "Reporting
Comprehensive Income" as of January 1, 1998. This statement
establishes standards for reporting and displaying of comprehensive
income and its components. This statement requires reporting, by major
components and as a single total, the change in net assets during the
period from nonshareholder sources. Adoption of this standard did not
materially impact the Company's consolidated financial position,
results of operations or cash flow.
In April 1998, the American Institute of Certified Public
Accountants issued Statement of Position 98-5, "Reporting on the Costs
of Start-up Activities" ("SOP 98-5") which requires that start-up
costs be expensed as incurred. The Company adopted the provisions of
SOP 98-5 in 1998. Accordingly, $1.8 million, net of applicable income
taxes of $.8 million of unamortized start-up costs at December 31,
1997, have been expensed in the accompanying Consolidated Statements
of Income and is reported as a cumulative effect of a change in
accounting principle. These start-up costs are primarily related to
product development costs associated with new business ventures.
On June 17, 1998, the Financial Accounting Standards board issued
FAS 133, "Accounting for Derivative Instruments and Hedging
Activities" effective for fiscal years beginning after June 15, 1999.
This statement standardizes the accounting for derivatives and hedging
activities and requires that all derivatives be recognized in the
statement of financial position as either assets or liabilities at
fair value. Changes in the fair value of derivatives that do not meet
the hedge accounting criteria are to be reported in earnings. Adoption
of this standard is not expected to have a material effect on the
Company's financial position, results of operations or cash flows.
Effective January 1, 1996, the Company adopted FAS 121,
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to be Disposed Of". FAS 121 requires that certain long-lived
assets and identifiable intangibles be written down to fair value
whenever an impairment review indicates that the carrying value cannot
be recovered on an undiscounted cash flow basis. The statement also
requires that certain long-lived assets and identifiable intangibles
to be disposed of be reported at fair value less selling costs. The
Company's adoption of this standard resulted in a non-cash charge of
$8.0 million (net of a tax benefit of $4.4 million) and is reported as
a cumulative effect of a change in accounting principle. The charge
represents the cumulative adjustment required by FAS 121 to remeasure
the carrying amount of certain assets held for disposal as of January
1, 1996. These assets held for disposal consist principally of
telephone switching equipment in the Company's Local Communications
Services segment as a result of management's commitment, in late 1995,
to a central office switch consolidation project primarily at Frontier
Telephone of Rochester and Frontier Communications of New York
subsidiaries.
- --------------------------------------------------------------------------------
13. Major Customer
The Company's revenues include the impact of a major carrier
customer whose revenues comprised approximately 3%, 4%, and 15% of
consolidated revenues in 1998, 1997 and 1996, respectively.
- --------------------------------------------------------------------------------
14. Commitments, Contingencies And Other
Operating Environment-The Company has evolved from being a
provider of local and long distance services in certain areas of the
country to being a nationwide provider of integrated communications
services. As a result, the Company has formidable competitors of
greater size and expects that, over time and due to the lifting of
regulatory restrictions, there will be more entrants into the long
distance business and its local markets.
Legal Matters-The Company and a number of its subsidiaries in the
normal course of business are party to a number of judicial,
regulatory and administrative proceedings. The Company's management
does not believe that any material liability will be imposed as a
result of any of these matters.
Leases and License Agreements-The Company leases buildings, land,
office space, fiber optic network, computer hardware and other
equipment, and has license agreements for rights-of-way for the
construction and operation of a fiber optic communications system.
41
<PAGE>
Total rental expense amounted to $133.9 million in 1998, $156.5
million in 1997, and $164.7 million in 1996.
Minimum annual rental commitments under non-cancelable operating
leases and license agreements in effect on December 31, 1998 were as
follows:
<TABLE>
<CAPTION>
In thousands of dollars
----------------------------------------------------------------------------------------------------
License
Years Buildings Equipment Agreements
----------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
1999 $ 18,417 $2,330 $ 54,526
2000 16,893 1,835 29,381
2001 15,666 280 16,928
2002 14,882 128 5,047
2003 14,118 - 1,647
2004 and thereafter 48,450 - -
----------------------------------------------------------------------------------------------------
Total $128,426 $4,573 $107,529
----------------------------------------------------------------------------------------------------
</TABLE>
Other Matters-In connection with the Company's capital program,
certain commitments have been made for the purchase of material and
equipment. Total capital expenditures for 1999 are currently projected
to be consistent with 1998. In October 1996, construction began on the
optronics network. At December 31, 1998 and 1997, the Company has
recorded $114.0 million and $238.2 million, respectively, of deposits
for the optronics network and other projects which are included in the
"Deferred and other assets" caption in the Consolidated Balance
Sheets.
Under the Company's Open Market Plan, dividend payments to the
parent company are temporarily prohibited until Frontier Telephone of
Rochester, Inc. ("FTR") receives clearance from the New York State
Public Service Commission that service requirements are being met.
Cash restricted for dividend payments by FTR, as of December 31, 1998,
was approximately $53.0 million.
- --------------------------------------------------------------------------------
15. Business Segment Information
Effective December 31, 1998, the Company has adopted the
provisions of FAS 131, " Disclosures about Segments of an Enterprise
and Related Information." This statement establishes annual and
interim reporting standards for an enterprise's business segments and
related disclosures about its products, services, geographic areas and
major customers. Adoption of this statement had no impact on the
Company's consolidated financial position, results of operations or
cash flows. Comparative information for earlier years has been
restated.
The Company reports its operating results in three segments:
Integrated Services, Local Communications Services and Corporate
Operations and Other. The Company's majority interest in certain
wireless properties are consolidated under Corporate Operations and
Other. The change in the definition of the Company's segments has been
made to better reflect the changing scope of the businesses in which
Frontier operates.
Revenues and sales, operating income, depreciation, construction
and identifiable assets by business segment are set forth in the
Business Segment Information on page 22.
42
<PAGE>
- --------------------------------------------------------------------------------
16. Quarterly Data (Unaudited)
<TABLE>
<CAPTION>
---------------------------------------------------------------------------------------------------------------
1998 Quarter
In thousands of dollars, ----------------------------------------------------- Full
except per share data 1st 2nd 3rd 4th Year
---------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Revenues $631,998 $648,316 $658,208 $655,036 $2,593,558
Operating Income 68,014 (1) 80,835 81,155 87,392 317,396
Income before taxes and
cumulative effect of changes
in accounting principles 59,131 (1) 89,199 75,638 83,135 307,103
Consolidated Net Income 33,914 (1) 45,908 45,757 50,209 175,788
Earnings per share:
Basic $.20 $.27 $.27 $.29 $1.02 (2)
Diluted $.20 $.26 $.26 $.29 $1.01
Market Price:
High $33.44 $33.00 $36.75 $34.13
Low $24.44 $28.31 $24.13 $24.81
---------------------------------------------------------------------------------------------------------------
<CAPTION>
---------------------------------------------------------------------------------------------------------------
1997 Quarter
In thousands of dollars, ----------------------------------------------------- Full
except per share data 1st 2nd 3rd 4th Year
---------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Revenues $577,576 $590,116 $606,521 $600,596 $2,374,809
Operating (Loss) Income (28,566) (3) 74,019 64,871 (24,166) (4) 86,158
Income (loss) before taxes and
cumulative effect of changes
in accounting principles (18,108) (3) 66,335 58,162 (30,400) (4) 75,989
Consolidated Net
(Loss) Income (15,902) (3) 39,334 32,451 (24,082) (4) 31,801
(Loss) earnings per share:
Basic $(.10) $.23 $.19 $(.14) $.18
Diluted $(.10) (5) $.23 $.19 $(.14) (5) $.18 (6)
Market Price:
High $23.25 $20.50 $24.19 $25.00
Low $17.75 $15.38 $19.00 $20.00
---------------------------------------------------------------------------------------------------------------
</TABLE>
(1) Includes a pre-tax charge of $6.5 million comprised of investment
banker, legal fees and other direct costs associated with the
acquisition of GlobalCenter.
(2) As a result of rounding, the total of the four quarters' earnings
does not equal the earnings per share for the year.
(3) Includes a pre-tax charge of $96.6 million primarily related to
the write-off of certain leased network costs no longer necessary
to support long distance traffic volumes.
(4) Includes a pre-tax charge of $86.8 million primarily related to
the divestiture of certain product lines and businesses.
(5) Due to the net loss incurred, the earnings per share calculation
excludes common stock equivalents.
(6) Convertible debentures are anti-dilutive in 1997.
43
