SHENANDOAH TELECOMMUNICATIONS COMPANY

INDEX

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SHENANDOAH TELECOMMUNICATIONS COMPANY AND SUBSIDIARIES

UNAUDITED CONSOLIDATED BALANCE SHEETS

(in thousands)

See accompanying notes to unaudited consolidated financial statements.

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SHENANDOAH TELECOMMUNICATIONS COMPANY AND SUBSIDIARIES

UNAUDITED CONSOLIDATED BALANCE SHEETS

(in thousands)

 

LIABILITIES AND SHAREHOLDERS’ EQUITY		September 30, 2014				December 31, 2013
Current Liabilities
Current maturities of long-term debt		$	23,000			$	5,750
Accounts payable			8,522				12,604
Advanced billings and customer deposits			12,336				11,661
Accrued compensation			4,850				4,192
Accrued liabilities and other			8,438				9,787
Total current liabilities			57,146				43,994
Long-term debt, less current maturities			207,000				224,250
Other Long-Term Liabilities
Deferred income taxes			66,637				74,547
Deferred lease payable			6,916				6,156
Asset retirement obligations			6,856				6,485
Other liabilities			9,384				7,259
Total other long-term liabilities			89,793				94,447
Commitments and Contingencies
Shareholders’ Equity
Common stock			28,667				26,759
Accumulated other comprehensive income			1,810				2,594
Retained earnings			230,196				204,962
Total shareholders’ equity			260,673				234,315
Total liabilities and shareholders’ equity		$	614,612			$	597,006

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SHENANDOAH TELECOMMUNICATIONS COMPANY AND SUBSIDIARIES

UNAUDITED CONSOLIDATED STATEMENTS OF INCOME AND

COMPREHENSIVE INCOME (LOSS)

(in thousands, except per share amounts)

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SHENANDOAH TELECOMMUNICATIONS COMPANY AND SUBSIDIARIES

UNAUDITED CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY

(in thousands, except per share amounts)

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SHENANDOAH TELECOMMUNICATIONS COMPANY AND SUBSIDIARIES

UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

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SHENANDOAH TELECOMMUNICATIONS COMPANY AND SUBSIDIARIES

UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

During the first nine months of 2013, the Company traded in certain PCS equipment and received credits of $14.2 million against the purchase price of new equipment.

At December 31, 2013, accounts payable included approximately $7.6 million associated with the capital expenditures related to the Network Vision project. These payables were disbursed during 2014.

See accompanying notes to unaudited consolidated financial statements.

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SHENANDOAH TELECOMMUNICATIONS COMPANY AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

1. Basis of Presentation

The interim consolidated financial statements of Shenandoah Telecommunications Company and Subsidiaries (collectively, the “Company”) are unaudited. In the opinion of management, all adjustments necessary for a fair presentation of the interim results have been reflected therein. All such adjustments were of a normal and recurring nature. These statements should be read in conjunction with the consolidated financial statements and related notes in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013. The balance sheet information at December 31, 2013 was derived from the audited December 31, 2013 consolidated balance sheet. Operating revenues and income from operations for any interim period are not necessarily indicative of results that may be expected for the entire year.

2. Property, Plant and Equipment

Property, plant and equipment consisted of the following (in thousands):

3. Earnings per share

Basic net income per share was computed on the weighted average number of shares outstanding. Diluted net income per share was computed under the treasury stock method, assuming the conversion as of the beginning of the period, for all dilutive stock options. Of 698 thousand and 764 thousand shares and options outstanding at September 30, 2014 and 2013, respectively, zero and 293 thousand were anti-dilutive, respectively. These options have been excluded from the computations of diluted earnings per share for their respective period. There were no adjustments to net income for either period.

4. Investments Carried at Fair Value

Investments include $2.6 million and $2.5 million of investments carried at fair value as of September 30, 2014 and December 31, 2013, respectively, consisting of equity, bond and money market mutual funds. These investments were acquired under a rabbi trust arrangement related to a non-qualified supplemental retirement plan maintained by the Company. During the nine months ended September 30, 2014, the Company recognized $111 thousand in dividend and interest income from investments, and recorded net unrealized gains of $40 thousand on these investments. Fair values for these investments held under the rabbi trust were determined by Level 1 quoted market prices for the underlying mutual funds.

5. Financial Instruments

Financial instruments on the consolidated balance sheets that approximate fair value include: cash and cash equivalents, receivables, investments carried at fair value, payables, accrued liabilities, interest rate swaps and variable rate long-term debt.

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6. Derivative Instruments, Hedging Activities and Accumulated Other Comprehensive Income

The Company’s objectives in using interest rate derivatives are to add stability to cash flows and to manage its exposure to interest rate movements. To accomplish this objective, the Company primarily uses interest rate swaps as part of its interest rate risk management strategy. Interest rate swaps (both those designated as cash flow hedges as well as those not designated as cash flow hedges) involve the receipt of variable-rate amounts from a counterparty in exchange for the Company making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount.

The Company entered into a pay-fixed, receive-variable interest rate swap of $63.3 million of notional principal in August 2010. This interest rate swap was not designated as a cash flow hedge. Changes in the fair value of interest rate swaps not designated as cash flow hedges are recorded in interest expense each reporting period. The changes in fair value recorded in interest expense for the three and nine months ended September 30, 2013 were decreases of $33 thousand and $239 thousand, respectively. This swap expired in July 2013.

The Company entered into a pay-fixed, receive-variable interest rate swap of $174.6 million of notional principal in September 2012. This interest rate swap was designated as a cash flow hedge. The total outstanding notional amount of the cash flow hedge was $174.6 million as of September 30, 2014.

The effective portion of changes in the fair value of interest rate swaps designated and that qualify as cash flow hedges is recorded in accumulated other comprehensive income and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. The Company uses its derivatives to hedge the variable cash flows associated with existing variable-rate debt. The ineffective portion of the change in fair value of the derivative is recognized directly in earnings through interest expense. No hedge ineffectiveness was recognized during any of the periods presented.

Amounts reported in accumulated other comprehensive income related to the interest rate swap designated and that qualifies as a cash flow hedge are reclassified to interest expense as interest payments are made on the Company’s variable-rate debt. As of September 30, 2014, the Company estimates that $1.5 million will be reclassified as an increase to interest expense during the next twelve months due to the interest rate swap since the hedge interest rate exceeds the variable interest rate on the debt.

The table below presents the fair value of the Company’s derivative financial instrument as well as its classification on the consolidated balance sheet as of September 30, 2014 and December 31, 2013 (in thousands):

The fair value of interest rate swaps is determined using a pricing model with inputs that are observable in the market (level 2 fair value inputs).

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The table below presents change in accumulated other comprehensive income by component for the nine months ended September 30, 2014 (in thousands):

7. Segment Information

Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision makers. The Company has three reportable segments, which the Company operates and manages as strategic business units organized by lines of business: (1) Wireless, (2) Cable, and (3) Wireline. A fourth segment, Other, primarily includes Shenandoah Telecommunications Company, the parent holding company.

The Wireless segment provides digital wireless service to a portion of a four-state area covering the region from Harrisburg, York and Altoona, Pennsylvania, to Harrisonburg, Virginia, as a Sprint PCS Affiliate. This segment also owns cell site towers built on leased land, and leases space on these towers to both affiliates and non-affiliated service providers.

The Cable segment provides video, internet and voice services in Virginia, West Virginia and Maryland, and leases fiber optic facilities throughout southern Virginia and West Virginia. It does not include video, internet and voice services provided to customers in Shenandoah County, Virginia.

The Wireline segment provides regulated and unregulated voice services, DSL internet access, and long distance access services throughout Shenandoah County and portions of Rockingham, Frederick, Warren and Augusta counties, Virginia. The segment also provides video services in portions of Shenandoah County, and leases fiber optic facilities throughout the northern Shenandoah Valley of Virginia, northern Virginia and adjacent areas along the Interstate 81 corridor through West Virginia, Maryland and portions of Pennsylvania.

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A reconciliation of the total of the reportable segments’ operating income to consolidated income before taxes is as follows:

The Company’s assets by segment are as follows:

8. Income Taxes

The Company files U.S. federal income tax returns and various state and local income tax returns. With few exceptions, years prior to 2011 are no longer subject to examination. The Company is under audit in the state of Maryland for the 2010 and 2011 tax years. No other state or federal income tax audits were in process as of September 30, 2014.

9. Subsequent Event

On October 20, 2014, the Company’s Board of Directors declared a dividend of $0.47 per share payable on December 1, 2014, to shareholders of record as of November 5, 2014. The Company expects to pay out approximately $11.3 million excluding the effect of dividend reinvestments.

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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This management’s discussion and analysis includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. When used in this report, the words “anticipate,” “believe,” “estimate,” “expect,” “intend,” “plan” and similar expressions as they relate to Shenandoah Telecommunications Company or its management are intended to identify these forward-looking statements. All statements regarding Shenandoah Telecommunications Company’s expected future financial position and operating results, business strategy, financing plans, forecasted trends relating to the markets in which Shenandoah Telecommunications Company operates and similar matters are forward-looking statements. We cannot assure you that the Company’s expectations expressed or implied in these forward-looking statements will turn out to be correct. The Company’s actual results could be materially different from its expectations because of various factors, including those discussed below and under the caption “Risk Factors” in the Company’s Annual Report on Form 10-K for its fiscal year ended December 31, 2013. The following management’s discussion and analysis should be read in conjunction with the Company’s Annual Report on Form 10-K for its fiscal year ended December 31, 2013, including the financial statements and related notes included therein.

General

Overview. Shenandoah Telecommunications Company is a diversified telecommunications company providing both regulated and unregulated telecommunications services through its wholly-owned subsidiaries. These subsidiaries provide wireless personal communications services (as a Sprint PCS Affiliate), local exchange telephone services, video, internet and data services, long distance, fiber optics facilities, and leased tower facilities. The Company has the following three reportable segments, which it operates and manages as strategic business units organized by lines of business:

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The Wireless segment provides digital wireless service to a portion of a four-state area covering the region from Harrisburg, York and Altoona, Pennsylvania, to Harrisonburg, Virginia, as a Sprint PCS Affiliate. This segment also owns cell site towers built on leased land, and leases space on these towers to both affiliates and non-affiliated service providers.

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The Cable segment provides video, internet and voice services in franchise areas in portions of Virginia, West Virginia and western Maryland, and leases fiber optic facilities throughout its service area. It does not include video, internet and voice services provided to customers in Shenandoah County, Virginia.

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The Wireline segment provides regulated and unregulated voice services, DSL internet access, and long distance access services throughout Shenandoah County and portions of Rockingham, Frederick, Warren and Augusta counties, Virginia. The segment also provides video services in portions of Shenandoah County, and leases fiber optic facilities throughout the northern Shenandoah Valley of Virginia, northern Virginia and adjacent areas along the Interstate 81 corridor through West Virginia, Maryland and portions of Pennsylvania.

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A fourth segment, Other, primarily includes Shenandoah Telecommunications Company, the parent holding company.

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Results of Operations

Three Months Ended September 30, 2014 Compared with the Three Months Ended September 30, 2013

Consolidated Results

The Company’s consolidated results for the third quarters of 2014 and 2013 are summarized as follows:

Operating revenues

For the three months ended September 30, 2014, operating revenues increased $4.8 million, or 6.1%. Wireless segment revenues increased $2.6 million compared to the third quarter of 2013. Net postpaid service revenues increased $1.8 million, driven by 4.8% year-over-year growth in average postpaid subscribers. Other Wireless revenue increased $0.8 million, primarily due to growth in prepaid service revenue and equipment revenue. Cable segment revenue grew $1.9 million. This increase included a $1.2 million growth in cable service revenue as a result of a 6.7% growth in average subscriber counts and an increase in revenue per subscriber. Growth in Cable equipment revenue of $0.6 million resulted primarily from an increase in customer premises equipment rents. Wireline segment revenue increased $0.9 million due primarily to growth in facility lease revenues from new contracts with affiliates and third parties.

Operating expenses

Total operating expenses were $68.1 million in the third quarter of 2014 compared to $64.3 million in the prior year period. Cost of goods and services sold increased $1.6 million, including increases of $1.2 million in PCS handset costs and $0.9 million in cable programming costs. Disposal costs increased $2.0 million, as the company disposed of obsolete equipment that had been taken out of service while upgrading its cable and wireline networks. The increase in disposal costs was offset by reductions in network costs and maintenance expense, driven primarily by an increased percentage of labor capitalized to projects. Selling, general and administrative expenses increased $0.6 million. Depreciation and amortization expense increased $1.7 million, primarily due to completion of the Network Vision and cable network upgrade projects.

Income tax expense

The Company’s effective tax rate decreased from 43.7% for the three months ended September 30, 2013 to 37.4% for the three months ended September 30, 2014. The 2013 period included $0.5 million in unfavorable adjustments resulting from finalizing the estimated effects of restructuring entities during 2012. The 2014 period included $0.2 million in favorable adjustments to estimates made for the 2013 federal and state returns filed in September 2014. The Company anticipates that its effective tax rate, without unanticipated adjustments, will be approximately 39.5%.

Net income

For the three months ended September 30, 2014, net income increased $1.3 million, or 19.1%, primarily reflecting growth in subscriber counts and revenue per subscriber in the Wireless segment, along with a lower effective income tax rate in the current quarter.

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Nine Months Ended September 30, 2014 Compared with the Nine Months Ended September 30, 2013

Consolidated Results

The Company’s consolidated results for the first nine months of 2014 and 2013 are summarized as follows:

Operating revenues

For the nine months ended September 30, 2014, operating revenues increased $13.2 million, or 5.7%. Wireless segment service revenues increased $6.7 million compared to the first nine months of 2013. Net postpaid service revenues increased $4.2 million, driven by 4.5% year-over-year growth in average postpaid subscribers. Net prepaid service revenues grew $2.6 million, or 8.5%, due to 4.6% growth in average prepaid subscribers and higher average revenue per subscriber in 2014 over 2013. Cable segment revenues increased $5.9 million due to a 6.3% increase in average revenue generating units compared to the 2013 period and to a $1.7 million increase in rent revenues for customer premises equipment, due to a change in January 2014 of charging customers separately for their first set top box, which previously had been included in the service fee. Growth in fiber lease revenue contributed $0.4 million to the year-over-year increase of Cable segment revenue. Wireline segment revenue increased $2.0 million, primarily due to growth in facility lease revenues from new contracts with affiliates and third parties.

Operating expenses

Total operating expenses were $198.5 million in the nine months ended September 30, 2014 compared to $188.0 million in the prior year period. Cost of goods and services sold increased $5.0 million, including increases of $2.5 million in PCS handset costs, $1.8 million in video programming costs and $0.9 million in network maintenance costs. Disposal costs increased $1.6 million, as the company disposed of obsolete equipment that had been taken out of service while upgrading the cable and wireline networks. The increase in disposal costs was offset by reductions in network costs, driven primarily by lower backhaul expenses along with an increase in labor capitalized to projects. Selling, general and administrative expenses increased $1.9 million, due to higher personnel costs, partially offset by lower wireless prepaid and bad debt expenses. Depreciation and amortization expense increased $3.7 million, primarily due to completion of the Network Vision and cable network upgrade projects.

Interest and other income (expense), net

Interest expense declined $0.2 million from the prior year period. During the first nine months of 2013, the Company recorded $0.2 million of interest expense charges to reflect changes in the fair value of an interest rate swap not designated as a cash flow hedge. This swap expired in July 2013.

Income tax expense

The Company’s effective tax rate decreased from 40.6% for the nine months ended September 30, 2013 to 38.9% for the nine months ended September 30, 2014. The 2013 period included $0.5 million in unfavorable adjustments from finalizing the estimated effects of restructuring entities during 2012. The 2014 period included $0.2 million in favorable adjustments to estimates made for the 2013 federal and state returns filed in September 2014. The Company anticipates that its effective tax rate should be approximately 39.5%.

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Net income

For the nine months ended September 30, 2014, net income increased $2.3 million, or 10.1%, reflecting growth in subscriber counts and revenue per subscriber in the Wireless segment, partially offset by increases in operating expenses incurred in support of this growth.

Wireless

The Company’s Wireless segment provides digital wireless service to a portion of a four-state area covering the region from Harrisburg, York and Altoona, Pennsylvania, to Harrisonburg, Virginia, through Shenandoah Personal Communications, LLC (“PCS”), a Sprint PCS Affiliate. This segment also leases land on which it builds Company-owned cell towers, which it leases to affiliated and non-affiliated wireless service providers, throughout the same four-state area described above, through Shenandoah Mobile, LLC (“Mobile”).

PCS receives revenues from Sprint for postpaid and prepaid subscribers that obtain service in PCS’s network coverage area. PCS relies on Sprint to provide timely, accurate and complete information to record the appropriate revenue for each financial period. Through July 31, 2013, postpaid revenues received from Sprint were recorded net of certain fees totaling 20% of net postpaid billed revenue retained by Sprint. These fees included an 8% management fee and a 12% net service fee. Effective August 1, 2013, the net service fee increased to 14%, the maximum allowed by the current Sprint Affiliate contract. The management fee remained unchanged at 8%. Sprint also retains a 6% management fee on prepaid revenues.

During 2014, the Company’s PCS stores began participating in Sprint’s handset financing programs, whereby Sprint enters into a financing agreement with the subscriber and the subscriber receives a handset from Sprint. The equipment revenue from the subscriber and the handset expense are Sprint’s responsibility and are not recorded by the Company.

The following tables show selected operating statistics of the Wireless segment as of the dates shown:

1)

POPS refers to the estimated population of a given geographic area and is based on information purchased from third party sources. Market POPS are those within a market area which the Company is authorized to serve under its Sprint PCS affiliate agreements, and Covered POPS are those covered by the Company’s network.

2)

The decrease from December 31, 2013 is primarily a result of termination of Sprint iDEN leases associated with the former Nextel network.

3)

PCS Average Monthly Retail Churn is the average of the monthly subscriber turnover, or churn, calculations for the period.

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Three Months Ended September 30, 2014 Compared with the Three Months Ended September 30, 2013

Operating revenues

Wireless service revenue increased $2.1 million, or 4.5%, for the three months ended September 30, 2014, compared to the comparable 2013 period. Net postpaid service revenues increased $1.8 million, driven by 4.8% year-over-year growth in average postpaid subscribers. As stated above, the net service fee increased from 12% of net billed revenues to 14% on August 1, 2013, reducing net postpaid service revenue by $0.3 million in the three months ended September 30, 2014. Net prepaid service revenues grew $0.3 million due to 5.0% growth in average prepaid subscribers over 2013.

The decrease in tower lease revenue resulted from the termination of Sprint iDEN leases associated with the former Nextel network. Equipment revenue increased due to growth in accessories sales and fewer discounts on handset sales. Other revenue increased, as the prior year period included a $0.3 million unfavorable adjustment to straight-line rent accruals related to the termination of iDEN leases.

Cost of goods and services

Cost of goods and services increased $0.4 million, or 2.0%, in 2014 from the third quarter of 2013. Prepaid handset subsidies increased $0.6 million, as higher cost of handsets was partially offset by a decrease in the volume of upgraded handsets. Postpaid handset costs increased $0.5 million, as higher volume of handset upgrades and tablet sales were largely offset by a reduction in the volume of subsidized handsets. Network costs decreased $0.8 million, due primarily to a $0.5 million decrease in backhaul costs following completion of the Network Vision project. An increase in labor capitalized to projects also contributed to the decrease in network costs.

Selling, general and administrative

Selling, general and administrative costs increased $0.3 million, or 4.0%, in the third quarter of 2014 from the comparable 2013 period. Advertising and commissions expenses increased $0.2 million, or 3.9%.

Depreciation and amortization

Depreciation and amortization increased $1.1 million, or 16.1%, in the third quarter of 2014 over the comparable 2013 period, following completion of Network Vision upgrades.

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Nine Months Ended September 30, 2014 Compared with the Nine Months Ended September 30, 2013

Operating revenues

Wireless service revenue increased $6.7 million, or 4.9%, for the nine months ended September 30, 2014, compared to the 2013 period. Net postpaid service revenues increased $4.2 million, or 3.9%, driven by 4.5% year-over-year growth in average postpaid subscribers. As stated above, the net service fee increased from 12% of net billed revenues to 14% on August 1, 2013, reducing net postpaid service revenue by $2.1 million, approximately $0.3 million per month. Net prepaid service revenues grew $2.6 million, or 8.5%, compared to the nine months ended September 30, 2013. Average prepaid subscribers increased 4.6% in 2014 over 2013, with changes in the mix of subscribers accounting for the remainder of the increase in prepaid service revenues.

The decrease in tower lease revenue resulted from the termination of Sprint iDEN leases associated with the former Nextel network. Equipment revenue increased due to growth in accessories sales and fewer discounts on handset sales. Other revenue increased, as the prior year period included a $0.8 million unfavorable adjustment to straight-line rent accruals related to the termination of iDEN leases.

Cost of goods and services

Cost of goods and services increased $2.1 million, or 3.9%, in 2014 from the first nine months of 2013. Postpaid handset costs increased $2.9 million, driven primarily by higher average cost per handset sold and a higher volume of handset upgrades. Prepaid handset subsidies decreased $0.5 million on lower volume of handsets sold. Network costs decreased $0.1 million, as a decrease in backhaul costs was partially offset by an increase in rent expense associated with the Network Vision project. An increase in labor capitalized to projects also contributed to the decrease in network costs. Maintenance expense grew $0.9 million due to increases in maintenance contracts that support the upgraded wireless network. These increases were largely offset by a one-time $0.4 million gain related to actual disposal costs for the Network Vision project being less than the previously accrued amounts and by $0.4 million lower costs from Sprint to service prepaid customers who take advantage of the “top-up” program.

Selling, general and administrative

Selling, general and administrative costs increased $0.5 million, or 1.9%, in the first nine months of 2014 over the comparable 2013 period primarily due to an increase in advertising and other marketing costs. Acquisition costs related to prepaid customers decreased due to lower volume of upgrades and new activations, but were partially offset by costs to support existing customers.

Depreciation and amortization

Depreciation and amortization increased $2.6 million, 12.4%, in 2014 over the first nine months of 2013, following completion of Network Vision upgrades.

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Cable

The Cable segment provides video, internet and voice services in franchise areas in portions of Virginia, West Virginia and western Maryland, and leases fiber optic facilities throughout its service area. It does not include video, internet and voice services provided to customers in Shenandoah County, Virginia.

1)

Homes and businesses are considered passed (“homes passed”) if we can connect them to our distribution system without further extending the transmission lines. Homes passed is an estimate based upon the best available information.