| NORTH PITTSBURGH SYSTEMS INC Item 1A Risk Factors A number of factors, which affect our future prospects, are important to an overall understanding of our Company and business |
| The following items are particularly noteworthy, although we do not represent that the list captures every possible existing or foreseeable factor or risk |
| The communications industry is becoming increasingly competitive, and this competition has resulted and most likely will continue to result in pricing pressures on our service offerings |
| As discussed in more detail in the preceding Competitive Environment section, the markets in which we operate are growing increasingly competitive |
| We still maintain a level of protection in our ILEC territory against intra-modal competition, and currently no non-facilities based CLECs are operating in our territory |
| Over the past several years, though, we have faced a high level of inter-modal competition from wireless carriers |
| Although historically existing more as a competitor in the toll market, wireless carriers are now competing more aggressively against our secondary and even primary lines |
| In addition, we have recently seen competition intensify in our ILEC market as the two cable companies that overlap the majority of our incumbent market have recently launched and are heavily promoting their telecommunications offerings |
| The toll market has continued to be extremely competitive and we would expect this trend to continue into the foreseeable future, especially driven by the unlimited calling packages promoted by the wireless, cable and independent VoIP competitors |
| The broadband market is also very competitive, with cable companies having offerings which compete very aggressively with our DSL and higher broadband circuits |
| Wireless carriers are also continuing to upgrade their networks and have begun to offer broadband products that compete with our DSL product |
| Many of our competitors are major communications companies that have more extensive resources |
| We compete in our various markets with telephone companies such as Verizon, Sprint and other national CLECs, cable companies that include Comcast and Armstrong, and all the major wireless and interexchange carriers |
| All of these companies have substantially greater financial and marketing resources as well as greater name recognition than the Company |
| In addition, given their financial resources and scale, these companies may be able to devote more capital to newer technologies and/or use their cost advantages to reduce prices for an extended period of time |
| We are subject to a complex and uncertain regulatory environment |
| The amounts that we charge for most of our services are subject to regulatory oversight at both the federal and state levels |
| Our business plans are also greatly affected by complex (and highly litigated) laws and regulations pertaining to competitive requirements in the markets in which we operate, such as regulatory barriers to entry in our ILEC territory and rules relating to both the availability and pricing of leased network elements in our edge-out territories |
| We expect that the competitive barriers to entry in our ILEC territory will continue to be reduced |
| With regard to the network elements that we utilize in our edge-out territories, any material negative changes in the availability or pricing of such network elements could have a material impact on our financial condition and future business plans |
| Approximately 29prca of our revenues for the year ended December 31, 2005 came from charges paid to us from other carriers for services which we performed in originating and terminating toll and local traffic (access revenues) and from proceeds which we received from universal service funds |
| Our access rates are subject to regulation and reviews at both the federal and state levels |
| There are currently a number of formal and informal proceedings reviewing both the current access compensation structure and also the current rules regarding the contribution methodology and eligibility requirements of the universal service funds |
| One of the proposals being developed by some of the larger companies in the communications industry, which would seek a migration to a 7 ______________________________________________________________________ [36]Table of Contents bill and keep intercarrier compensation mechanism, could have a material negative impact on our financial results and condition if adequate carve-outs are not made for rural carriers to support the high cost of providing services in rural communities |
| In addition, any substantive modifications to the availability of, or ability to recover costs from, federal and state universal service funds could have a material negative impact on our financial results and condition |
| As a result of the expansion of our customer base in our CLEC edge-out markets, the increases experienced in broadband revenues, and several revenue neutral rate rebalancings that our ILEC has made in the past two years (which rebalancings have increased end-user charges while decreasing access rates), the percentage of our consolidated revenues which we receive from the above-mentioned access charges and universal service funds (29prca for 2005) has decreased from 31prca and 35prca of our consolidated revenues for 2004 and 2003, respectively |
| Although our exposure to these revenue sources has declined over the past several years, those revenue sources still constitute a material percentage of our overall revenues and operating margins |
| In addition, newer technologies, such as VoIP, have been introduced since the passage of the 1996 Act |
| Many of these new technologies do not readily fit into the legacy telecommunications regulatory framework and are causing regulators at both the federal and state levels to reconsider many of the basic assumptions in regard to public policy and regulation of the telecommunications industry |
| The FCC has issued a Notice of Proposed Rulemaking proceeding to examine the regulatory treatment of VoIP In the interim, the FCC and individual states have been ruling on narrow issues concerning VoIP and other access issues on a case-by-case basis |
| No comprehensive regulatory framework has yet been established |
| The FCC’s final rules, or an extended period of regulatory uncertainty during which carriers might refuse to pay portions of their applicable access charges, might detrimentally affect our future access revenues |
| While it is currently advantageous for our North Pittsburgh subsidiary to be an average schedule company, its interstate revenues and earnings are subject to more volatility than those of comparable cost companies |
| North Pittsburgh participates in the interstate tariff and settlement pooling process that is administered by the National Exchange Carrier Association (NECA) as an average schedule company, which means North Pittsburgh’s interstate settlements are determined by formulas based on a statistical sampling of the costs and service demand quantities of comparable companies that perform cost studies |
| On December 29, 2005, NECA filed with the FCC proposed modifications of average schedule formulas |
| In that filing, NECA proposed to revise the formulas for average schedule interstate settlement disbursements for interstate access services provided during the period beginning July 1, 2006 through June 30, 2007 |
| In this filing, NECA not only proposed changes to the average schedule formulas based on the normal projected changes in cost and demand for the July 1, 2006 through June 30, 2007 period but also proposed some structural changes to the formulas in order to more closely align average schedule company settlements to the companies estimated interstate revenue requirements based on statistical sampling |
| In its filing, NECA estimated that settlement rates for all average schedule companies would decrease overall by about 1dtta7 percent, assuming constant demand; however, the individual impact on an average schedule company depends on its size and demand characteristics |
| As a result, some companies with larger study areas, such as North Pittsburgh, would see a significant decrease in settlements, while many smaller study areas would see increases, if the proposals are implemented |
| The proposed formulas also reflect the trend of reduced access minutes |
| Due to the significant decrease in interstate settlements that would be experienced by some companies, the NECA filing also recommended that the FCC consider implementing a two-year phase in of the reduction in settlements resulting from the proposed structural changes in the formulas |
| The filing included a detailed procedure on how that phase in might be accomplished |
| 8 ______________________________________________________________________ [37]Table of Contents As a relatively large average schedule company, North Pittsburgh would be affected by the proposed reduction in settlements if the FCC approves the proposed revised formulas |
| North Pittsburgh estimates that the proposed formulas would cause a reduction of approximately dlra190 per month in its interstate settlements (based on demand data for the month of December 2005) |
| The estimated dlra190 per month reduction consists of two elements, an approximate dlra50 per month decrease related to the normal changes in the year-over-year overall average schedules formulas and an approximate dlra140 per month decrease related to the proposed structural changes to the formulas |
| The dlra50 per month decrease that pertains to the normal changes in the formulas would result in an immediate decrease in settlement revenues effective July 1, 2006 |
| If the FCC implements the recommended two-year phase in of the reduction in settlements proposed in the NECA filing, the dlra140 per month decrease related to the proposed structural changes would not all be recognized immediately, but rather the reduction would be phased in ratably over a twenty-four month period of time |
| It is uncertain at this time whether the FCC will approve or modify the NECA proposed average schedule formulas and the phase in |
| We continue to monitor whether or not it is advantageous for North Pittsburgh to participate in the NECA pool as an average schedule company or, alternatively, to be a cost company subject to its own individual cost and demand data studies |
| It is important to note, though, that as an average schedule company, North Pittsburgh’s interstate revenues and earnings can be subject to more volatility than those of comparable cost companies due to the lack of an exact relationship between the cost structure and demand data of an average schedule company such as North Pittsburgh and its ultimate settlement pursuant to average schedules |
| Our ability to grow will require investments in markets and products that may not achieve our desired returns |
| With the increased competition in our existing markets and pressures on profit margins, we may have to invest in markets and products that most likely will not generate the margins we have traditionally experienced in our core access line business in our ILEC territory |
| Access lines in our edge-out markets carry lower margins, mainly due to pricing discounts we offer from the incumbent’s rates, incremental costs we incur to lease some of the facilities we use and overall lower access rates that we charge to carriers using our network |
| In addition, some of the products which we have deployed over the last several years, such as DSL, have been introduced into already competitive environments that have lower overall margins than our traditional ILEC access lines |
| Some of these products, although producing a new source of revenue, have had detrimental impacts on other existing revenue streams (such as second lines which can be rendered redundant by DSL) |
| Although we believe that we can continue to penetrate our current edge-out markets (which mostly encompass Pittsburgh and its surrounding communities), potential expansion into other markets, which may be needed to grow revenues, will most likely carry greater risk because our brand recognition will not be as strong and our network efficiencies may not be as great as we are currently experiencing in our existing edge-out markets |
| A lack of parity between us and our competitors concerning regulatory fees and assessments as well as taxation laws could adversely impact our ability to profitably compete |
| The telecommunications industry is one of the most heavily taxed in our country |
| When telephone companies were monopolies in the past, both federal and state agencies used telephone companies to impose onto individuals and businesses a multitude of taxes and regulatory assessments, including, but not limited to, federal excise taxes, gross receipts taxes, 911 recovery fees, universal service assessments, Pennsylvania relay service charges and state and local sales taxes (where applicable) |
| Typically, such assessments and taxes can constitute 10prca to 20prca of the gross amount of a telephone bill, dependent upon the types of services purchased |
| We recognize no margin on these fees and taxes but rather serve as the pass through entity responsible for charging and collecting the fees and taxes from our end-user customers and remitting the monies collected to the taxing and regulatory authorities |
| As inter-modal competition continues to develop, companies which do not meet the traditional definitions of telecommunications carriers and/or offer services which do not neatly fit into the outdated definitions of such terms as communication services (that is, for example, a service that may instead be deemed an informational service) have claimed and may continue to claim that they are not subject to some or all of the above-mentioned taxes and assessments |
| Unless regulators and taxing authorities change or clarify their 9 ______________________________________________________________________ [38]Table of Contents rules and regulations to include such companies and services as being subject to such taxes and assessments or deregulate and exclude us from being subject to such taxes and assessments, the lack of parity could adversely impact our ability to effectively compete on price |