Executive Overview

The following discussion and analysis should be read in conjunction with Telephone and Data Systems, Inc.’s (“TDS”) interim consolidated financial statements and notes included herein, and with the description of TDS’ business, its audited consolidated financial statements and Management's Discussion and Analysis (“MD&A”) of Financial Condition and Results of Operations included in TDS’ Annual Report on Form 10-K (“Form 10-K”) for the year ended December 31, 2015.  Analysis of TDS’ financial results compares the three and nine months ended September 30, 2016 to the three and nine months ended September 30, 2015.  Calculated amounts and percentages are based on the underlying actual numbers rather than the numbers rounded to millions as presented.

This report contains statements that are not based on historical facts, including the words “believes,” “anticipates,” “intends,” “expects” and similar words.  These statements constitute and represent “forward looking statements” as this term is defined in the Private Securities Litigation Reform Act of 1995.  Such forward looking statements involve known and unknown risks, uncertainties and other factors that may cause actual results, events or developments to be significantly different from any future results, events or developments expressed or implied by such forward looking statements. See Private Securities Litigation Reform Act of 1995 Safe Harbor Cautionary Statement for additional information.

TDS uses certain “non-GAAP financial measures” throughout the MD&A.  A discussion of the reason TDS determines these metrics to be useful and a reconciliation of these measures to their most directly comparable measures determined in accordance with accounting principles generally accepted in the United States of America (“GAAP”) are included in the Supplemental Information Relating to Non-GAAP Financial Measures section within the MD&A of this Form 10-Q Report.

TDS Mission and Strategy

TDS’ mission is to provide outstanding communications services to its customers and meet the needs of its shareholders, its people, and its communities.  In pursuing this mission, TDS seeks to profitably grow its businesses, create opportunities for its associates and employees, and steadily build value over the long-term for its shareholders.  Across all of its businesses, TDS is focused on providing exceptional customer experiences through best-in-class services and products and superior customer service.

TDS’ long-term strategy calls for the majority of its capital to be reinvested in its operating businesses to strengthen their competitive positions, while still returning value to TDS shareholders through the payment of a regular quarterly cash dividend and share repurchases. 

In 2016, TDS is working to build shareholder value by continuing to execute on its strategies to build strong, competitive businesses providing high-quality, data-focused services and products.  Strategic efforts include:

• U.S. Cellular deployed 4G LTE as a result of U.S. Cellular’s strategic initiative to enhance its network.  4G LTE reaches 99% of postpaid connections and 98% of cell sites.  The adoption of data-centric smartphones and connected devices is driving significant growth in data traffic.  At the end of the third quarter of 2016, 77% of postpaid connections had 4G capable devices, with the LTE network handling 90% of data traffic.  U.S. Cellular continues to devote efforts to enhance its network capabilities with the deployment of VoLTE technology and plans a multi-year roll out beginning with one market in early 2017.  VoLTE, when deployed commercially, will enable customers to utilize the LTE network for both voice and data services, and will enable enhanced services such as high definition voice, video calling and simultaneous voice and data sessions.  The deployment of VoLTE also will expand U.S. Cellular’s ability to offer roaming services to additional carriers.
• U.S. Cellular continued to enhance its spectrum position and monetize non-strategic assets by entering into multiple agreements with third parties.  Certain of these agreements involve the purchase of licenses for cash, while others involve the exchange of licenses in non-operating markets for other licenses in operating markets and cash.  As a result of the closing of multiple exchange agreements in the nine months ended September 30, 2016, U.S. Cellular received $15 million of cash and recognized gains of $16 million.  The remaining license purchase and exchange transactions are expected to close in the fourth quarter of 2016, at which point U.S. Cellular expects to recognize additional gains.  See Note 5 — Acquisitions, Divestitures and Exchanges for additional information related to these transactions.
• U.S. Cellular is focused on expanding its solutions available to business and government customers, including a growing suite of machine-to-machine solutions across various categories.  U.S. Cellular will continue to enhance its advanced wireless services and connected solutions for consumer, business and government customers.
• U.S. Cellular is committed to continuous innovation so as to provide customers in the markets it serves with the latest technology that can enhance their lives or businesses.  During the third quarter of 2016, U.S. Cellular successfully tested 5G technology in both indoor and outdoor environments for the first time.  The company plans additional tests geared towards understanding the propagation characteristics of the new technology and contributing to the development of 5G standards.  When deployed commercially, 5G technology is expected to help address customers’ growing demand for data services as well as create opportunities for new services requiring high speed and low latency.

• TDS Telecom’s Wireline business has substantially completed its currently planned deployment of fiber technology in its existing markets to provide internet speeds of up to 1 Gigabit per second (“Gbps”).  In certain non-fiber markets, TDS Telecom offers speeds reaching up to 50 Megabits per second (“Mbps”) using bonded copper lines.  By leveraging its high-speed network, Wireline continues to drive growth in its IPTV, broadband, and managedIP services.
• TDS Telecom’s Cable business has continued to make network capacity investments and offer more advanced services in its markets in line with its strategy to increase connections and grow broadband penetration.
• TDS Telecom’s HMS business is focused on growing recurring service revenues through increased sales of IT solutions including hosted and managed services, colocation services, and cloud computing, and through increasing the utilization of its service delivery platform and data center assets.
  

Terms Used by TDS

All defined terms in this MD&A are used as defined in the Notes to Consolidated Financial Statements, and additional terms are defined below:

• 4G LTE – fourth generation Long-Term Evolution which is a wireless broadband technology.
• 5G – fifth generation wireless broadband technology.
• Account – represents an individual or business financially responsible for one or multiple associated connections. An account may include a variety of types of connections such as handsets and connected devices.
• Auction 97 – An FCC auction of AWS-3 spectrum licenses that ended in January 2015.
• Auctions 1000, 1001, and 1002 –  Auction 1000 is an FCC auction of 600 MHz spectrum licenses being held in 2016 involving: (1) a “reverse auction” in which broadcast television licensees submit bids to voluntarily relinquish spectrum usage rights in exchange for payments (referred to as Auction 1001); (2) a “repacking” of the broadcast television bands in order to free up certain broadcast spectrum for other uses; and (3) a “forward auction” of licenses for spectrum cleared through this process to be used for wireless communications (referred to as Auction 1002).
• Broadband Connections – refers to the number of Wireline customers provided high-capacity data circuits via various technologies, including fiber, DSL and dedicated internet circuit technologies or the Cable billable number of lines into a building for high-speed data services.
• Churn Rate – represents the percentage of the connections that disconnect service each month.  These rates represent the average monthly churn rate for each respective period.
• FCC – Federal Communications Commission.
• Gross Additions – represents the total number of new connections added during the period, without regard to connections that were terminated during that period.
• IPTV Connections – represents the number of Wireline customers provided video services using IP networking technology.
• Machine-to-Machine or M2M – technology that involves the transmission of data between networked devices, as well as the performance of actions by devices without human intervention.  U.S. Cellular sells and supports M2M solutions to customers, provides connectivity for M2M solutions via the U.S. Cellular network, and has partnerships with device manufacturers and software developers which offer M2M solutions.
• ManagedIP Connections – refers to the number of telephone handsets, data lines and IP trunks providing communications using IP networking technology.
• Net Additions – represents the total number of new connections added during the period, net of connections that were terminated during that period.
• Postpaid Average Billings per Account (“Postpaid ABPA”) – non-GAAP metric is calculated by dividing total postpaid service revenues plus equipment installment plan billings by the average number of postpaid accounts and by the number of months in the period.
• Postpaid Average Billings per User (“Postpaid ABPU”) – non-GAAP metric is calculated by dividing total postpaid service revenues plus equipment installment plan billings by the average number of postpaid connections and by the number of months in the period.
• Postpaid Average Revenue per Account (“Postpaid ARPA”) – metric is calculated by dividing total postpaid service revenues by the average number of postpaid accounts and by the number of months in the period.
• Postpaid Average Revenue per User (“Postpaid ARPU”) – metric is calculated by dividing total postpaid service revenues by the average number of postpaid connections and by the number of months in the period.
• Retail Connections – the sum of postpaid connections and prepaid connections.
• Smartphone Penetration – is calculated by dividing postpaid smartphone connections by postpaid handset connections.
• Universal Service Fund (“USF”) – A system of telecommunications collected fees and support payments managed by the FCC intended to promote universal access to telecommunications services in the United States.
• U.S. Cellular Connections - individual lines of service associated with each device activated by a customer.  This includes smartphones, feature phones, tablets, modems, and machine-to-machine devices.
• Video Connections – generally, a home or business receiving video programming counts as one video connection.  In counting bulk residential or commercial connections, such as an apartment building or a hotel, connections are counted based on the number of units/rooms within the building receiving service.
• Voice Connections – refers to the individual circuits connecting a customer to Wireline’s central office facilities or the Cable billable number of lines into a building for voice services.
• VoLTE – Voice over Long-Term Evolution is a technology specification that defines the standards and procedures for delivering voice communications and related services over 4G LTE networks.
• Wireline Residential Revenue per Connection – is calculated by dividing total Wireline residential revenue by the average number of total Wireline residential connections and by the number of months in the period.

Results of Operations — TDS Consolidated

Refer to individual segment discussions in this MD&A for additional details on operating revenues and expenses at the segment level.

Equity in earnings of unconsolidated entities

Equity in earnings of unconsolidated entities represents TDS’ share of net income from entities in which it has a noncontrolling interest and that are accounted for by the equity method.  TDS’ investment in the Los Angeles SMSA Limited Partnership (“LA Partnership”) contributed $17 million and $19 million to Equity in earnings of unconsolidated entities for the three months ended September 30, 2016 and 2015, respectively, and $57 million and $58 million for the nine months ended September 30, 2016 and 2015, respectively.  See Note 7 — Investments in Unconsolidated Entities in the Notes to Consolidated Financial Statements for additional information.

Interest and dividend income

Interest and dividend income increased due to imputed interest income recognized on equipment installment plans of $13 million and $9 million for the three months ended September 30, 2016 and 2015, respectively, and $37 million and $24 million for the nine months ended September 30, 2016 and 2015, respectively.

Interest expense

Interest expense increased due primarily to U.S. Cellular’s issuance of $300 million of 7.25% Senior Notes due 2064 in November 2015 and borrowing of $225 million on U.S. Cellular’s senior term loan facility that was drawn in July 2015.

Income tax expense

TDS’ effective tax rate on Income before income taxes for the three and nine months ended September 30, 2016 was 46.6% and 43.6%, respectively, and for the three and nine months ended September 30, 2015 was 42.1% and 40.3%.  The effective tax rates for the three and nine month periods primarily reflect a normalized combined rate of federal and state taxes, but are also affected by certain discrete items in each period which increase or decrease the effective tax rate for each period.  Because certain discrete items are not annualized, these rates may not be indicative of the annual rate for 2016.

Net income attributable to noncontrolling interests, net of tax

Net income attributable to noncontrolling interests, net of tax includes the noncontrolling public shareholders’ share of U.S. Cellular’s net income and the noncontrolling shareholders’ or partners’ share of certain U.S. Cellular subsidiaries’ net income (loss).  The decrease from 2015 to 2016 for both the three and nine month periods is due to lower income from U.S. Cellular and certain other partnerships in 2016.

Business Overview

U.S. Cellular owns, operates, and invests in wireless markets throughout the United States.  U.S. Cellular is an 83%-owned subsidiary of TDS.  U.S. Cellular’s strategy is to attract and retain wireless customers through a value proposition comprised of a high-quality network, outstanding customer service, and competitive devices, plans, and pricing, all provided with a local focus. 

Operational Overview

Postpaid ARPU and Postpaid ARPA decreased for the three and nine months ended September 30, 2016 due primarily to the impact of the loyalty rewards points program that was discontinued in September 2015, industry-wide price competition, and discounts on shared data plans provided to customers on equipment installment plans and those providing their own device at the time of activation or renewal.  Postpaid ARPU also decreased due to growth in the number of connected devices, which on a per unit basis contribute less revenue than handsets.  These factors were partially offset by the impacts of continued adoption of smartphones and the related increase in service revenues from data usage. 

Equipment installment plans increase equipment sales revenue as customers pay for their wireless devices in installments at a total device price that is generally higher than the device price offered to customers in conjunction with alternative plans that are subject to a service contract.  Equipment installment plans also have the impact of reducing service revenues as many equipment installment plans provide for reduced monthly access charges.  In order to show the trends in total service and equipment revenues received, U.S. Cellular has presented Postpaid ABPU and Postpaid ABPA, which are calculated as Postpaid ARPU and Postpaid ARPA plus average monthly equipment installment plan billings per connection and account, respectively.

Equipment installment plan billings increased for the three and nine months ended September 30, 2016 due to increased adoption of equipment installment plans by postpaid customers.  Postpaid ABPU and ABPA decreased in 2016 as the increase in equipment installment plan billings was more than offset by the decline in Postpaid ARPU and ARPA discussed above.  U.S. Cellular expects the adoption and penetration of equipment installment plans to continue to increase as plan offerings shift more toward equipment installment plans.  Effective in September 2016, new postpaid handset sales to retail consumers are made under equipment installment plans; business and government customers may purchase equipment under either installment plans or alternative plans that are subject to a service contract.

Financial Overview — U.S. Cellular

Key components of changes in the statement of operations line items were as follows:

Total operating revenues

Service revenues decreased for the three and nine months ended September 30, 2016 as a result of (i) a decrease in retail service revenues driven by the $58 million impact of the loyalty rewards program that ended in September 2015; (ii) industry-wide price competition, including discounts on shared data plans provided to customers on equipment installment plans and those providing their own device at the time of activation or renewal; and (iii) reductions in inbound roaming revenues driven by lower roaming rates.  Such reductions were partially offset by an increase in the average connections base and continued adoption of smartphones and shared data plans.

Federal USF revenue was $23 million and $69 million for the three and nine months ended September 30, 2016, respectively, which remained flat when compared to the same periods last year. Pursuant to the FCC's Reform Order (“Reform Order”), U.S. Cellular’s Federal USF support was to be phased down at the rate of 20% per year beginning July 1, 2012. The Phase II Mobility Fund was not operational as of July 2014 and, therefore, as provided by the Reform Order, the phase down was suspended at 60% of the baseline amount. U.S. Cellular will continue to receive USF support at the 60% level until the FCC takes further action. At this time, U.S. Cellular cannot predict the changes that the FCC might make to the USF high cost support program and, accordingly, cannot predict whether such changes will have a material adverse effect on U.S. Cellular’s business, financial condition or results of operations. 

Equipment sales revenues increased for the three months ended September 30, 2016 when compared to the three months ended September 30, 2015 due primarily to a shift in mix to sales under equipment installment plans together with an increase in average revenue per device sold under such plans.  Equipment installment plan sales contributed $192 million and $89 million during the three months ended September 30, 2016 and 2015, respectively. 

Equipment sales revenues increased for the nine months ended September 30, 2016 when compared to the nine months ended September 30, 2015 due to an overall increase in the number of devices sold, and a shift in mix to sales under equipment installment plans together with an increase in average revenue per device sold under such plans.  Equipment installment plan sales contributed $501 million and $226 million during the nine months ended September 30, 2016 and 2015, respectively.  Equipment installment plan connections represented 40% and 23% of total postpaid connections as of September 30, 2016 and 2015, respectively.

System operations expenses

System operations expenses decreased by modest amounts for the three and nine months ended September 30, 2016 when compared to the same periods last year.

U.S. Cellular expects system operations expenses to increase in the future to support the continued growth in cell sites and other network facilities as it continues to add capacity, enhance quality and deploy new technologies as well as to support increases in total customer data usage.  However, these increases are expected to be offset to some extent by cost savings generated by shifting data traffic to the 4G LTE network from the 3G network.

Cost of equipment sold

Cost of equipment sold decreased for the three months ended September 30, 2016 when compared to the three months ended September 30, 2015 as a result of a decrease in the average cost per device sold driven by the lower cost of smartphones and to a lesser extent the lower sales of accessories.  Cost of equipment sold included $200 million and $113 million related to equipment installment plan sales for the three months ended September 30, 2016 and 2015, respectively.  Loss on equipment, defined as Equipment sales revenues less Cost of equipment sold, was $41 million and $114 million for the three months ended September 30, 2016 and 2015.

Cost of equipment sold increased for the nine months ended September 30, 2016 when compared to the nine months ended September 30, 2015 primarily as the result of a 4% increase in devices sold, partially offset by a decrease in the average cost per device sold.  Cost of equipment sold included $534 million and $305 million related to equipment installment plan sales for the nine months ended September 30, 2016 and 2015, respectively.  Loss on equipment was $144 million and $318 million for the nine months ended September 30, 2016 and 2015, respectively.

Selling, general and administrative expenses

Selling, general and administrative expenses decreased by modest amounts for the three and nine months ended September 30, 2016 when compared to the same periods last year.  This decrease was attributable to various expense reductions that were partially offset by a $13 million expense recognized in the three months ended September 30, 2016 as a result of the termination of a naming rights agreement.

Depreciation, amortization, and accretion expenses

The increases in Depreciation, amortization, and accretion expenses for the three and nine months ended September 30, 2016 were mainly driven by the increase in amortization expense related to billing system upgrades.

(Gain) loss on asset disposals, net

The increases in Loss on asset disposals were primarily driven by more disposals of certain network assets during the three and nine months ended September 30, 2016 when compared to the same periods last year.

(Gain) loss on sale of business and other exit costs, net

The net gain for the nine months ended September 30, 2015 was due primarily to a $108 million gain recognized on sale of towers and certain related contracts, assets and liabilities.

(Gain) loss on license sales and exchanges, net

The net gains in 2016 and 2015 were due to gains recognized on license exchange transactions with third parties.  See Note 5 — Acquisitions, Divestitures and Exchanges in the Notes to Consolidated Financial Statements for additional information.  

Business Overview

TDS Telecom operates in three reportable segments: Wireline, Cable and HMS. The overall strategy for the Wireline and Cable businesses is to own the best data pipes in each market in order to capitalize on data growth and the need for higher broadband speeds and leverage that growth by bundling services with video and voice.  In addition, through its HMS business, TDS Telecom provides a wide range of Information Technology (“IT”) services including colocation, dedicated hosting, hosted application management, cloud computing services and the planning, engineering, procurement, installation, sales and management of  IT infrastructure hardware solutions.

Financial Overview — TDS Telecom