**UNITED STATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

## **FORM 10-K**

 

**ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE**

**SECURITIESEXCHANGE ACT OF 1934**

 

**For thefiscal year ended December 31, 2005**

 

**CommissionFile Number: 001-13891**

 

**HECTORCOMMUNICATIONS CORPORATION**

 

| **Minnesota**                                                    | ** ** | **41-1666660**                         |
|------------------------------------------------------------------|------------|----------------------------------------|
| (State or other  jurisdiction  of incorporation or organization) |       | (Federal Employer  Identification No.) |

 

**211 SouthMain Street**

**P.O. Box428**

**Hector, MN 55342**

(Address ofprincipal executive offices and zip code)

 

Registrant’stelephone number, including area code:**(320) 848-6611**

 

Securitiesregistered pursuant to Section 12(b) of the Act:

 
| **Title of each class** | ** ** | **Name of each exchange on which registered** |
|----------------------------------------|------------|-----------------------------------------------------------------------------|
| **Common Stock, $.01 par value**       | ** ** | **American Stock Exchange**                                                 |

 

**Securitiesregistered pursuant to Section 12(g) of the Act: None**

 

Indicate by checkmark if the registrant is a well-known seasoned issuer, as defined in Rule 405of the Securities Act Yes o   No  ý

 

Indicate by checkmark if the registrant is not required to file reports pursuant to Section 13or Section 15(d) of the Act Yes o   No  ý

 

Indicate by checkmark whether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months and (2) has been subject to such filing requirements for the past 90days Yes ý   Noo

 

Indicate by acheck mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to the bestof registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or any amendment tothis Form 10-K. o

 

Indicate by acheck mark whether the registrant is a large accelerated filer, an acceleratedfiler, or a non-accelerated filer. See the definition of  “accelerated filer” and “large acceleratedfiler” in Rule 12b-2 of the Exchange Act.

(Check one): LargeAccelerated Filer o   AcceleratedFiler o   Non-accelerated Filer ý

 

Indicated by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of theAct).  Yes o   No ý

 

The aggregatemarket value of the voting and nonvoting common equity held by non-affiliatesof the Registrant (shareholders other than officers and directors) wasapproximately $72,349,000 based upon the closing sale price of the Company’scommon stock on the American Stock Exchange on June 30, 2005.

 

As of March 15,2006 there were outstanding 4,037,200 shares of the Registrant’s common stock.

 

Documents Incorporated by Reference: Portions of the Company’sdefinitive proxy statement for its Annual Meeting of Shareholders to be held onMay 25, 2006 are incorporated by reference into Part III of this Form 10-K.

 

 

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**TABLEOF CONTENTS**

 
| **Item**     |                                                                                             | ** ** | ** ** |
|--------------|--------------------------------------------------------------------------------------------------|------------|------------|
| **PART I**   |
|         |                                                                                             |       |
| 1.           | Business                                                                                         |       |
| 1A.          | Risk Factors                                                                                     |       |
| 1B.          | Unresolved Staff Comments                                                                        |       |
| 2.           | Properties                                                                                       |       |
| 3.           | Legal Proceedings                                                                                |       |
| 4.           | Submission of Matters to a  Vote of Security Holders                                             |       |
|         |                                                                                             |       |
| **PART II**  |
|         |                                                                                             |       |
| 5.           | Market for Company’s Common  Equity and Related Stockholder Matters                         |       |
| 6.           | Selected Financial Data                                                                          |       |
| 7.           | Management’s Discussion and  Analysis of Financial Condition and Results of Operations      |       |
| 7A           | Quantitative  and Qualitative Disclosures About Market Risk                                      |       |
| 8.           | Financial  Statements and Supplementary Data                                                     |       |
| 9.           | Changes in  and Disagreements with Accountants on Accounting and Financial Disclosure            |       |
| 9A           | Controls and  Procedures                                                                         |       |
| 9B           | Other Information                                                                                |       |
|         |                                                                                             |       |
| **PART III** |
|         |                                                                                             |       |
| 10.          | Directors  and Executive Officers of the Registrant                                              |       |
| 11.          | Executive  Compensation                                                                          |       |
| 12.          | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters |       |
| 13.          | Certain  Relationships and Related Transactions                                                  |       |
| 14.          | Principal  Accountant Fees and Services                                                          |       |
|         |                                                                                             |       |
| **PART IV**  |
|         |                                                                                             |       |
| 15.          | Exhibits and  Financial Statement Schedules                                                      |       |

 

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**PART I.**

 

**CAUTIONARY STATEMENT**

 

The Private SecuritiesLitigation Reform Act of 1995 contains certain safe harbor provisions regardingforward-looking statements. This 2005 Annual Report on Form 10-K, otherdocuments filed by Hector Communications Corporation (“Hector” or the “Company,”)under the federal securities laws and public disclosures by means of pressrelease or otherwise may include forward-looking statements. These statementsmay include, without limitation, statements with respect to anticipated futureoperating and financial performance, growth opportunities and growth rates,acquisition and divestiture opportunities, business strategies, business andcompetitive outlook and other similar forecasts and statements of expectation.Words such as expects, anticipates, intends, plans, believes, seeks, estimatesand should, and variations of these words and similar expressions, are intendedto identify these forward-looking statements. Such forward-looking statementsare subject to risks and uncertainties (some of which are presented under Item1A, “Risk Factors” herein) that could cause Hector’s actual results to differmaterially from such statements.

 

Due to the uncertaintieslisted and the fact that any forward-looking statements made by Hector and itsmanagement are based on estimates, projections, beliefs and assumptions ofmanagement, they are not guarantees of future performance. Except as requiredby law, Hector disclaims any obligation to update or revise any forward-lookingstatements based on the occurrence of future events, the receipt of newinformation, or otherwise.

 

**ITEM 1. BUSINESS**

 

**[a]****                      GENERALDEVELOPMENT OF BUSINESS**

 

Hector CommunicationsCorporation is a telecommunications holding company, which, through itswholly-owned subsidiaries, primarily provides local telephone, cable televisionand Internet access services. The Company also participates in the ownership ofother companies providing wireless telephone and other telecommunicationsrelated services.

 

Hector, directly andthrough its 100% owned subsidiary, Alliance Telecommunications Corporation (“Alliance”)owns and operates nine local exchange company subsidiaries (generally referredto as “local exchange carriers” or “LECs”) which served 29,407 access lines in28 rural communities in Minnesota, Wisconsin and North Dakota at December 31,2005.  Hector, through its wholly-ownedsubsidiaries, also provides cable television service or video service to 7,923subscribers in Minnesota.

 

Prior to July 7, 2003Alliance was 68% owned by Hector. Golden West Telecommunications Cooperative,Inc. (“Golden West”) of Wall, South Dakota and Alliance CommunicationsCooperative, Inc. (“ACCI”) of Garretson, South Dakota owned the remaininginterests in Alliance. Effective July 7, 2003 Alliance was reorganized underSection 355 of the Internal Revenue Code (“the Split-Up Transactions’).  In the Split-Up Transactions, Golden Westexchanged its minority ownership interest in Alliance for all of theoutstanding stock of Sioux Valley Telephone Company, which included a pro ratashare of Alliance’s ownership interest in Midwest Wireless Holdings, LLC andcertain other Alliance assets. ACCI exchanged its minority ownership interestin Alliance for all of the outstanding stock of Hills Telephone Company, whichincluded a pro rata share of Alliance’s ownership interest in Midwest WirelessHoldings, LLC and certain other Alliance assets. Hector became the 100% ownerof all remaining Alliance assets and operations. (See “Split-up of AllianceTelecommunications Corporation” in Item 7.) The disclosures in this report related to periods prior to July 7, 2003have been restated to reflect the Company’s continuing operations.

 

The Company maintains a website at www.hectorcom.com.  Our Annual Reports on Form 10-K, ourQuarterly Reports on Form 10-Q and our periodic reports on Form 8-K (and anyamendments to these reports) are available free of charge by linking from ourwebsite to the Securities & Exchange Commission’s website.

 

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**[b]****                      FINANCIALINFORMATION ABOUT INDUSTRY SEGMENTS**

 

The Company’ssegment information is presented for two segments, POTS and OtherServices.  The majority of the Company’soperations consist of providing basic telephone services (often referred to as “plainold telephone service” or “POTS”) to residential and business customers withinits service territories.  POTS revenuesconsist mainly of fees for local service which are billed directly to customersand access revenues which are received for intrastate and interstate exchangeservices provided to long distance carriers. POTS revenues are subject to regulation by a number of state and federalgovernment agencies.

 

The Company alsoprovides a number of nonregulated telecommunications services tocustomers.  These Other Services includecable television or video service, Internet access services, lease of fiberoptic transport facilities, billing and collection services to long distancecarriers, telephone directory services and equipment rental.  The Company also makes retail sales ofconsumer telecommunications equipment and sells wireless telephone services ona commission basis.

 

Information regardingsegment operations is provided in Note 13 to the financial statements foundunder Item 8 of this report.

 

** [c]****                   NARRATIVEDESCRIPTION OF BUSINESS**

 

The Companyderives the majority of its revenues from providing basic telephone services(often referred to as “plain old telephone service” or “POTS”) to residentialand business customers within its service territories.  POTS revenues consist mainly of fees forlocal service which are billed directly to customers and access revenues whichare received for intrastate and interstate exchange services provided to longdistance carriers.  POTS revenues aresubject to regulation by a number of state and federal government agencies.

 

The Company alsoearns revenues by providing a number of nonregulated telecommunicationsservices to customers.  These servicesinclude cable television or video service, internet access services, lease offiber optic transport facilities, billing and collection services to longdistance carriers, telephone directory services, engineering services and equipmentrental.  The Company also makes retailsales of consumer telecommunications equipment and sells wireless telephoneservices on a commission basis.

 

The followingtable presents the percentage of revenues derived from local service revenues,access revenues, nonregulated telecommunications activities and cabletelevision operations for the last three years:

 
| ** **                   | ** ** | **Year Ended December 31** | ** ** |
|------------------------------|------------|----------------------------|------------|
| ** **                   | ** ** | **2005**                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Local network                |       | 18.8                       | %          | 19.7 | % | 18.9 | % |
| Network access               |       | 49.1                       |       | 48.5 |   | 49.7 |   |
| Video services               |       | 9.8                        |       | 10.5 |   | 11.1 |   |
| Internet  services           |       | 11.8                       |       | 10.0 |   | 8.2 |   |
| Other  nonregulated services |       | 10.5                       |       | 11.3 |   | 12.1 |   |
|                         |       | 100.0                      | %          | 100.0 | % | 100.0 | % |

 

The Company alsoowns minority interests in joint ventures, partnerships and limited liabilitycorporations (“LLCs”) that provide a wide variety of telecommunicationsservices, including wireless telephone services, fiber-optic transport servicesand directory services.  The Company’smost significant minority ownership position is its 8% interest in MidwestWireless Holdings LLC.

 

**(1)****                     PlainOld Telephone Service (“POTS”)**

 

# Local Network

 

The Company’s LECsubsidiaries provide basic local telephone services to residential and businesscustomers in Minnesota, Wisconsin and North Dakota. Local service revenues areearned by providing customers with local service to connecting points withinthe local exchange boundaries and, in certain cases, to nearby local exchangesunder extended area service (“EAS”) plans that eliminate long distance chargesto the neighboring exchanges.

 

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Monthly rates fortelephone service differ among the LECs depending upon the cost of providingservice, the type and grade of service, the number of customers and callingpatterns within the toll free calling area and other factors. An “access line”is a single or multi-party circuit between the customer’s establishment and thecentral switching office.  The followingchart presents the number of access lines served by the Company’s LECsubsidiaries at December 31, 2005, 2004 and 2003:

 
| ** **                            | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Arrowhead  Communications Corporation |       | 776      |       | 787      |       | 804      |       |
| Eagle Valley  Telephone Company       |       | 692      |       | 715      |       | 719      |       |
| Granada  Telephone Company            |       | 271      |       | 284      |       | 287      |       |
| Pine Island  Telephone Company        |       | 3,256    |       | 3,303    |       | 3,339    |       |
| Indianhead  Telephone Company         |       | 2,337    |       | 2,376    |       | 2,383    |       |
| Loretel Systems,  Inc.                |       | 13,126   |       | 12,993   |       | 13,253   |       |
| Sleepy Eye  Telephone Company         |       | 6,236    |       | 6,366    |       | 6,298    |       |
| Felton Telephone  Company             |       | 704      |       | 717      |       | 732      |       |
| Hager TeleCom,  Inc.                  |       | 2,009    |       | 2,033    |       | 2,067    |       |
|                                  |       |     |       |     |       |     |       |
| Total Access  Lines                   |       | 29,407   |       | 29,574   |       | 29,882   |       |

 

The Company’s LECsubsidiaries offer their customers a number of enhanced custom calling featuresincluding call waiting, caller identification and voice mail.  Charges for custom calling services aregenerally billed monthly together with the customers’ local service bill.

 

The Company maintains alocal presence in each of its LEC subsidiaries. The Company provides its LEC subsidiaries with various services,including finance, accounting and treasury services, marketing, customerservice, purchasing, engineering and construction, customer billing, rateadministration, credit and collection, and development of administrative andprocedural practices.

 

# Access Revenues

 

Access revenuesare received by LECs for intrastate and interstate exchange services providedto long distance carriers (generally referred to as interexchange carriers or “IXCs”).These services enable IXCs to provide long distance service to end users in thelocal exchange network.

 

Access revenuesare determined, in the case of interstate calls, according to rules promulgatedby the Federal Communications Commission (“FCC”) and administered by theNational Exchange Carriers Association (“NECA”).  In the case of intrastate calls, accessrevenues are determined by state regulatory agencies.  A portion of the Company’s interstate accessrevenue is derived from subscriber line charges (“SLCs”) determined by the FCCand billed directly to end users for access to long distance carriers. Anotherportion, administered by the Universal Service Administrative Company (“USAC”)is universal service funds received based upon the cost of providing service tothe local network or “loop”.  The balanceof the interstate access revenue is received from NECA, which collects paymentsfrom IXCs and distributes settlement payments to LECs and distributesinterstate common line and local switching support funds (“high cost support”).In 2005, 16% of the Company’s access revenues were received from SLCs, 11% werefrom the universal service fund, 23% from IXCs, 22% from high cost supportfunds, and 28% were from intrastate sources.

 

Settlement payments arebased on a number of factors, including the cost of providing service and theamount of time the local network is utilized to provide long distanceservices.  Through the 1980s and 1990s avariety of factors, including increased subscriber counts, cultural andtechnological changes, and rate reductions by IXCs, resulted in a consistentpattern of increasing use of the nation’s telephone network.  This growth produced higher revenues for NECAand increased settlements for its participating LECs.  The 2000s have seen a leveling of thispattern as access minutes billed to IXCs have declined and wireless access minutes(which are billed at significantly lower rates than minutes billed to the IXCs)have increased.

 

Intrastate accessrevenues are received from long distance carriers based on recorded customerusage multiplied by the appropriate tariff rate.         Where applicable, Hector’s LECs participate inintrastate access tariffs approved by state regulatory authorities forintrastate intra-LATA (Local Access Transport Area) and inter-LATA services.

 

5

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These intrastate arrangementsare intended to compensate LECs for the costs, including a fair rate of return,of facilities provided in originating and terminating intrastate long distanceservices.

 

**(2)****                     NonregulatedTelecommunications Activities**

 

Video services

 

The Company, through itscable television and LEC subsidiaries, provide cable television services to7,923 subscribers in Minnesota. Video service revenues are derived almostexclusively from monthly fees for basic and premium programming.  Fees for basic services range from $22.95 to$52.49 per month.  Basic service caninclude the major television networks, non-network independent stations, sportsprogramming, news services and automated information channels, children’sprogramming, access channels for public, governmental, educational and leaseduse, senior citizens’ and religious programming and CD-quality musicchannels.  Premium programming services,such as the HBO or Showtime movie services, are provided to subscribers oneither an individual channel basis or in packages for additional fees rangingfrom of $1.75 to $29.95 per month per channel. Premium programming is obtainedfrom suppliers for a flat monthly fee per subscriber and/or a fee based on themonthly charge to subscribers for the service.

 

Internet

 

Revenues from internetservices were $3,832,000, $3,150,000 and $2,647,000 in 2005, 2004 and 2003,respectively.  Internet access isavailable, through local dial-up telephone numbers, to all of the Company’slocal service customers. Digital subscriber lines (“DSL”) permit high-speedInternet access and are available in all the Company’s service areas although,due to technological issues, access to the service is restricted for somecustomers.  The Company provided dial-upinternet services to 6,070, 6,679 and 7,464 customers at December 31, 2005,2004 and 2003 respectively.  The Companyprovided DSL services to 5,129, 3,881 and 2,778 customers at December 31, 2005,2004 and 2003, respectively.

 

Triple-Play

 

The Company has deployedbroadband equipment manufactured by Next Level Communications, Inc. in itsexchanges serving Pine Island, MN, Goodhue, MN, Mazeppa, MN and Sleepy Eye,MN.  This equipment makes it possible todeliver a “Triple-Play” (POTS, video and high speed Internet) of services tothe customer over the same circuit. Video programming is delivered utilizing adigital “super headend” owned by Broadband Visions, LLC, which is 17% owned bythe Company.  These services are offeredto customers in a variety of packages at a discount compared to what they mightpay for the same services individually. The Company believes the Triple-Playpackages increase the sales penetration of services to customers and reducecustomer churn. 52% of the Company’s DSL subscribers are in exchanges whereTriple-Play services are offered.  TheCompany is planning to install broadband equipment in additional exchanges infuture years.  The Company’s broadbandproduct offerings are dependent on the availability of equipment maintenanceand product support from Next Level Communications, Inc.  If the Company cannot obtain necessarysupport it could have a material adverse affect on its broadband operations.

 

Other services

 

Hector’s LECsprovide fiber optic transport facilities, sell and lease customer premisetelephone equipment, provide inside wiring services and sell and lease otherfacilities for private line, teletype, data transmission and othercommunications services. All of the fiber-optic facilities leased are owned byHector’s LEC subsidiaries and are located almost entirely within the LEC’slocal exchange boundaries.  The LECs alsoprovide billing and collection services for certain IXCs in lieu of such IXCsdirectly billing customers within the LEC’s service areas.  Prior to July 2004 the Company operated anengineering services company.  The assetsof that company were sold in July 2004.

 

6

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Hector’s revenues fromother nonregulated services were as follows:

 
| ** **                                  | ** ** | **2005** | ** ** | **2004** | ** ** | **2003**  | ** ** |
|---------------------------------------------|------------|----------|------------|----------|------------|-----------|------------|
| Fiber leases                                |       | $        | 664,860    |     | $          | 657,022   |       | $ | 682,521 |   |
| Directory                                   |       | 536,230  |       | 529,796  |       | 491,902   |       |
| Billing and  collection                     |       | 137,342  |       | 169,378  |       | 212,622   |       |
| Retail sales                                |       | 412,203  |       | 469,609  |       | 522,269   |       |
| Cellular sales  commissions                 |       | 377,289  |       | 495,704  |       | 316,337   |       |
| Long distance  service sales commissions    |       | 477,885  |       | 382,936  |       | 381,825   |       |
| Equipment rent                              |       | 114,618  |       | 126,130  |       | 118,292   |       |
| Customer  equipment installation and repair |       | 371,704  |       | 379,755  |       | 434,435   |       |
| Engineering fees                            |       |     |       | 70,378   |       | 305,423   |       |
| Other                                       |       | 315,040  |       | 289,963  |       | 437,381   |       |
|                                        |       | $        | 3,407,171  |     | $          | 3,570,671 |       | $ | 3,903,007 |   |

 

**(3)****                     UnconsolidatedAffiliates and Investments**

 

# Midwest Wireless HoldingsLLC

 

Midwest Wireless HoldingsLLC (“Midwest Wireless”) provides wireless telecommunications services to441,000 customers in fourteen rural service areas and one metropolitan servicearea in Minnesota, Wisconsin and Iowa. Population of the service areas is approximately 1,910,000.  Midwest Wireless offers a complete package ofservices, including custom calling features, facsimile and data transmission.

 

Midwest Wireless is ownedby telecommunications companies (principally LECs) located within MidwestWireless’ operating footprint in southern Minnesota, northern Iowa and westcentral Wisconsin.  Hector is presentlythe third largest member of Midwest Wireless Holdings LLC, with an 8.0%ownership stake. Hector actively participates in Midwest Wireless’ operationsand has had a seat on the Board of Directors since the inception of theCompany.  Hector accounts for itsinvestment in Midwest Wireless using the equity method.  Income recognized was $4,682,000, $2,766,000and $2,148,000 in 2005, 2004 and 2003, respectively.

 

On November 17, 2005Midwest Wireless and Alltel Corporation (“Alltel”) entered into a definitiveagreement for Alltel to purchase Midwest Wireless.  Compensation paid by Alltel would total $1.075billion, including payments to Midwest Wireless shareholders, payments tominority interest holders in certain Midwest properties and assumption ofMidwest Wireless’ outstanding debt.  TheCompany estimates its pretax share of the proceeds will be $64,900,000.  U.S. Cellular Corporation has initiatedproceedings at the FCC and in Delaware State court contesting the definitiveagreement.  Midwest Wireless expects toclose the transaction in 2006, subject to settlement of U.S. Cellular’s claims,satisfaction of customary conditions and receipt of regulatory approvals.

 

# Fiber-Optic Transport Investments

 

TheCompany is an investor in three companies that build and lease fiber-optictransport facilities.  These facilitiesafford high-quality, high-capacity communications links and generally are usedto carry long-distance traffic.  Fiberroutes owned by these companies serve the major telecommunications markets inMinnesota, Wisconsin, North Dakota and South Dakota including Minneapolis–St.Paul, Milwaukee, Madison, Duluth-Superior, Sioux Falls, Fargo-Moorhead,Rochester, St. Cloud and Grand Forks.

 

# Other Investments 

 

The Company is aninvestor in 702 Communications, a competitive local exchange carrier (“CLEC”)providing telecommunications services in the Fargo-Moorhead area, Wahpeton, NDand Breckenridge MN.  The Company is alsoan investor in Desktop Media, Inc., a CLEC using a network employing ethernetarchitecture to provide telecommunications services in southeasternMinnesota.   The Company is an investorin Independent Pinnacle Services, LLC, a telephone directory publishing companythat provides directory services to over 150 telephone companies in 15 states.   The Company is also an investor in BroadbandVisions LLC which delivers high quality digital television signals to itsmembers/customers via a super headend located in Hutchinson, MN.

 

7

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**(4)****                     OtherInvestments**

 

# Bank Stocks

 

As part of its borrowing agreements, the Company hasstock investments in CoBank ACB, the Rural Telephone Finance Cooperative andthe Rural Telephone Bank (“RTB”). In 2005, the Board of Directors of the RTBapproved resolutions to liquidate the bank and redeem its stock.  Congress removed legal restrictions on theredemption of RTB stock in 2005.  It isexpected the RTB will be dissolved in 2006 and outstanding RTB stock will beredeemed at par value.  At December 31,2005 the par value of the Company’s RTB stock is $11,610,000 and the carryingvalue is $1,269,000.

 

As a condition of maintaining the its loan fromCoBank, the Company owns stock in the bank. The Company’s investment in CoBank stock was $2,739,000 and $2,768,000at December 31, 2005 and 2004 respectively.

 

# Onvoy, Inc.

 

Onvoy,Inc. is a privately held company that provides integrated voice, data, andnetwork services through its fiber optic communications network linkingcommunities throughout Minnesota, including all major metropolitan areas.  Onvoy, Inc. is a provider of Internet, longdistance, video-conferencing and high-speed data networking services.  Onvoy’s customers include Minnesota basedFortune 500 companies and many small-to-medium sized businesses. Onvoy alsoserves the state’s higher education institutions, the state’s K-12 schools,public libraries, state and county governments, more than 70 regional Internetservice providers and the state’s independent local telephone companies. TheCompany’s investment in Onvoy debt totaled $247,000 and $672,000 at December 31,2005 and 2004 respectively.

 

# Other long-term investments

 

The Company has a long-term investment in Solix, Inc.which it accounts for using the cost method. The Company also has receivables from economic development loans madethrough the Rural Utilities Service, has notes receivable from sales of cabletelevision systems in 2004 and has other small investments.

 

**(5)****                     Competition**

 

# Telephone Service

 

LECs are subject to manyforms of competition.  Its competitorsprincipally are:

 

•                  Facilities-basedcompetition from providers, including cable television service providers, withtheir own local service network;

 

•                  Resalecompetition from resale interconnection (providers who purchase local servicesfrom the LEC at wholesale rates and resell the services to their customers);

 

•                  Competitionfrom unbundled network element interconnection (providers who lease some of thenetwork elements from the LEC)

 

•                  Wirelessproviders who may charge a competitive fee for services that compete withwireline based local service.

 

•                  Voiceover Internet Protocol (VoIP) based services that deliver telecommunicationsservices over high-speed internet connections.

 

Rural areas like thoseserved by the Company are less likely to experience competition fromfacilities-based competitors due to the significant investment in plant andequipment required in relation to the lower customer density in ruralmarkets.  No facilities based competitorsare presently operating in any of the Company’s service areas.  However, Sprint, as an underlying carrier forMediacom, has filed with the Minnesota Public Utilities Commission to provideservice in the Company’s Sleepy Eye exchange, where Mediacom also providescable television service.

 

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Competition from resaleinterconnection or unbundled network element interconnection is more likely inrural areas.  Under theTelecommunications Act of 1996, (the “Telecommunications Act”) the Company’sLECs are not currently required to lease facilities to competitors seeking tointerconnect with its networks.  However,there is no assurance that interconnection may not be required in the future.

 

Wireless service hasalways competed directly with wireline local service among certain classes ofcustomers, principally customers with seasonal or lake homes.  Newer wireless service offerings that bundlelocal and long distance minutes for a flat fee are competing with wirelineservices over a broader class of customers. These wireless service offerings can be particularly attractive in ruralareas, where the toll free dialing areas offered by wireline carriers areusually quite small.  Significant numbersof long distance minutes are migrating from the wireline to the wireless networkdue to these rate plans.  This drivesdown the revenues of IXCs and reduces the Company’s access revenues.  Developments in technology related tocellular, PCS, digital microwave, coaxial cable, fiber optics and otherwireline or wireless services could also present greater competition to traditionallocal services.

 

LECs are increasinglysubject to competition from competing access providers (“CAPs”) whichconstruct, modify or lease facilities that enable high volume long distanceusers to bypass the local telephone network. Cable television companies may also be able to modify their networks tocarry telephone messages that bypass the local telephone network.

 

VoIP providers typicallyoffer unlimited internet based calling for a flat monthly fee.  Customers wishing to use the service musthave a high speed internet connection. Due to the cost of the service and the high speed internet connection,VoIP customers tend to be high volume users of long distance services.  Due to the lower quality of the service,businesses have been reluctant to use VoIP for their customer contacts.  However, recent improvements in thetechnology have led more business and government customers to utilize theservice.  Vonage and Skype are probablythe best known VoIP providers at this time, but the Regional Bell OperatingCompanies and Internet service providers like AOL and Yahoo! are consideringproduct offerings.

 

# Video Services

 

In addition tocompetition from off-air television, direct broadcast satellite (“DBS”)services, such as Direct TV and Dish Network, present the most significantcompetition to the Company’s cable operations. Other competing technologiesinclude low power television stations, multi-point distribution systems andover-the-air subscription television. Cable television also competes for customers in local markets withproviders of other forms of entertainment, news and information.  These competitors include radio, newspapers,magazines, motion picture theaters, video cassettes and Internet serviceproviders.

 

All of the Company’scable television franchises are non-exclusive. The 1992 Cable Act prohibits franchising authorities from unreasonablyrefusing to grant franchises to competing cable television systems. The Companycompetes with a municipally owned cable system in one community it serves.  It also competes with a much largermulti-system operator in Sleepy Eye, where the Company is using broadbandequipment to deliver video services.  Thedegree of competition from other cable providers will be dependent upon thestate and federal regulations concerning entry, interconnection requirementsand the degree of unbundling of the LECs’ networks.  The Company expects to compete based uponproduct, service quality, breadth of services offered and, to a lesser extent,on price.

 

Maintaining and expandingthe Company’s subscriber base depends on numerous factors, including thequality and quantity of signals available from “off-air” television stations,demand for satellite and premium television channels and average householdincome in the service area.  Promotionalefforts for video services include telephone and door-to-door selling and localmedia advertising.

 

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# InternetCompetition

 

Potential competitors tothe Company’s Internet access service offerings include cable televisioncompanies, CLECs, wireless carriers, satellite-based companies and IXCs. Manyof these competitors provide direct access to the Internet along with a varietyof supporting services to businesses and individuals. Cable televisionoperators are aggressively entering the Internet access markets and directlycompete with the Company’s service offerings in its Sleepy Eye and Clarissaexchanges.  IXCs have substantialtransmission capabilities, traditionally carry data to large numbers ofcustomers and have an established billing system infrastructure that permitsthem to deliver Internet services. Satellite companies are offering broadbandaccess to the Internet from desktop personal computers. Many of thesecompetitors have substantially greater resources than the Company.

 

**(6)****                     Regulation**

 

The Company’s LECs andcable television systems are subject to federal, state and localregulation.  The Communications Act of1934 and the Telecommunications Act govern federal regulations.  Under these federal statutes, the FCCexercises jurisdiction over all interstate telecommunications activities.  Intrastate activities are governed by rulesand regulations set by the respective state public utility commissions.

 

Federal Regulations

 

Under federalregulations, incumbent local exchange carriers (“ILECs”) are required to complywith the Communications Act of 1934 and rules issued by the FCC.  While the Telecommunications Act of 1996amended the earlier law to reduce regulatory burdens and promote competition,ILECs remain subject to extensive regulatory requirements.  ILECs are required to maintain accountingrecords according to Uniform System of Accounts, to structure access chargesaccording to FCC rules and to reflect their charges for interstate services ata rate of return prescribed by the FCC. The FCC also regulates transfer of control and assignments of operatingauthorizations and construction licenses. The FCC requires carriers providing access services to file tariffs withthe FCC reflecting rates, terms and conditions of the services.  Tariffs filed are subject to review andpotential objection by third parties.

 

Regulation of CostRecovery and Nonregulated Revenue Allocation

 

As a regulated commoncarrier, the Company’s LEC subsidiaries can set maximum rates at a level thatallows recovery of reasonable costs incurred to provide regulated service andearns a reasonable return on the investment required to provide these services.

 

Costs are recoveredthrough:

 

•                  Monthlycharges to end users for basic local telephone services and enhanced services;

 

•                  Accesscharges to interexchange carriers for originating and terminating interstateand intrastate interexchange calls; and

 

•                  Paymentsfrom the federal Universal Service Fund and the state universal service funds(where applicable) that offset the high cost of providing service in certainrural markets.

 

Rates for regulatedservices and the amount of universal service fund support are set forth by theFCC with respect to interstate services and by state regulatory agencies withrespect to intrastate services.

 

In conjunction with therecovery of costs and establishment of rates, a LEC must first determine itsaggregate costs and then allocate those costs between regulated and nonregulatedservices.  After identifying theregulated costs of providing local telephone service, a LEC must allocate thosecosts among its various local exchange and interstate and intrastateinterexchange services and between state and federal jurisdictions.  Allocating costs is complicated because thesame pieces of a LEC’s plant and equipment are utilized for different services,such as local telephone and interstate and intrastate access services.  The allocation process is called “separation”and is governed primarily by FCC regulations. The purpose of separation is to determine how a carrier’s expenses areallocated

 

10

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and recovered fromfederal and state jurisdictions.   TheFCC is considering whether to change or eliminate this process.  Any change in separation rules by the FCCcould reduce or increase the LEC’s revenues. However, at this time it is not possible to predict what changes, ifany, may be made.

 

InterstateEnd-User Rates 

 

The part of the localtelephone network running from the switching facility to the customer is calledthe “local loop.”  Costs to construct,operate and maintain the loop are among the most significant costs incurred bya local exchange carrier.  In 1984 theFCC established a rate structure that provides for the recovery of a portion ofthe cost of the local loop allocated to interstate jurisdiction directly fromend-users through the assessment of a subscriber line charge (“SLC”). Theremaining portions of the interstate local loop costs were recovered frominterstate access charges to interexchange carriers.

 

In November 2001 the FCCadopted access charge reforms based in part on a proposal by theMulti-Association Group (the “MAG Plan”). The MAG Plan increased the maximum rate caps for SLCs in steps to thecurrent rates of $6.50 for a residential or single line business phone and$9.20 for a multi-line business phone. The increased SLC revenues are offset by reductions in recovery of localloop costs from interexchange carriers. SLC charges represented $2,468,000, $2,475,000 and $2,398,000 of theCompany’s access revenues in 2005, 2004 and 2003 respectively.  The plan is intended to be revenue neutralfor affected LECs.

 

Due to demographic andgeographic conditions, costs to provide local loop and switching services areoften higher, on a per customer basis, in rural areas compared to urbanareas.  Absent a regulatory framework topermit recovery of these costs, rural LECs would be compelled to chargeconsiderably higher rates for local network services.  Consequently, the FCC provides for additionalinterstate recovery by eligible telecommunications carriers through high costsupport funds and the federal Universal Service Fund.  These funds are available to local exchangecarriers whose local loop costs are significantly above the national average asdetermined by FCC rules. High cost support funds are received by the companythrough the inter-carrier settlements process administered by USAC and totaled$3,419,000, $3,497,000 and $3,501,000 in 2005, 2004 and 2003,respectively.   Interstate universalservice funds provided additional support totaling $1,819,000, $1,744,000 and$1,879,000 in 2005, 2004 and 2003, respectively.

 

Interstate AccessRates

 

Interstate access ratesare developed on the basis of a LEC’s measurement of its interstate costs toprovide access service to IXCs divided by its projected demand forservice.  The resulting rates arepublished in the LEC’s interstate access tariff and filed with the FCC, atwhich time they are subject to challenge by third parties and to review by theFCC.

 

The FCC recognized thatthe rate making and tariff filing process is administratively burdensome forsmall local exchange carriers. In 1983, the FCC established the NationalExchange Carriers Association (“NECA”) to develop and administer interstateaccess service rates, terms and conditions. NECA develops interstate accessrates on the basis of data provided by participating local exchange carriers.The data is blended to yield average rates. These rates are intended togenerate revenue equal to the aggregate costs plus a return on the investmentof all of the participants.

 

Individual LECs arelikely to have service costs that differ from the revenues generated by applyingthe overall NECA tariff rates. To allow for this, revenues generated byparticipating LECs are pooled and redistributed on the basis of each individualcompany’s costs. This process eliminates the burden of individual tariff filingand produces a system in which small companies can share and spread risk. Forexample, if a small local exchange carrier filed its own tariff andsubsequently suffered the loss of major customers that utilize interstateaccess service, the local exchange carrier could suffer significantunder-recovery of its costs. In the NECA pool environment, the impact of thisloss is reduced because it is spread over all of the pool participants.

 

NECA operates separatepools for traffic sensitive costs (primarily switching costs) and non-trafficsensitive costs (primarily loop costs). LECs can choose to develop andadminister their own interstate access charges and not participate in the NECApools. All of Hector’s LECs participate in the traffic sensitive andnon-traffic sensitive NECA pools.

 

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The FCC is reviewing itsrates and policies governing interstate access and the rate of returnapplicable to incumbent local exchange carriers who are subject torate-of-return, rather than price cap, regulation. The outcome of this reviewcould adversely affect Hector’s earnings, however, the outcome of thisproceeding cannot be predicted at this time.

 

Wireless Access

 

Access rates for wireless carriers are determined by a FCC mandatednegotiation process that takes place outside of the NECA tariff structure.  Where no agreement on access rates existbetween a wireless carrier and the LEC, no billing of access charges can bemade.  The Company’s LECs have reciprocalcompensation agreements in place with many of the wireless carriers that usethe LECs facilities to terminate calls — but not all of them.  Where agreements are in place, they are atrates significantly below what an IXC would pay to terminate a similarcall.  The Company believes the currentwireless access rate rules and rate structure give wireless carriers asignificant competitive advantage over landline carriers and have a materiallynegative effect on the Company’s access revenues.

 

VoIP Access

 

In October 2003 the U.S. District Court issued an injunction providingrelief from regulation to any service provider providing VoIP based services inMinnesota.  The ruling held that VoIPservices are information services that can be regulated only by the FCC and nottelecommunications services that can be regulated by the Minnesota PublicUtilities Commission.  Under current FCCrules VoIP originated calls that cross over to the public switched telephonenetwork (“PSTN”) can use the PSTN without paying access charges.  The Company cannot predict what the impact ofthis ruling on future access revenues will be. (An appeal of this ruling by the Minnesota PUC was rejected by theFederal Court of Appeals, 8th Circuit in December, 2004.)

 

TheTelecommunications Act

 

The TelecommunicationsAct was enacted to promote competition without jeopardizing the availability ofnationwide universal service at affordable rates. These two objectives haveresulted in a complex set of rules intended to promote competitive entry in theprovision of local telephone services, except where entry would adverselyeffect the provision of universal service or the public interest.

 

Promotion of LocalService Competition and the Rural Exemptions

 

The TelecommunicationsAct made competitive entry into the local telephone business more attractive toother carriers by removing barriers to competition. In order to promotecompetition the Telecommunications Act established new interconnection rulesgenerally requiring local exchange carriers to allow competing carriers to interconnectwith their local networks. Congress recognized, however, that the desire topromote competition conflicted with the ability of some existing LECs toprovide universal service to high cost customers.  Congress exempted these LECs (classified as “RuralTelephone Companies”) from interconnection requirements until the continuationof the exemption was no longer in the public interest, as defined in theTelecommunications Act.

 

Under theTelecommunications Act, all local exchange carriers, including both incumbentlocal exchange carriers and new competitive carriers, are required to:

 

•           Offerreasonable and nondiscriminatory resale of their telecommunications services,

 

•           Ensurethat customers can keep their telephone numbers when changing carriers,

 

• Ensure that competitors’ customers can use the samenumber of digits when dialing and receive nondiscriminatory access to telephonenumbers, operator service, directory assistance and directory listing,

 

•           Ensureaccess to telephone poles, ducts, conduits and rights of way and

 

•           Compensatecompetitors for the costs of terminating traffic.

 

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The TelecommunicationsAct also requires incumbent local exchange carriers to:

 

•           Negotiate in good faiththe terms and conditions of interconnection with any competitive carrier makinga bona fide request for same,

 

•           Interconnect theirfacilities and equipment with any requesting telecommunications carrier at anytechnically feasible point,

 

•           Unbundle and provide nondiscriminatoryaccess to unbundled network elements, such as local loops, switches andtransport  facilities, atnondiscriminatory rates and on nondiscriminatory terms and conditions,

 

•           Offer resaleinterconnection at wholesale rates,

 

•           Provide reasonablenotice of changes in the information necessary for transmission and routing ofservices over the 

incumbentlocal exchange carrier’s facilities or in the information necessary forinteroperability and

 

•           Provide for thephysical co-location of equipment necessary for interconnection or access tounbundled network elements at  thepremises of the incumbent local exchange carrier, at rates, terms andconditions that are just, reasonable and  nondiscriminatory.

 

In order to implementinterconnection requirements, local exchange carriers generally enter intonegotiated interconnection arrangements with competing carriers. Local exchangecarriers may also offer interconnection tariffs, available to all competitors.

Competitors are requiredto compensate a local exchange carrier for the cost of providinginterconnection services. In the case of resale interconnection, the rulesprovide that the rates charged should be on a wholesale basis and reflect thecurrent retail rates of the incumbent local exchange carrier, excluding theportion of costs avoided by the incumbent local exchange carrier. In the caseof unbundled network element interconnection, rates are based on costingmethodologies that employ a forward-looking economic cost pricing methodologyknown as total element long run incremental cost. The Telecommunications Actspecifies that resale and unbundled network element rates are to be negotiatedamong the parties, or, if the parties fail to reach an agreement, arbitrated bythe relevant state regulatory authority. Once the parties have come toagreement, the proposed rates are subject to final approval by the stateregulatory commission.

 

The Company’s LECsubsidiaries are defined as “rural telephone companies” under theTelecommunications Act. As rural telephone companies, they were granted ruralexemptions from the requirements relating to both resale interconnection andunbundled network element interconnections. The rural exemptions are continueduntil regulatory authorities determine that interconnection is technicallyfeasible, not unduly economically burdensome and consistent with theTelecommunications Act’s universal service provisions.

 

Promotion ofUniversal Service

 

While theTelecommunications Act promoted Congress’ policy of ensuring that affordableservice is provided to consumers universally in rural, high-cost areas of thecountry, the Telecommunications Act altered the framework for providinguniversal service by:

 

•           Providing for theidentification of those services eligible for universal service support,

 

•           Requiring the FCC tomake implicit subsidies explicit,

 

•           Expanding the types ofcommunications carriers required to pay universal service support and

 

•           Allowing competitivelocal exchange carriers to be eligible for funding.

 

These and otherprovisions were intended to make provision of universal service supportcompatible with a competitive market.

 

13

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Pursuant to theTelecommunications Act, federal Universal Service Fund payments are onlyavailable to carriers that are designated as eligible telecommunicationscarriers (“ETC”) by a state public utilities commission. In areas served byrural LECs, the Telecommunications Act provides that a state public utilitiescommission may designate more than one eligible telecommunications carrier, inaddition to the incumbent local exchange carrier, only after determining thatthe designation of an additional ETC will serve the public interest. Wirelessproviders have received ETC designation in each of the Company’s served areas.The addition of these ETCs could have the effect of reducing the fundingavailable to the Company’s LECs from the federal Universal Service Fund.  Such a reduction could materially adverselyaffect the Company’s ability to achieve a reasonable rate of return on thecapital invested in its network.

 

# State Regulation of RuralLECs

 

Hector’s LEC subsidiariesare subject to regulation by Minnesota, North Dakota and Wisconsin regulatoryagencies with respect to:

 

•           Intrastate tollrates,

•           Intrastateaccess charges billed to intrastate IXCs,

•           Service areas,

•           Servicestandards,

•           Accounting andrelated matters, and

•           The use ofradio frequencies in telephone operations

 

In some cases stateregulations also apply to local service rates, rate of return, depreciationrates, construction plans and borrowings, and certain other financialtransactions.

 

Local service rates arenot directly determined by regulatory authorities, but are limited byregulation of these other areas.  The Companyhas sought appropriate increases in local and other service rates and approvalfor changes in rate structures necessary to achieve reasonable rates andearnings.

 

The bulk of the Company’saccess lines are located in Minnesota.  Abill passed by the 1995 Minnesota legislature allows telephone companiesserving fewer than 50,000 access lines to elect to provide service under analternate form of regulation. All of Hector’s Minnesota-based LEC subsidiaries(except Felton Telephone Company) elected alternative rate regulation.  Local rate increases under alternativeregulation are not subject to review by the Minnesota Public UtilitiesCommission unless the lower of 500 or five percent of customers file a petitionrequesting such review.

 

For the past severalyears the Minnesota Public Utilities Commission has been considering a plan toreduce intrastate access charges and implement a state universal service fundto compensate high cost companies.  In2004 the PUC issued orders referring elements of the proposed plan to acontested case hearing.  In Minnesotathese hearings provide an opportunity for public debate before the PUC issuesfinal rules.  In December 2004 the PUCsuspended process of the proposed new rules due to concerns expressed by stateagencies that the proposed access rate reductions would result in higher localservice rates.  The Company cannotpredict the outcome of the rate investigation or if any part of the proposedplan will be adopted.

 

Wisconsin based LECs aresubject to rate of return review where their residential local service rate(the “R1” rate) exceeds the statewide average R1 rate (currently $14.81 permonth).  In November 2004 the WisconsinPublic Service Commission conducted a rate of return review of the Company’sHager TeleCom LEC.  As a result of thereview, the Company agreed to reduce its R1 rate by $3.10 per month and to makecertain other rate reductions.  The newrates went into effect January 1, 2005.

 

# Cable Television SystemRegulation

 

The FCC regulates theproviders of satellite communications services and facilities for thetransmission of programming services, the cable television systems that carrysuch services, and, to some extent, the availability of the programmingservices themselves through its regulation of program licensing.  Municipalities and other state

 

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and local governmentauthorities also regulate cable television systems.  FCC regulations contain many detailedprovisions including:

 

•           “Must carry” rulesregarding the broadcast television and translator signals that must be includedin channel offerings to subscribers,

•           Exclusivity provisionswhich require the deletion of certain programming carried by out-of-areastations where it would duplicate programming carried by local stations,

•           Technical standards andperformance testing requirements, and

•           Franchise feesapplicable to state and local cable television franchises.

 

Thus far, Hector’s cablesystems have not experienced any difficulty in complying with the FCC rules.

 

In Minnesota, the awardof cable franchises and certain aspects of cable operations are subject torules of the Minnesota Cable Communications Board.  Cable television systems are operated under15 year, non-exclusive franchises granted by local government authorities.  Franchises contain many conditions, includingtime limitations on commencement or completion of construction, approval ofinitial fees charged to subscribers for basic service, the number of channelsoffered and the types of programming. Hector does not anticipate difficulty inobtaining renewal of its franchises at the expiration of their current terms.

 

The regulation of cabletelevision at the federal, state and local levels is subject to the politicalprocess and has been in constant flux over the past decade.  This process continues in the context oflegislative proposals for new laws and the adoption or deletion ofadministrative regulations and policies. The Company anticipates further material developments in these areas,but cannot anticipate their direction and impact on its cable televisionoperations.

 

**(7)****                                 BusinessStrategy**

 

The Company is focused onbusiness opportunities in rural telecommunications.  Its three-part strategy is to:

 

•           Expandits existing operations through internal growth

•           Pursueacquisitions of attractive properties, particularly the acquisition ofadditional rural telephone exchanges and cable television properties

•           Participatein opportunities afforded by new telecommunications technologies

 

Future growth in existingtelephone and cable operations is expected to come from providing service tonew or presently unserved homes and businesses, from sales of enhanced servicesto existing customers and from providing new services made possible byimprovements in technology.

 

The Company continuallyassesses possible acquisition opportunities. Competition to acquire attractive telephone or cable televisionproperties is intense.  Acquisitions ofrural telephone exchanges are subject to the approval of regulatory agencies insome states and, in some cases, to federal waivers that may affect the form ofregulation or amount of interstate cost recovery of acquired telephoneexchanges.  The Company will aggressivelypursue acquisitions of telephone exchanges (consistent with realisticvaluations of such exchanges), but there is no assurance that acquisitions canbe made on acceptable terms or that regulatory approval, where required, willbe received.

 

The Company hasaggressively invested in new telecommunications technologies, primarily throughinvestments in partnerships and limited liability companies.  The Company has substantial investments inwireless communications companies, fiber optic transport groups, CLECs andinternet service providers.  The Companyintends to pursue additional investment opportunities in the future.

 

Midwest Wireless HoldingsLLC, which is expected to be sold in 2006, has been the driver for the Company’sincreases in net income and per share earnings in recent years.  The Company also expects its core wirelinetelephone business to face significant challenges in the future including butnot limited to: the loss of access revenue due to the impact of the dramaticgrowth in wireless telephony, possible changes to the level of regulatorysupport for rural telecommunications and the emergence of Voice over InternetProtocol (VoIP). The management

 

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and Board of Directors ofthe Company have retained the investment-banking firm of Stifel Nicholaus, Inc.for assistance in assessing available strategic options for maximizing value toshareholders.

 

**(8)****                     Employees**

 

At March 1, 2006, theCompany had 125 full-time and part-time employees.  None of the Company’s employees are representedunder collective bargaining agreements. Hector believes its employee relations to be good.

 

**(9)****                     ExecutiveOfficers of Registrant**

 

The executive officers ofthe Company and their ages at March 1, 2006 were as follows:

 
| **Name**           | ** ** | **Age** | ** ** | **Position**                                      |
|--------------------|------------|---------|------------|---------------------------------------------------|
|               |       |    |       |                                              |
| Curtis  A. Sampson |       | 72      |       | Chairman of the Board and Chief Executive Officer |
|               |       |    |       |                                              |
| Steven  H. Sjogren |       | 63      |       | President and Chief Operating Officer             |
|               |       |    |       |                                              |
| Paul  N. Hanson    |       | 59      |       | Vice President, Secretary and Treasurer           |
|               |       |    |       |                                              |
| Charles  A. Braun  |       | 48      |       | Chief Financial Officer                           |

 

Executive officersserve at the pleasure of the Board of Directors and are elected annually forone-year terms.  Each officer above hasserved the Company in the indicated capacity since 1990.  Mr. Sjogren devotes his full time to theCompany’s business.  Messrs. Sampson,Hanson and Braun devote approximately 50%, 50% and 80% respectively of theirworking time to the Company’s business with the balance devoted to managementresponsibilities at Communications Systems, Inc. (“CSI”), a diversified telecommunicationsholding company also located in Hector, Minnesota, for which they areseparately compensated by CSI.

 

**[d]****                      FINANCIALINFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS AND EXPORT SALES**

 

Not Applicable.

 

**ITEM 1A.**                    RISK FACTORS

 

The Company’s business involves many risks, includingthe following:

 

Regulatory Changes

Nearly half of the Company’s 2005 revenues came fromaccess.  The Company’s access revenuestreams include material amounts of revenues from high cost support funds anduniversal service funds.  Severalproposals have been made in the Congress and at the FCC that would reduce thesupport revenues the Company presently receives.  Significant reductions in these revenueswould materially harm the Company’s financial results.

 

The Company’s local and intrastate rates and servicesare under the supervision of state regulatory authorities.  Changes in state regulatory rules, reductionsin allowed rates of return for local service or reductions of intrastate accessrates charged to long distance providers could materially harm the Company’sfinancial position.

 

Competition 

The Company’s service offerings face increasingcompetition from newer technologies, including wireless and VoIP services.  Potentially the Company could also facecompetition from local exchange carriers (“CLECS”) operating in its serviceterritories.  Many of these competitorsprovide service to customers at prices lower than the Company charges forsimilar service.  These competitors oftenhave greater resources than the Company and have lower tax and regulatoryburdens.   If the Company is unable tosuccessfully compete for new customers or maintain its existing customer base,its business could be harmed.

 

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Credit Risk

A significant portion of the Company’s revenues isreceived from long distance carriers (IXCs) in the telephone industry.  Consequently, the Company is directlyaffected by the financial well-being of that industry.  If the IXCs are unable to operate profitablyor pay their bills the Company’s financial position would be harmed.

 

Effects of the Midwest Wireless Sale on Earnings andDividends

The Company’s investment in Midwest Wireless hasaccounted for a significant and growing percentage of the Company’s earnings inrecent years.  Following the sale ofMidwest Wireless (which is expected to occur in 2006) it may be difficult tomaintain the Company’s profits at current levels, which could negatively affectthe Company’s stock price.  The Company’sloan covenants with its lenders restrict dividend payments to shareholders to apercentage of net income.  Withoutearnings from the Midwest Wireless investment, the Company may not be able tomaintain its current dividend, which could negatively affect the Company’s stockprice.

 

Ability to Comply with Sarbanes–Oxley Section 404Requirements

Due to the small size of the Company’s executive andaccounting staff the Company believes it would be difficult and expensive forit to comply with the internal control framework mandated by the Committee ofSponsoring Organizations of the Treadway Commission (“COSO”). If the Companyincurs significant expenses to meet the requirements its earnings and shareprice may be harmed.  If the Companyfails to meet the requirements and discloses material deficiencies in itsinternal control system its financial reputation and share price may be harmed.

 

Stock Price Volatility and Anti-takeover Provisions

Certain provisions of Minnesota law, the Company’sarticles of incorporation and bylaws and the Company’s shareholder rights planor “poison pill” may discourage, delay or prevent an offer or transaction thatshareholders may consider favorable and may limit the market price for theCompany’s stock.  These provisionsinclude:

 

•                  Staggeredterms for the Board of Directors

•                  Advancenotice requirements for shareholder proposals

•                  Limitationson business combinations with interested shareholders

•                  Authorizationfor the Board of Directors to issue preferred stock without shareholderapproval

 

A significant percentage of the Company’s stock isowned by a few individuals or organizations. Due to the relatively low average daily trading volume of the Company’sshares, a decision by these individuals or organizations to sell their shares,regardless of motivation, could have a significant negative effect on the shareprice.  The Company’s share price canalso be materially affected by occurrences in the telecommunications industryand in the general market place over which the Company has no control.

 

Obsolescence and Technology Changes

The Company utilizes technology from several keysuppliers including Nortel, Cisco, Paradyne, Next Level and Calix.  If these suppliers fail to maintain theirproduct offerings at competitive levels or if the Company is unable to obtainadditional equipment when needed, the Company’s business could be adverselyaffected.

 

Debt Availability

The Company believes its current cash assets andexisting loan structure are sufficient to meet its needs.  The Company has loan commitments from theRural Utilities Service (“RUS”) for financing of future capital additions. Ifthese RUS funds are not available and the Company cannot obtain suitable creditfrom other lenders, its business could be harmed.

 

Additionally, risks that the Company is unaware of orbelieves are immaterial or insignificant may also cause events that couldimpair the Company’s business operations.

 

**ITEM1B.**                    UNRESOLVEDSTAFF COMMENTS

 

There are nounresolved written comments received from the Securities and ExchangeCommission staff 180 days or more before the end of the Company’s fiscal yearrelating to the Company’s periodic or current reports under the SecuritiesExchange Act of 1934.

 

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**ITEM 2.****                             PROPERTIES**

 

The Company’stelephone property consists of central office switching equipment, the land andbuildings in which the equipment is housed, connecting lines consisting ofaerial and underground cable, conduit, and poles and wires which connectcustomers’ premises with central offices. Connecting lines are generally located under or above public rights ofway or land owned by others pursuant to consents of various governmental bodiesor private leases, permits, easements, agreements or licenses.  The Company also owns customer-leasedtelephones and related terminal equipment and a small amount of connectinglines that are located on customers’ premises.

 

Connecting linesconstitute approximately 49% of the Company’s gross property in service.  Central office switching equipment representsapproximately 29%. Telephones, customer premise broadband equipment and relatedequipment constitute approximately 4%. Video and cable television equipment are approximately 7%.  Land, buildings, data processing equipment,service vehicles and construction equipment constitute the remaining 11%.  The Company owns substantially all the landand buildings in which its central office equipment is located.  Hector’s principal general offices,administrative services department and business office are located in Hector,Minnesota and are rented by Hector from CSI.

 

The physicalassets of the Company’s cable television systems consist of signal receptionequipment and distribution electronics and cables.  The receiving equipment is comprised of atower and antennas for reception of broadcast television signals and one ormore satellite dishes for reception of satellite signals.  The Company owns or leases the land on whichthe towers for its cable systems and the buildings containing other receivingequipment are located.  Pole attachmentspace is rented from utilities serving the community.

 

See Note 9 of “Notesto Consolidated Financial Statements” for additional information regardingpledged assets.

 

**ITEM 3.****                             LEGALPROCEEDINGS**

 

No materiallitigation or other claims are presently pending against the Company.

 

**ITEM 4.****                             SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS**

 

Not applicable.

 

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**PART II**

 

**ITEM 5.****                             MARKETFOR THE REGISTRANT’S COMMON EQUITY AND RELATED****STOCKHOLDERMATTERS**

 

**[a]****                      MARKETINFORMATION**

 

The Company’scommon stock is traded on the American Stock Exchange (“AMEX”).  The table below presents the range of highand low trading prices for the Company’s stock for each period as reported byAMEX:

 
| ** **  | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------|------------|----------|------------|----------|------------|
| **Quarter** | ** ** | **High** | ** ** | **Low**  | ** ** | **High** | ** ** | **Low** | ** ** |
|        |       |     |       |     |       |   |   |   |   |
| First       |       | $        | 22.25      |     | $          | 20.15 |   | $ | 19.36 |   | $ | 13.85 |   |
| Second      |       | 23.95    |       | 20.85    |       | 21.70 |   | 18.65 |   |
| Third       |       | 30.00    |       | 22.87    |       | 21.50 |   | 19.80 |   |
| Fourth      |       | 29.70    |       | 28.01    |       | 22.00 |   | 20.00 |   |
|             |            |          |            |          |            |  |  |  |  |  |  |  |  |

 

**[b]****                      HOLDERS**

 

At March 1, 2006there were 410 holders of record of Hector Communications Corporation commonstock.

 

**[c]****                      DIVIDENDS**

 

In December 2004Hector adopted a policy to pay regular quarterly dividends on its outstandingcommon and preferred stock.  Per sharedividend payments from that time to December 31, 2005 have been as follows:

 
| December 15,  2004  |   | $   | .05    |   |
|---------------------|--------|-----|--------|--------|
| March 15, 2005      |   | .05 |   |
| June 15, 2005       |   | .05 |   |
| September 15,  2005 |   | .08 |   |
| December 15,  2005  |   | .10 |   |

 

The amount offuture dividends will be determined at the discretion of the Board ofDirectors.  Hector has no obligation topay dividends on its preferred stock except that preferred stock receives thesame per share dividend as common stock.

 

The financingagreements between Hector’s subsidiaries and their lenders, and Hector and itslenders restrict the ability of Hector to pay dividends.  See Management’s Discussion and Analysis ofFinancial Condition and Results of Operations, and also Note 9 to theConsolidated Financial Statements under Item 8 herein for a description ofrestrictions on dividends.

 

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**ITEM 6.****                             SELECTEDFINANCIAL DATA**

 

**SELECTEDCONSOLIDATED FINANCIAL INFORMATION**

(in thousands except pershare amounts)

 
| ** **                                                                                       | ** ** | **Year Ended December 31** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                                       | ** ** | **2005**                   | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| **Selected  Income Statement Information**                                                       |       |                       |       |   |   |   |   |   |   |   |   |
|                                                                                             |       |                       |       |   |   |   |   |   |   |   |   |
| Revenues from  Continuing Operations                                                             | ** ** | **$**                      | **32,373** |   | $ | 31,570 |   | $ | 32,322 |   | $ | 30,517 |   | $ | 31,073 |   |
| Costs and  Expenses                                                                              | ** ** | **24,383**                 |       | 24,588 |   | 24,365 |   | 23,875 |   | 24,404 |   |
| Operating Income  from Continuing Operations                                                     | ** ** | **7,990**                  |       | 6,982 |   | 7,957 |   | 6,642 |   | 6,669 |   |
| Other Income  (Expenses):                                                                        |       |                       |       |   |   |   |   |   |   |   |   |
| Income from  Midwest Wireless Holdings, LLC                                                      | ** ** | **4,682**                  |       | 2,766 |   | 2,148 |   | 2,261 |   | 1,153 |   |
| Other                                                                                            | ** ** | **(1,740**                 | )          | (1,854 | ) | (1,832 | ) | (3,314 | ) | 599 |   |
| Other Income  (Expenses), net                                                                    | ** ** | **2,942**                  |       | 912 |   | 316 |   | (1,053 | ) | 1,752 |   |
|                                                                                             |       |                       |       |   |   |   |   |   |   |   |   |
| Income from  Continuing Operations Before Income Taxes and Minority Interest                     | ** ** | **10,932**                 |       | 7,894 |   | 8,273 |   | 5,589 |   | 8,421 |   |
|                                                                                             |       |                       |       |   |   |   |   |   |   |   |   |
| Income Tax  Expense                                                                              | ** ** | **4,365**                  |       | 3,250 |   | 3,316 |   | 2,483 |   | 4,162 |   |
| Income from  Continuing Operations Before Minority Interest                                      | ** ** | **6,567**                  |       | 4,644 |   | 4,957 |   | 3,106 |   | 4,259 |   |
|                                                                                             |       |                       |       |   |   |   |   |   |   |   |   |
| Minority  Interest in Earnings of Alliance Telecommunications Corporation                        |       |                       |       |   |   | 660 |   | 782 |   | 1,078 |   |
| Income from  Continuing Operations                                                               | ** ** | **6,567**                  |       | 4,644 |   | 4,297 |   | 2,324 |   | 3,181 |   |
|                                                                                             | ** ** | ** **                 |       |   |   |   |   |   |   |   |   |
| Income from  Discontinued Operations                                                             |       |                       |       |   |   | 882 |   | 1,331 |   | 1,435 |   |
| Income Before  Cumulative Effect of Change in Accounting Principle                               | ** ** | **6,567**                  |       | 4,644 |   | 5,179 |   | 3,655 |   | 4,616 |   |
|                                                                                             |       |                       |       |   |   |   |   |   |   |   |   |
| Cumulative  Effect of Change in Accounting Principle, net of Income Taxes and Minority  Interest |       |                       |       |   |   |   |   | (3,147 | ) |   |   |
| Net Income                                                                                       | ** ** | **$**                      | **6,567**  |   | $ | 4,644 |   | $ | 5,179 |   | $ | 508 |   | $ | 4,616 |   |
|                                                                                             |       |                       |       |   |   |   |   |   |   |   |   |
| Basic Income  from Continuing Operations per common share                                        | ** ** | **$**                      | **1.72**   |   | $ | 1.28 |   | $ | 1.23 |   | $ | .67 |   | $ | .92 |   |
| Diluted Income  from Continuing Operations per common share                                      | ** ** | **$**                      | **1.61**   |   | $ | 1.17 |   | $ | 1.14 |   | $ | .62 |   | $ | .85 |   |
| Cash Dividends  per share                                                                        | ** ** | **$**                      | **.28**    |   | $ | .05 |   | $ | — |   | $ | — |   | $ | — |   |
|                                                                                             |       |                       |       |   |   |   |   |   |   |   |   |
| Average Shares  Outstanding:                                                                     |       |                       |       |   |   |   |   |   |   |   |   |
| Common shares  only                                                                              | ** ** | **3,821**                  |       | 3,635 |   | 3,487 |   | 3,498 |   | 3,465 |   |
| Common and  potential common shares                                                              | ** ** | **4,084**                  |       | 3,970 |   | 3,765 |   | 3,770 |   | 3,763 |   |
|                                                                                             |       |                       |       |   |   |   |   |   |   |   |   |
| **Selected  Balance Sheet Information**                                                          |       |                       |       |   |   |   |   |   |   |   |   |
|                                                                                             |       |                       |       |   |   |   |   |   |   |   |   |
| Working Capital                                                                                  | ** ** | **$**                      | **18,981** |   | $ | 17,601 |   | $ | 13,314 |   | $ | 5,718 |   | $ | 7,633 |   |
| Property, Plant  and Equipment, net                                                              | ** ** | **37,382**                 |       | 40,040 |   | 43,088 |   | 56,666 |   | 57,362 |   |
| Excess of Cost  Over Net Assets Acquired, net                                                    | ** ** | **30,921**                 |       | 30,921 |   | 31,692 |   | 49,075 |   | 53,663 |   |
| Total Assets                                                                                     | ** ** | **127,754**                |       | 124,923 |   | 123,059 |   | 154,486 |   | 158,251 |   |
| Long-Term Debt                                                                                   | ** ** | **49,456**                 |       | 54,084 |   | 57,529 |   | 75,148 |   | 79,642 |   |
| Stockholders’  Equity                                                                       | ** ** | **61,446**                 |       | 54,213 |   | 48,044 |   | 42,249 |   | 42,241 |   |

 

Effective January1, 2002, the Company adopted the provisions of Statement of FinancialAccounting Standards No. 142, “Goodwill and Other Intangible Assets”.

 

20

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| **ITEM 7.** | ** ** | **MANAGEMENT’S DISCUSSION AND ANALYSIS OF  FINANCIAL   CONDITION AND RESULTS OF OPERATIONS** |
|-------------|------------|---------------------------------------------------------------------------------------------------|

 

Hector, directly andthrough its 100% owned subsidiary, Alliance Telecommunications Corporation (“Alliance”)operates nine local exchange company subsidiaries (generally referred to as “localexchange carriers” or “LECs”) which served 29,407 access lines, 5,129 digital subscriberline (“DSL”) customers and 6,070 dial-up internet customers in 28 ruralcommunities in Minnesota, Wisconsin and North Dakota at December 31, 2005.  Hector, through its wholly-ownedsubsidiaries, also provides cable television service or video service to 7,923subscribers in Minnesota.  Hector’ssubsidiaries also have substantial ownership interests in othertelecommunications ventures, including, Midwest Wireless Holdings LLC.

 

Prior to July 7, 2003Alliance was 68% owned by Hector. Golden West Telecommunications Cooperative,Inc. (“Golden West”) of Wall, South Dakota and Alliance CommunicationsCooperative, Inc. (“ACCI”) of Garretson, South Dakota owned the remaininginterests in Alliance. Effective July 7, 2003 Alliance was reorganized underSection 355 of the Internal Revenue Code (“the Split-Up Transactions’).  In the Split-Up Transactions, Golden Westexchanged its minority ownership interest in Alliance for all of theoutstanding stock of Sioux Valley Telephone Company, which included a pro ratashare of Alliance’s ownership interest in Midwest Wireless Holdings, LLC andcertain other Alliance assets. ACCI exchanged its minority ownership interestin Alliance for all of the outstanding stock of Hills Telephone Company, whichincluded a pro rata share of Alliance’s ownership interest in Midwest WirelessHoldings, LLC and certain other Alliance assets. Hector became the 100% ownerof all remaining Alliance assets and operations. (See “Split-up of AllianceTelecommunications Corporation” below.)  Thedisclosures in this report related to prior periods have been restated toreflect the Company’s continuing operations.

 

CriticalAccounting Policies

 

The presentationof financial statements in conformity with generally accepted accountingprinciples requires management to make estimates and assumptions that affectthe reporting of the Company’s operating results and financial position. Theestimates and assumptions used in the Company’s financial statements are basedupon management’s evaluation of the relevant facts and circumstances as of thetime of the financial statements.  Theseestimates are often difficult, subjective and complex. Actual results coulddiffer from the estimates.  Hector alsogives accounting recognition to the actions of federal and state regulatoryauthorities where appropriate as prescribed by SFAS No. 71.

 

Revenuerecognition:****Revenues are recognized whenearned, regardless of the period in which they are billed.  Network access revenues are furnished inconjunction with interexchange carriers and are determined by cost separationstudies and nationwide average schedules. Revenues include estimates pending finalization of cost studies.  Network access revenues are based uponinterstate tariffs filed with the Federal Communications Commission by theNational Exchange Carriers Association and state tariffs filed with stateregulatory agencies.  Management believesrecorded revenues are reasonable based on estimates of final cost separation studies,which are typically settled within two years.

 

Allowance forDoubtful Accounts: The allowance for doubtful accounts is an estimate based onspecifically identified problem accounts and historical collectionexperience.  Specific accounts areevaluated where the Company has information that the customer may not be ableto meet its financial obligations, where payment is delinquent or where chargesare in dispute.  Reserves are reevaluatedand adjusted as information affecting the accounts is received.  If circumstances change, recoverability ofamounts due the Company could be materially affected.

 

Property, plantand equipment: The Company regularly reviews the carrying value of its fixedassets for impairment.  Carrying valuesare estimated based on expected future cash flows and/or established marketvaluations of other similar assets. Depreciation is calculated using the straight-line method based on theestimated useful lives of the various asset classes.  Reserves established for asset retirementobligations have not been significant.

 

Goodwill andintangible assets: Effective January 1, 2002 the Company adopted SFAS No. 142, “Goodwilland Other Intangible Assets”.  Under theprovisions of this accounting standard, goodwill and intangible assets withindefinite useful lives are no longer amortized but are instead tested forimpairment on at least an annual basis.

 

21

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The goodwillimpairment test requires the Company to determine the fair value of itsreporting units.  The valuation is estimatedbased on access line and customer valuations and cash flow multiple valuationsthe Company considers appropriate in the current marketplace.  If circumstances or assumptions supportingthese estimates change, the carrying value of the Company’s goodwill could bematerially affected.

 

Income taxes: TheCompany estimates its income tax expense for each jurisdiction in which itoperates.  The process includesapportioning the Company’s income among the jurisdictions, estimating currenttax liabilities and establishing deferred tax assets and liabilities. Deferredtaxes are calculated where the carrying amounts of assets and liabilities aredifferent for financial and tax reporting purposes.  Valuation allowances are recorded in the taxaccounts for amounts management believes may not be recoverable in futureperiods.

 

Results ofOperations

 

# 2005 Compared to 2004

 

Revenues fromcontinuing operations increased 3% to $32,373,000 in 2005 from $31,570,000 in2004. The revenue breakdown was as follows:
| ** **                                      | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|-------------------------------------------------|------------|------------|------------|------------|------------|
| Plain old telephone service (“POTS”): | ** ** | ** ** | ** ** | ** ** | ** ** |
| Local network                                   |       | $          | 6,088,047  |       | $          | 6,201,326 |   |
| Network access  revenues:                       | ** ** | ** ** | ** ** | ** ** | ** ** |
| Long distance  providers - interstate           |       | 3,688,715  |       | 3,182,635  |       |
| Long distance  providers – intrastate      |       | 4,480,873  |       | 4,425,222  |       |
| SLC Revenue                                     |       | 2,467,530  |       | 2,474,656  |       |
| High cost  support                              |       | 3,418,830  |       | 3,496,862  |       |
| Universal  service fund support                 |       | 1,819,155  |       | 1,743,721  |       |
| Total network  access revenues                  |       | 15,875,103 |       | 15,323,096 |       |
| Total POTS revenues                             |       | 21,963,150 |       | 21,524,422 |       |
| Other services:                                 |       |       |       |       |       |
| Video services                                  |       | 3,171,117  |       | 3,324,588  |       |
| Internet  services                              |       | 3,832,037  |       | 3,150,089  |       |
| Other  nonregulated services:                   |       |       |       |       |       |
| Fiber leases                                    |       | 664,860    |       | 657,022    |       |
| Wireless sales  commissions                     |       | 377,289    |       | 495,704    |       |
| Directory  revenues                             |       | 536,230    |       | 529,796    |       |
| Retail sales                                    |       | 412,203    |       | 469,609    |       |
| Long distance  service sales commissions        |       | 477,885    |       | 382,936    |       |
| Customer  equipment installation and repair     |       | 371,704    |       | 379,755    |       |
| Billing and  collection                         |       | 137,342    |       | 169,378    |       |
| Equipment rent                                  |       | 114,618    |       | 126,130    |       |
| Engineering  services                           |       |       |       | 70,378     |       |
| All other  revenues                             |       | 315,040    |       | 289,963    |       |
| Total  nonregulated services revenue            |       | 3,407,171  |       | 3,570,671  |       |
| Total other service revenues                    |       | 10,410,325 |       | 10,045,348 |       |
| Total revenue                                   |       | $          | 32,373,475 |       | $          | 31,569,770 |   |

 

Total POTSrevenues increased $439,000 or 2%.  Localnetwork revenues decreased $113,000 or 2%.  The decrease was due to decreases in access lines and local service ratereductions in the Company’s Hager TeleCom LEC. The Company’s access lines countdeclined 1% in 2005.  The number ofaccess lines served fell due to substitution of cellular phones for landlinephones by customers.

 

Network accessrevenues increased $552,000 or 4%. The revenue increase was due to favorablecost study settlements in the Company’s high cost LECs.  2005 revenues also include a favorableadjustment for overearnings by NECA in its cost settlement pools.   Access revenues were also helped because theCompany received access payments from more wireless carriers due tointerconnection agreements negotiated in 2005. Access rates for wirelesscarriers remain significantly below those for wireline carriers.  The Company’s access minutes provided toother telecommunications carriers by the Company’s Minnesota LECs in 2005 and2004 were as follows:

 

22

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| **Access minutes of use** | ** ** | **2005**    | ** ** | **2004**    | ** ** |
|---------------------------|------------|-------------|------------|-------------|------------|
| Wireline  carriers        |       | 98,949,000  |       | 109,500,000 |       |
| Wireless  carriers        |       | 31,136,000  |       | 23,200,000  |       |
|                      |       | 130,085,000 |       | 132,700,000 |       |

 

(Access minutesfor the Company’s Wisconsin LECs are not included in the above table becauseWisconsin does not allow revenue recovery for terminating traffic.)  Revenues from high cost funds and universalservice funds decreased $3,000. Increases in support funds the Company received in areas where it has newlyinstalled Next Level equipment were offset by decreases in support for otherareas.

 

Total revenuesfrom other services increased $365,000 or 4%. Revenues from video (cable television) services declined $153,000 or 5%.Video service revenues in 2005 were reduced by the sale of the Hudson TownshipWI system in June 2004.  The Company isalso experiencing subscriber losses in the many small systems it owns where itdoes not offer digital service or channel offerings that are competitive withsatellite television.  Revenues frominternet services increased $682,000 or 22%, due to a 32% increase in thenumber of customers subscribing to high-speed DSL service. The DSL customergrowth has been facilitated by the Company’s deployment of broadband equipmentmanufactured by Next Level Communications, Inc. This equipment makes itpossible to deliver voice, video and high speed internet services to thecustomer over the same circuit. The Company expanded its deployment of NextLevel equipment to its Goodhue exchange in 2004 and to Mazeppa in 2005.

 

Revenues fromother nonregulated services declined $164,000 or 5%.  The revenue decline was due to lowercommissions earned for sales of wireless telephone services, lower billing andcollections revenues from long distance carriers and lower retail sales. TheCompany sold its engineering service company in July 2004.

 

Operating costsand expenses were $24,384,000 in 2005, a decrease of 1% from $24,588,000 in2004.  The breakdown of costs andexpenses was as follows:

 
| ** **                                       | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|--------------------------------------------------|------------|------------|------------|------------|------------|
| Plain old  telephone service (“POTS”): | ** ** | ** ** | ** ** | ** ** | ** ** |
| Plant  operations, excluding depreciation        |       | $          | 4,564,885  |       | $          | 4,335,140 |   |
| Depreciation and  amortization                   |       | 6,116,020  |       | 6,275,688  |       |
| Customer  operations                             |       | 1,592,893  |       | 1,406,020  |       |
| General and  administrative                      |       | 3,536,275  |       | 3,475,741  |       |
| Other costs and  expenses                        |       | 551,070    |       | 752,647    |       |
| Total POTS costs  and expenses                   |       | 16,361,143 |       | 16,245,236 |       |
|                                             |       |       |       |       |       |
| Other services:                                  |       |       |       |       |       |
| Plant operations                                 |       | 3,066      |       | 3,962      |       |
| Depreciation and  amortization                   |       | 1,572,671  |       | 1,714,528  |       |
| Customer  operations                             |       | 185,614    |       | 211,747    |       |
| General and  administrative                      |       | 607,919    |       | 394,070    |       |
| Other costs and  expenses:                       |       |       |       |       |       |
| Video services  expenses                         |       | 3,228,645  |       | 3,059,031  |       |
| Internet  expenses                               |       | 967,315    |       | 959,834    |       |
| Other                                            |       | 1,457,389  |       | 1,999,182  |       |
| Total other  service costs and expenses          |       | 8,022,619  |       | 8,342,354  |       |
| Total costs and  expenses                        |       | $          | 24,383,762 |       | $          | 24,587,590 |   |

 

Total POTS costsand expenses increased $116,000 or 1%. Plant operations expenses increased $230,000 or 5%. Customer operationsexpenses increased $187,000 or 13% due to increased marketing costs. Generaland administrative expenses increased $61,000 or 2%.  Other costs and expenses declined $202,000from the 2004 period which included $305,000 in expenses for write-offs ofaccounts receivable for access services provided to wireless telephone serviceproviders. Operating income in 2005 from POTS was $5,602,000, an increase of 6%from $5,279,000 in 2004.

 

23

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Total costs andexpenses for other services decreased $320,000 or 4% reflecting the following:Video service expenses increased $170,000 or 6% due to higher fee payments toprogramming providers, which more than offset expense reductions from the salesof the Hudson WI cable television system in 2004.   Internet expenses increased $7,000 or lessthan 1%. General and administrative expenses increased $214,000 from 2004mainly due to consulting and legal fees associated with the Company’s strategicplanning initiative.  Depreciation andamortization expenses decreased $142,000 or 8% because cable televisionproperty in some of the Company’s older systems is becoming fully depreciated.The $542,000 decline in other costs and expenses is due to the disposal ofHastad Engineering in 2004. Operating income in 2005 from other services was$2,388,000, an increase of 40% from $1,703,000 in 2004. Consolidated operatingincome from continuing operations increased 14% to $7,990,000.

 

Interest expensesfor 2005 increased $90,000 due to higher interest rates on the floating portionof the Company’s CoBank loan. Interest and dividend income increased $573,000due to higher cash balances available for investment, higher interest rates onfunds invested in money markets and savings accounts and increased dividends onthe Company’s expanded marketable securities portfolio.

 

Income from theCompany’s investment in Midwest Wireless Holdings, LLC was $4,682,000 in 2005compared to $2,766,000 in 2004.  MidwestWireless operations in 2005 benefited from increased customer counts and frominvestments made in 2004 to switch its cellular network to CDMAtechnology.  CDMA makes it possible forcustomers to utilize new wireless services including camera phones and textmessaging.  At December 31, 2005 MidwestWireless had 441,000 wireless customers, a 9% increase from 2004.  The Company had income from otherunconsolidated affiliates of $199,000 in 2005 compared to $483,000 in 2004. In2004, the Company sold the assets of the cable television system serving HudsonTownship, WI for a gain of $72,000 and sold the assets of Hastad EngineeringCompany for a gain of $13,000.

 

Income fromcontinuing operations before income taxes and minority interest increased 38%to $10,932,000.  Income tax expenseincreased to $4,365,000 in 2005 from $3,250,000 in 2004.  The Company’s tax rate varies from thefederal tax rate due to state income taxes. The Company’s state tax rate varies from year to year due to variabilityin apportioning earnings over the various taxing jurisdictions. Net incomeincreased 41% to $6,567,000 in 2005 compared to $4,644,000 in 2004.

 

# 2004 Compared to 2003

 

Revenues fromcontinuing operations decreased 2% to $31,570,000 in 2004 from $32,322,000 in2003. The revenue breakdown was as follows:
| ** **                                      | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|-------------------------------------------------|------------|------------|------------|------------|------------|
| Plain old telephone service (“POTS”): | ** ** | ** ** | ** ** | ** ** | ** ** |
| Local network                                   |       | $          | 6,201,326  |       | $          | 6,117,238 |   |
| Network access  revenues:                       | ** ** | ** ** | ** ** | ** ** | ** ** |
| Long distance  providers - interstate           |       | 3,182,635  |       | 3,484,387  |       |
| Long distance  providers – intrastate      |       | 4,425,222  |       | 4,813,392  |       |
| SLC Revenue                                     |       | 2,474,656  |       | 2,397,624  |       |
| High cost  support                              |       | 3,496,862  |       | 3,500,732  |       |
| Universal  service fund support                 |       | 1,743,721  |       | 1,879,119  |       |
| Total network  access revenues                  |       | 15,323,096 |       | 16,075,254 |       |
| Total POTS revenues                             |       | 21,524,422 |       | 22,192,492 |       |
|                                                 |            |            |            |            |            |  |  |

 

24

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| ** **                                  | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|---------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Other services:                             |       |       |       |       |       |
| Video services                              |       | 3,324,588  |       | 3,579,773  |       |
| Internet  services                          |       | 3,150,089  |       | 2,647,156  |       |
| Other  nonregulated services:               |       |       |       |       |       |
| Fiber leases                                |       | 657,022    |       | 682,521    |       |
| Wireless sales  commissions                 |       | 495,704    |       | 316,337    |       |
| Directory  revenues                         |       | 529,796    |       | 491,902    |       |
| Retail sales                                |       | 469,609    |       | 522,269    |       |
| Long distance  service sales commissions    |       | 382,936    |       | 381,825    |       |
| Customer  equipment installation and repair |       | 379,755    |       | 434,435    |       |
| Billing and  collection                     |       | 169,378    |       | 212,622    |       |
| Equipment rent                              |       | 126,130    |       | 118,292    |       |
| Engineering  services                       |       | 70,378     |       | 305,423    |       |
| All other  revenues                         |       | 289,963    |       | 437,381    |       |
| Total  nonregulated services revenue        |       | 3,570,671  |       | 3,903,007  |       |
| Total other service revenues                |       | 10,045,348 |       | 10,129,936 |       |
| Total revenue                               |       | $          | 31,569,770 |       | $          | 32,322,428 |   |
|                                             |            |            |            |            |            |  |  |

 

Total POTSrevenues decreased $668,000 or 3%.  Localnetwork revenues increased $84,000 or 1%. The increase was primarily due to increased revenues from CLASS servicefeatures (such as caller identification, call waiting, call forwarding andother related services) and increased extended area service (“EAS”) revenues inone exchange. EAS enables customers to call neighboring telephone systems tollfree in exchange for a flat monthly fee. The Company increased the ratescharged for CLASS services during the 2003 period.  The Company’s access lines count declined 1%in 2004.  The number of access linesserved fell due to substitution of cellular phones for landline phones bycustomers and the reduced number of second lines being used for dial-upinternet service.

 

Network accessrevenues decreased $752,000 or 5%.  TheCompany’s access minutes provided to other telecommunications carriers in 2004and 2003 were as follows:

 
| **Access minutes of use** | ** ** | **2004**    | ** ** | **2003**    | ** ** |
|---------------------------|------------|-------------|------------|-------------|------------|
| Wireline carriers         |       | 109,500,000 |       | 114,900,000 |       |
| Wireless carriers         |       | 23,200,000  |       | 17,500,000  |       |
|                      |       | 132,700,000 |       | 132,400,000 |       |

 

The revenuedecrease was due to lower network access revenues from wireline carriers, whichreflected the declining minutes of use by these providers.  However, access revenues from wirelesscommunications providers were also lower, despite the increased minutes theyused, due to the impact of the lower rates included in new interconnectionagreements that have been negotiated between the Company and selected wirelesscarriers.  Access revenues in 2003 werehigher than normal due to greater than anticipated recovery of bankruptcyreserves the Company established against its MCI/World Com receivables in 2002.High cost and universal service support funding decreased $139,000 or 3%.  Increases in support funds the Companyreceived in areas where it has newly installed Next Level equipment were offsetby decreases in support for other areas.

 

Total revenuesfrom other services decreased $85,000 or 1%. Revenues from video (cable television) services declined $255,000 or 7%.Video service revenues in 2004 were reduced by the sales of seven systemsserving 2,080 subscribers during the second quarter of 2003 and by the sale ofthe Hudson Township WI system in June 2004. Revenues from internet services increased $503,000 or 19%, due to a 40%increase in the number of customers subscribing to high-speed digitalsubscriber line (“DSL”) service.  AtDecember 31, 2004 the Company had 3,881 DSL customers and 6,679 dial-upinternet customers, compared to 2,778 DSL customers and 7,464 dial-up customersin December 2003. The DSL customer growth was facilitated by the deployment ofbroadband equipment manufactured by Next Level Communications, Inc. in theCompany’s Sleepy Eye, MN exchange in 2002 and 2003. This equipment makes itpossible to deliver voice, video and high speed internet services to thecustomer over the same circuit.

 

25

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Revenues fromother nonregulated services declined $332,000 or 9%.  The revenue decline was due to lower feesfrom engineering services, lower billing and collections revenues from longdistance carriers and lower revenues from leases of fiber optic facilities,which offset higher wireless sales commissions. The Company sold itsengineering service company in July 2004.

 

Operating costsand expenses were $24,588,000 in 2004, an increase of $222,000 or 1% from2003.  The breakdown of costs andexpenses was as follows:

 
| ** **                                       | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|--------------------------------------------------|------------|------------|------------|------------|------------|
| Plain old  telephone service (“POTS”): | ** ** | ** ** | ** ** | ** ** | ** ** |
| Plant  operations, excluding depreciation        |       | $          | 4,335,140  |       | $          | 4,511,421 | ** ** |
| Depreciation and  amortization                   |       | 6,275,688  |       | 6,178,096  |       |
| Customer  operations                             |       | 1,406,020  |       | 1,359,408  |       |
| General and  administrative                      |       | 3,475,741  |       | 3,435,078  |       |
| Other costs and  expenses                        |       | 752,647    |       | 413,019    |       |
| Total POTS costs  and expenses                   |       | 16,245,236 |       | 15,897,022 |       |
| Other services:                                  |       |       |       |       |       |
| Plant operations                                 |       | 3,962      |       | 5,290      |       |
| Depreciation and  amortization                   |       | 1,714,528  |       | 1,673,415  |       |
| Customer  operations                             |       | 211,747    |       | 192,701    |       |
| General and  administrative                      |       | 394,070    |       | 1,096,658  |       |
| Other costs and  expenses:                       |       |       |       |       |       |
| Video services  expenses                         |       | 3,059,031  |       | 3,026,613  |       |
| Internet  expenses                               |       | 959,834    |       | 910,900    |       |
| Other                                            |       | 1,999,182  |       | 1,563,183  |       |
| Total other  service costs and expenses          |       | 8,342,354  |       | 8,468,760  |       |
| Total costs and  expenses                        |       | $          | 24,587,590 |       | $          | 24,365,782 | ** ** |

 

Total POTS costsand expenses increased $348,000 or 2%. Plant operations expenses decreased $176,000 or 4% reflecting a reducedheadcount in 2004 and that 2003 included severance charges for employeeheadcount reductions. Customer operations expenses increased $47,000 or 3%.General and administrative expenses increased $41,000 or 1%.  The 2004 period included $305,000 in expensesfor write-offs of accounts receivable for access services provided to wirelesstelephone service providers. Operating income in 2004 from POTS was $5,279,000,a decrease of 16% from $6,295,000 in 2003.

 

Total costs andexpenses for other services decreased $126,000 or 1% reflecting the following:Video service expenses increased $32,000 or 1% as expense reductions due tosales of cable television systems in 2004 and 2003 were offset by higher feepayments to programming providers. Internet expenses increased $49,000 or 5%. General and administrativeexpenses decreased $703,000 from 2003 mainly due to the sale of the Company’sengineering business in 2004.  2003expenses also compared unfavorably due to costs incurred in the Split-UpTransaction.  Depreciation andamortization expenses increased $41,000 or 2% due to depreciation on new plantinvestments. Operating income in 2004 from other services was $1,703,000, anincrease of 3% from $1,661,000 in 2003. Consolidated operating income fromcontinuing operations decreased 12% to $6,982,000.

 

Interest expensesfor 2004 decreased $534,000 due to lower interest rates on borrowings fromCoBank.  A significant portion of theCompany’s CoBank debt moved from a higher fixed interest rate to lower floatingmarket rates during the fourth quarter of 2003. Interest and dividend incomeincreased $53,000 due to higher cash balances available for investment.

 

Income from theCompany’s investment in Midwest Wireless Holdings, LLC was $2,766,000 in 2004compared to $2,148,000 in 2003.  MidwestWireless operations in 2004 benefited from determinations by regulators thatits operations were eligible to receive universal service high cost supportfunds. The Company had income from other unconsolidated investments of $483,000in 2004 compared to $96,000 in 2003. In 2004, the Company sold the assets ofthe cable television system serving Hudson Township, WI for a gain of $72,000and sold the assets of Hastad Engineering Company for a gain of $13,000.  The Company sold two groups of cabletelevision systems during the second quarter of 2003 for a total gain of$1,081,000.

 

26

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Income fromcontinuing operations before income taxes and minority interest decreased 5% to$7,894,000.  Income tax expense decreasedto $3,250,000 in 2004 from $3,316,000 in 2003. The Company’s tax rate varies from the federal tax rate due to stateincome taxes.  The Company’s state taxrate varies from year to year due to variability in apportioning earnings overthe various taxing jurisdictions.  Incomebefore minority interest in the earnings of Alliance was $4,644,000 in 2004compared to $4,957,000 in 2003.  Minorityinterests in earnings of Alliance from continuing operations in 2003 were$660,000. Income from continuing operations totaled $4,644,000 compared to$4,297,000 in 2003.

 

Income fromdiscontinued operations before minority interest in 2003 was $989,000.  Minority interests in those earnings were$316,000. The Company recorded a gain on the split-up of Alliance, net ofincome taxes, of $210,000 in 2003.  TheCompany had net income of $4,644,000 in 2004 compared to $5,179,000 in 2003.

 

Liquidity andCapital Resources

 

Operations

 

Cash flows fromconsolidated operating activities (including the activities of discontinuedoperations up to the Alliance split-up date) were $11,956,000, $10,464,000, and$12,953,000 in 2005, 2004 and 2003, respectively. At December 31, 2005, theCompany’s cash and cash equivalents totaled $25,245,000 compared to $19,981,000at December 31, 2004.  Working capital atDecember 31, 2005 was $18,981,000 compared to $17,601,000 at December 31,2004.  The current ratio was 2.8 to 1 atDecember 31, 2005 compared to 2.7 to 1 at December 31, 2004.

 

The Companyregularly makes improvements to its facilities to provide up-to-datetelecommunications services to its customers. Plant additions in support of POTS operations were $4,261,000,$3,371,000 and $2,927,000 in 2005, 2004 and 2003, respectively.  Plant additions for nonregulated operationsin 2005, 2004 and 2003 were $737,000, $811,000 and $729,000 respectively.  Plant additions for discontinued operationsup to the Alliance split-up date were $257,000 in 2003.  Plant additions for 2006 are expected tototal $4,234,000.  These plant additionswill upgrade the Company’s telephone switching equipment to allow for moreadvanced telecommunications services, expand telecommunications services intonew construction developments and increase usage of Next Level broadbandequipment and high capacity fiber optics in the telephone network.

 

# Long-TermObligations and  Commitments

 

TheCompany’s LEC subsidiaries borrow from the Rural Utilities Service (“RUS”) andthe Rural Telephone Bank (“RTB”) to help finance asset additions.  Proceeds from long-term borrowings from RUSand RTB were $2,501,000, $2,893,000 and $5,998,000 in 2005, 2004 and 2003,respectively.  The average interest rateon outstanding RUS and RTB loans is 5.0%. The Company’s Loretel Systemssubsidiary received a new loan commitment from the RUS in 2005.  This new loan would provide funding for theinstallation of “triple play” capable fiber and electronics in exchanges servedby Loretel.  At December 31, 2005unadvanced loan commitments from the RUS and RTB to the Company’s LECsubsidiaries totaled $57,615,000.

 

Substantially allof the assets of the Company’s LEC subsidiaries are pledged or are subject tomortgages to secure obligations to the RUS and RTB.  The Company’s loan agreements placesignificant restrictions on cash distributions from the subsidiaries to theparent company.  At December 31, 2005,$20,804,000 of subsidiaries’ retained earnings was available for dividendpayments to Hector. At December 31, 2005, $42,152,000 of Hector’s retainedearnings was not available to pay dividends to shareholders due to restrictionsin the debt agreements.  It has been theCompany’s practice, in so far as practical, to maintain its cash balances atthe subsidiary level to support their operations.

 

The Company incurredsignificant debt in 1996 to finance Alliance’s acquisition of Ollig UtilitiesCompany. In connection with the Split-Up Transaction the Company repaid the1996 acquisition loan with proceeds from a new term loan provided to Hector byCoBank. The loan is secured by a pledge of the stock of Hector’s subsidiarycompanies.  Interest rates on long-termportions of the loan are fixed through 2007, while the non-fixed portion floatsat short-term market rates. The average rate on the total loan wasapproximately 6.9% at December 31, 2005. Principal payments are made quarterly and will continue until April2013. The outstanding balance on this

 

27

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loan at December 31, 2005was $20,625,000.  CoBank is acooperative, owned and controlled by its customers. Each customer borrowingfrom the bank on a patronage basis shares in the bank’s net income throughpayment of patronage refunds. As a condition of maintaining the loan, Hectorowns stock in the bank.  Its investmentin CoBank stock was $2,739,000 at December 31, 2005.

 

As part offinancing its ownership interest in Alliance in 1996, Hector received a 15-yearterm loan from Rural Telephone Finance Cooperative (“RTFC”).   The loan was repaid in July 2003 as part ofthe CoBank refinancing.

 

In addition to itsdebt agreements, Hector and its subsidiaries have entered into contracts withsuppliers to provide switching services and fiber optic transport facilitiesand other services.  The Company’s cashpayments due for these obligations are as follows (interest payments areestimated using December 31, 2005 interest rates):

 
| ** **    | ** ** | **Total**  | ** ** | **Long-Term  Debt** | ** ** | **Interest  Payments** | ** ** | **Operating  Leases** | ** ** |
|---------------|------------|------------|------------|---------------------|------------|------------------------|------------|-----------------------|------------|
| 2006          |       | $          | 9,824,100  |                | $          | 6,527,400              |       | $                     | 2,998,700  |   | $ | 298,000 |   |
| 2007          |       | 9,132,400  |       | 6,312,400           |       | 2,636,200              |       | 183,800               |       |
| 2008          |       | 8,711,600  |       | 6,409,100           |       | 2,204,600              |       | 97,900                |       |
| 2009          |       | 8,471,500  |       | 6,584,800           |       | 1,838,200              |       | 48,500                |       |
| 2010          |       | 8,358,700  |       | 6,852,500           |       | 1,460,800              |       | 45,400                |       |
| After 2010(1) |       | 26,408,438 |       | 23,297,338          |       | 3,086,200              |       | 24,900                |       |
|          |       | $          | 70,906,738 |                | $          | 55,983,538             |       | $                     | 14,224,700 |   | $ | 698,500 | ** ** |
|               |            |            |            |                     |            |                        |            |                       |            |  |  |  |  |  |  |  |  |

 

----

(1)                      The Companyhas an obligation to pay Broadband Visions LLC (“BBV”) $3,000 per month forfiber optic transport facilities until such time that the Company is not amember of BBV.  This obligation isreflected in the table for each year from 2006 through 2010.  No amount is included after 2010.

 

The Company hasentered into employment agreements or change in control agreements withofficers and key employees of the Company. The agreements provide for severance payments in the event of a changein control of the Company and employment termination for reasons other thancause.

 

Investments

 

Investment incomehas been derived almost exclusively from interest earned on the Company’s cashand cash equivalents.  Interest incomehas fluctuated in relation to changes in interest rates and availability ofcash for investment.  In 2005 and 2004the Company invested $655,000 and $321,000 respectively in the common stock oftwo other Minnesota based telecommunications companies and may make additionalinvestments if market conditions warrant.

 

The Company is aninvestor in partnerships and limited liability companies that provide wirelesstelecommunications services, fiber optic transport services, directoryservices, competing local exchange (CLEC) services and video headend services.  Cash distributions to the Company from theseinvestments have generally been limited to amounts necessary to pay incometaxes.  The Company’s participation inthese ventures makes certain services available to customers which wouldotherwise be beyond the Company’s means to provide. The Company expects to makeadditional investments of this type as opportunities arise.

 

As part of itsborrowing agreements, the Company has stock investments in CoBank, RuralTelephone Finance Cooperative and the Rural Telephone Bank (“RTB”). In 2005,the Board of Directors of the RTB approved resolutions to liquidate the bankand redeem its stock.  Congress removedlegal restrictions on the redemption of RTB stock in 2005.  It is expected the RTB will be dissolved in2006 and outstanding RTB stock will be redeemed at par value.  At December 31, 2005 the par value of theCompany’s RTB stock is $11,610,000 and the carrying value is $1,269,000.

 

The Company alsohas long-term investments in stock and notes of non-marketable corporations andnotes receivable and in rural development note receivables that were funded byno-interest loans from the Rural Utilities Service.

 

28

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Midwest WirelessHoldings LLC

 

Midwest Wireless HoldingsLLC (“Midwest Wireless’) is owned by telecommunications companies (principallyLECs) located within Midwest Wireless’ operating footprint in southernMinnesota, northern Iowa and west central Wisconsin.  Hector is presently the third largest memberof Midwest Wireless Holdings LLC, with an 8.0% ownership stake. On November 17,2005 Midwest Wireless and Alltel Corporation (“Alltel”) entered into adefinitive agreement for Alltel to purchase Midwest Wireless.  Compensation paid by Alltel would total$1.075 billion, including payments to Midwest Wireless shareholders, paymentsto minority interest holders in certain Midwest properties and assumption ofMidwest Wireless’ outstanding debt.  TheCompany estimates its pretax share of the proceeds will be $64,900,000.  U.S. Cellular Corporation has initiatedproceedings at the FCC and in Delaware State court contesting the definitiveagreement.  Midwest Wireless expects toclose the transaction in 2006, subject to settlement of U.S. Cellular’s claims,satisfaction of customary conditions and receipt of regulatory approvals.

 

Credit Risk

 

Financialinstruments that potentially subject the Company to concentrations of creditrisk consist principally of cash and cash equivalents.  The Company places its cash investments withhigh credit quality financial institutions. The Company maintains its cash in bank deposit and brokerage moneymarket accounts.  The account balances attimes exceed the federally insured limits. The Company has not experienced losses in these accounts and does notbelieve they are exposed to any significant credit risk.

 

A significantportion of the Company’s revenues is received from long distance carriers inthe telephone industry.  Consequently,the Company is directly affected by the financial well-being of thatindustry.  The credit risk associatedwith these accounts is minimized due to the large number of long distancecarriers.

 

Common Stock

 

The Company’sBoard of Directors has authorized the purchase and retirement, from time totime, of shares of the Company’s stock on the open market, or in privatetransactions consistent with overall market and financial conditions. TheCompany purchased and retired 1,169 and 1,106 in 2005 and 2003respectively.  No shares were repurchasedin 2004.  Cost of the repurchased shareswas $30,000 and $17,000 in 2005 and 2003 respectively.  At December 31, 2005, 213,800 shares could berepurchased under outstanding Board authorizations.  Proceeds to the Company from exercises ofemployee stock options and employee stock purchase plan shares totaled$1,021,000,  $1,445,000, and $431,000 in2005, 2004 and 2003, respectively.

 

Dividends

 

Hector paid cashdividends on its common stock and preferred stock totaling $.28 and $.05 pershare in 2005 and 2004 respectively.  Theamount and timing of future dividends will be determined at the discretion ofthe Board of Directors.  Hector has noobligation to pay dividends on its preferred stock except that holders ofpreferred stock receive the same per share dividend as common stock.

 

**Sales of Cable Television Systems andOther Business**

 

**The Company continuously evaluates its investments inbusiness properties.  These evaluationshave led it to sell or discontinue investments where it does not believe it canearn an adequate return or which do not fit its strategic plan.  In 2004 the Company sold the assets of HastadEngineering Company to Finley Engineering Company.  Proceeds from the sale totaled $48,390 andthe Company recorded a gain of $12,805. In 2004 the Company sold the assets of the cable television systemserving Hudson Township, WI to Baldwin Telecom Inc. for $193,000 of cash and anote receivable of $395,000. The Company recorded a gain on the sale of$72,466. In 2003 the Company sold four systems in rural North Dakota serving930 subscribers to MLGC, LLC for $200,000 of cash and a note receivable of$650,000.  The Company sold systemsserving 1,150 subscribers in three communities surrounding the Fargo, ND —Moorhead, MN area to Cable One, Inc. for $1,545,000 of cash. The Company isconsidering sales of additional cable television properties in areas where itdoes not plan to also provide telephone and internet services.**

** **

29

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Acquisitions

 

The Company is continually evaluating possible acquisitions thatadvance its plan to be a provider of top quality telecommunications services torural customers. In the past, the Company has been a member of investor groupsthat sought unsuccessfully to acquire rural telephone properties offered forsale by major telephone companies. The Company cannot predict if it will besuccessful in acquiring additional properties and does not currently havefinancing plans in place to pay for possible acquisitions.

 

Byutilizing cash flow from operations, current cash and investment balances, andother available financing sources, the Company feels it has adequate resourcesto meet its anticipated operating, debt service and capital expenditurerequirements.

 

Split-Up Transactions

 

In July 2001, Golden West and ACCI, respectively the 20% and 12%minority shareholders of Alliance, advised the Company that they wereinterested in exchanging their minority investment for a share of the assetsand liabilities of Alliance. Thereafter the parties engaged in negotiationsthat continued through December 2002. The negotiation process includedevaluations and appraisals of Alliance’s business components, negotiations withAlliance’s lenders (CoBank, Rural Utilities Service and Rural Telephone Bank)regarding waivers, lien releases, interest penalties where applicable andfuture financing terms. The process also included seeking necessary regulatoryapprovals from local, state and national regulators.

 

The Company completed the Split-Up Transactions on July 7, 2003. Asagreed among the parties, in the split-up, Golden West exchanged its 20%ownership interest in Alliance for all of the outstanding stock of Sioux ValleyTelephone Company, which included a pro rata share of Alliance’s ownership inMidwest Wireless Holdings, LLC and certain other Alliance assets. ACCIexchanged its 12% ownership interest in Alliance for all of the outstandingstock of Hills Telephone Company, which included a pro rata share of Alliance’sownership in Midwest Wireless Holdings, LLC and certain other Alliance assets.Immediately prior to the breakup Sioux Valley and Hills paid a dividend toAlliance of approximately $12,849,000. The dividend proceeds were applied torepay a portion of Alliance’s acquisition loan from CoBank. Concurrent with thesplit-up, the balance of Alliance’s debt to CoBank and the balance of theCompany’s debt to Rural Telephone Finance Cooperative were retired usingproceeds from a new $26,813,000 loan from CoBank to Hector CommunicationsCorporation. A number of other stock and asset transfers also occurred amongAlliance and its subsidiaries prior to the split-up in order to satisfy variousregulatory and lender requirements.

 

The Company believes the Split-Up Transactions are tax-free underSection 355 of the Internal Revenue Code. The Company also believes thatrelated internal stock and asset transfers that occurred prior to the split-upare tax-free under Section 355, related Code provisions and the consolidated returnregulations, although no private letter ruling was sought from the IRS inconnection with the split-up. In connection with the Split-Up Transactions, theparties entered agreements with regard to cooperation, exchange of information,interim use of common services, employee benefits, tax allocations andindemnification generally in proportion to ownership percentages with respectto unexpected adverse tax consequences, and other matters arising after theSplit-Up Transactions which relate to commitments, events or circumstances ineffect as of the date of the Split-Up Transactions.

 

Effects of Inflation

 

The Company’s ability to accommodate expense increases due to inflationare constrained by the regulatory environment in which its POTS segmentoperates. The Company’s local exchange telephone companies are subject to thejurisdiction of Minnesota, North Dakota and Wisconsin regulatory authoritieswith respect to a variety of matters, including rates for intrastate accessservices, the conditions and quality of service, issuance of debt, depreciationrates and accounting methods. Rates for local telephone service are notestablished directly by regulatory authorities, but their authority over othermatters limits the Company’s ability to implement rate increases. In addition,the regulatory process inherently restricts the Company’s ability toimmediately pass cost increases along to customers unless the cost increasesare anticipated and the rate increases implemented prospectively.

 

30

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New Accounting Standards

 

In December 2004, the FASB issued SFAS No. 123R, “Shared-BasedPayment”. SFAS 123R requires all share-based payments to employees, includinggrants of employee stock options, to be valued at fair value on the date ofgrant and expensed over the applicable vesting period. Compensation expense foroutstanding unvested awards will be measured based on the fair value of theawards as previously calculated developing the pro forma disclosures previouslypermitted under SFAS 123R. On April 14, 2005 the SEC issued a rule that changedthe effective date of SFAS 123R for public companies to the first annual periodor interim period in the first fiscal year beginning after June 15, 2005. TheCompany has chosen the modified prospective basis of the Black-Scholes optionpricing model to calculate future stock compensation expense, using a fairvalue method as prescribed under SFAS 123R. The valuation of equity instrumentsunderlying stock-based compensation and the period in which the related expenseis recognized will be based on various assumptions including the estimated lifeof equity instruments, stock volatility, interest rates and vesting terms. TheCompany has assessed the impact of adopting SFAS 123R and determined that thedisclosures made in Notes 1 and 10 of the Notes to Consolidated FinancialStatements provide a reasonable expectation of future expense.

 

**ITEM 7A.****                    QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

The Company does not use derivative financial instruments in itsoperations or investment portfolio. Its operations are not subject to risksassociated with changes in the value of foreign currencies. Portions of theCompany’s long-term debt have variable interest rates based on the lenders’cost of money. The Company has investments in money market funds and mutualfunds that earn interest at prevailing market rates. In the opinion ofmanagement, the Company does not have a material exposure to loss caused bymarket risk.

 

**ITEM 8.****                             FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA**

 

**(a)  FINANCIAL STATEMENTS**

**REPORT OFMANAGEMENT**

 

The management of Hector Communications Corporation and its subsidiarycompanies is responsible for the integrity and objectivity of the financialstatements and other financial information contained in the annual report. Thefinancial statements and related information were prepared in accordance withaccounting principles generally accepted in the United States of America andinclude amounts that are based on management’s informed judgments andestimates.

 

In fulfilling its responsibilities for the integrity of financialinformation, management maintains accounting systems and related controls.These controls provide reasonable assurance, at appropriate costs, that assetsare safeguarded against losses and that financial records are reliable for usein preparing financial statements. Management recognizes its responsibility forconducting the Company’s affairs according to the highest standards of personaland corporate conduct.

 

The Audit Committee of the Board of Directors, composed solely ofoutside directors, meets with the independent auditors and managementperiodically to review accounting, auditing, financial reporting and internalcontrol matters. The independent auditors have free access to this committee,without management present to discuss the results of their audit work and theiropinion on the adequacy of internal financial controls and the quality offinancial reporting.

 
|   | /s/Curtis A. Sampson                 |                    | /s/Charles A. Braun |   |
|--------|--------------------------------------|-------------------------|---------------------|--------|
|   | Chai armannd Chief Executive Officer | Chief Financial Officer |

** **

31

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** **

**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

** **

Shareholders and Board of Directors

Hector Communications Corporation

 

We have audited the accompanying consolidated balance sheets of HectorCommunications Corporation and subsidiaries as of December 31, 2005 and 2004,and the related consolidated statements of income, comprehensive income,stockholders’ equity and cash flows for each of the three years in the periodended December 31, 2005. These financial statements are the responsibility ofthe Company’s management. Our responsibility is to express an opinion on thesefinancial statements based on our audits. We did not audit the financialstatements of Midwest Wireless Holdings L.L.C., a limited liability company,the investment in which, as discussed in Note 5 to the consolidated financialstatements, is accounted for by the equity method of accounting. The investmentin Midwest Wireless Holdings L.L.C. was $18,067,471 and $15,380,543 as ofDecember 31, 2005 and 2004 and the equity earnings in its net income was$4,681,888, $2,765,887 and $2,148,444 for the years ended December 31, 2005,2004 and 2003. The financial statements of Midwest Wireless Holdings L.L.C.were audited by other auditors whose report has been furnished to us, and ouropinion, insofar as it relates to the amounts included for Midwest WirelessHoldings L.L.C., is based solely on the report of the other auditors.

 

We conducted our audits in accordance with the standards of the PublicCompany Accounting Oversight Board (United States). Those standards requirethat we plan and perform the audit to obtain reasonable assurance about whetherthe financial statements are free of material misstatement. The Company is notrequired to have, nor were we engaged to perform, an audit of its internalcontrol over financial reporting. Our audit included consideration of internalcontrol over financial reporting as a basis for designing audit procedures thatare appropriate in the circumstances, but not for the purpose of expressing anopinion on the effectiveness of the Company’s internal control over financialreporting. Accordingly, we express no such opinion. An audit also includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements, assessing the accounting principles used andsignificant estimates made by management, as well as evaluating the overallfinancial statement presentation. We believe that our audits provide areasonable basis for our opinion.

 

In our opinion, based on our audits and the report of other auditors,the consolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of Hector Communications Corporationand subsidiaries as of December 31, 2005 and 2004, and the results of theiroperations and their cash flows for each of the three years in the period endedDecember 31, 2005 in conformity with accounting principles generally acceptedin the United States of America.

 
| /s/Olsen Thielen & Co., Ltd. |   |
|----------------------------------|--------|
| St. Paul, Minnesota              |
| February 17, 2006                |

 

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HECTOR COMMUNICATIONS CORPORATION ANDSUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

 
| ** **                                                                                                                                   | ** ** | **December 31** | ** **  |
|----------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|-------------|
| ** **                                                                                                                                   | ** ** | **2005**        | ** **  | **2004** | ** ** |
| ASSETS                                                                                                                                       | ** ** | ** **      | ** **  | ** ** | ** ** |
| CURRENT ASSETS:                                                                                                                              |       |            |        |   |   |
| Cash and cash equivalents                                                                                                                    |       | $               | 25,245,358  |   | $ | 19,980,506 |   |
| Construction fund (Note 9)                                                                                                                   |       | 756,260         |        | 3,944,684 |   |
| Accounts receivable (net of allowance for  doubtful accounts of $26,000 and $37,000, respectively)                                           |       | 2,678,690       |        | 3,017,569 |   |
| Materials, supplies and inventories (Note  1)                                                                                                |       | 795,181         |        | 820,081 |   |
| Other current assets                                                                                                                         |       | 247,182         |        | 250,276 |   |
| TOTAL CURRENT ASSETS                                                                                                                         |       | 29,722,671      |        | 28,013,116 |   |
|                                                                                                                                         |       |            |        |   |   |
| PROPERTY, PLANT AND EQUIPMENT,net (Notes 1  and 3)                                                                                           |       | 37,381,570      |        | 40,040,493 |   |
|                                                                                                                                         |       |            |        |   |   |
| INVESTMENTS AND OTHER ASSETS:                                                                                                                |       |            |        |   |   |
| Excess of cost over net assets acquired  (Note 4)                                                                                            |       | 30,921,094      |        | 30,921,094 |   |
| Investment in Midwest Wireless Holdings LLC  (Note 5)                                                                                        |       | 18,067,471      |        | 15,380,543 |   |
| Investments in other unconsolidated  affiliates (Note 6)                                                                                     |       | 3,307,593       |        | 3,304,726 |   |
| Other investments (Notes 1, 7 and 16)                                                                                                        |       | 8,037,986       |        | 6,880,549 |   |
| Other assets (Notes 1 and 4)                                                                                                                 |       | 315,906         |        | 382,322 |   |
| TOTAL OTHER ASSETS                                                                                                                           |       | 60,650,050      |        | 56,869,234 |   |
| TOTAL ASSETS                                                                                                                                 |       | $               | 127,754,291 |   | $ | 124,922,843 |   |
|                                                                                                                                         |       |            |        |   |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                    |       |            |
| CURRENT LIABILITIES:                                                                                                                         |       |            |        |   |   |
| Notes payable and current portion of  long-term debt (Note 9)                                                                                |       | $               | 6,527,400   |   | $ | 6,352,000 |   |
| Accounts payable (Note 12)                                                                                                                   |       | 1,287,547       |        | 2,072,722 |   |
| Accrued expenses                                                                                                                             |       | 1,873,656       |        | 1,936,188 |   |
| Income taxes payable                                                                                                                         |       | 1,052,944       |        | 51,701 |   |
| TOTAL CURRENT LIABILITES                                                                                                                     |       | 10,741,547      |        | 10,412,611 |   |
|                                                                                                                                         |       |            |        |   |   |
| LONG-TERM DEBT, less current portion (Note  9)                                                                                               |       | 49,456,138      |        | 54,084,480 |   |
|                                                                                                                                         |       |            |        |   |   |
| DEFERRED INVESTMENT TAX CREDITS (Note 8)                                                                                                     |       | 2,638           |        | 3,340 |   |
|                                                                                                                                         |       |            |        |   |   |
| DEFERRED INCOME TAXES (Note 8)                                                                                                               |       | 5,306,152       |        | 5,460,554 |   |
|                                                                                                                                         |       |            |        |   |   |
| DEFERRED COMPENSATION (Note 11)                                                                                                              |       | 802,116         |        | 749,128 |   |
|                                                                                                                                         |       |            |        |   |   |
| COMMITMENTS AND CONTINGENCIES (Notes 9 and  15)                                                                                              |       |            |        |   |   |
|                                                                                                                                         |       |            |        |   |   |
| STOCKHOLDERS’ EQUITY: (Notes 1, 9 and 10)                                                                                               |       |            |        |   |   |
| Preferred stock, par value $1.00 per share;  3,000,000 shares authorized:  Convertible Series A, 0 and 157,800 shares issued and outstanding |       |            |        | 157,800 |   |
| Common stock, par value $.01 per share;  10,000,000 shares authorized;  3,982,789 and 3,723,390 shares issued and outstanding                |       | 39,828          |        | 37,234 |   |
| Additional paid-in capital                                                                                                                   |       | 17,138,826      |        | 15,621,048 |   |
| Retained earnings                                                                                                                            |       | 43,794,447      |        | 38,359,117 |   |
| Accumulated other comprehensive income  (Note 7)                                                                                             |       | 472,599         |        | 37,531 |   |
| TOTAL STOCKHOLDERS’ EQUITY                                                                                                              |       | 61,445,700      |        | 54,212,730 |   |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                              |       | $               | 127,754,291 |   | $ | 124,922,843 |   |

 

See notes to consolidated financialstatements.

 

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HECTOR COMMUNICATIONS CORPORATION ANDSUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

 
| ** **                                                                             | ** ** | **Year Ended December 31** | ** ** |
|----------------------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                             | ** ** | **2005**                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| REVENUES  FROM CONTINUING OPERATIONS:                                                  |       |                       |       |   |   |   |   |
| Local network                                                                          |       | $                          | 6,088,047  |   | $ | 6,201,326 |   | $ | 6,117,238 |   |
| Network access                                                                         |       | 15,875,103                 |       | 15,323,096 |   | 16,075,254 |   |
| Video services                                                                         |       | 3,171,117                  |       | 3,324,588 |   | 3,579,773 |   |
| Internet services                                                                      |       | 3,832,037                  |       | 3,150,089 |   | 2,647,156 |   |
| Other nonregulated services                                                            |       | 3,407,171                  |       | 3,570,671 |   | 3,903,007 |   |
| TOTAL REVENUES                                                                         |       | 32,373,475                 |       | 31,569,770 |   | 32,322,428 |   |
| COSTS AND EXPENSES:                                                                    |       |                       |       |   |   |   |   |
| Plant operations, excluding depreciation                                               |       | 4,567,951                  |       | 4,339,102 |   | 4,516,711 |   |
| Depreciation and amortization                                                          |       | 7,688,691                  |       | 7,990,216 |   | 7,851,511 |   |
| Customer operations                                                                    |       | 1,778,507                  |       | 1,617,767 |   | 1,552,109 |   |
| General and administrative                                                             |       | 4,144,194                  |       | 3,869,811 |   | 4,531,736 |   |
| Other operating expenses:                                                              |       |                       |       |   |   |   |   |
| Video service expenses                                                                 |       | 3,228,645                  |       | 3,059,031 |   | 3,026,613 |   |
| Internet expenses                                                                      |       | 967,315                    |       | 959,834 |   | 910,900 |   |
| Other                                                                                  |       | 2,008,459                  |       | 2,751,829 |   | 1,976,202 |   |
| TOTAL COSTS AND EXPENSES                                                               |       | 24,383,762                 |       | 24,587,590 |   | 24,365,782 |   |
| OPERATING  INCOME FROM CONTINUING OPERATIONS                                           |       | 7,989,713                  |       | 6,982,180 |   | 7,956,646 |   |
| OTHER INCOME  (EXPENSES):                                                              |       |                       |       |   |   |   |   |
| Interest expense                                                                       |       | (2,957,370                 | )          | (2,867,135 | ) | (3,401,479 | ) |
| Income (loss) from investments in  unconsolidated affilates:                           |       |                       |       |   |   |   |   |
| Midwest Wireless Holdings, LLC (Note 5)                                                |       | 4,681,888                  |       | 2,765,887 |   | 2,148,444 |   |
| Other unconsolidated affiliates (Note 6)                                               |       | 199,462                    |       | 482,847 |   | 96,299 |   |
| Interest and dividend income                                                           |       | 1,018,641                  |       | 445,333 |   | 391,897 |   |
| Gain on sale of cable television systems  and other business (Note 14)                 |       |                       |       | 85,271 |   | 1,080,723 |   |
| OTHER INCOME (EXPENSES), net                                                           |       | 2,942,621                  |       | 912,203 |   | 315,884 |   |
| INCOME FROM CONTINUING OPERATIONS BEFORE  INCOME TAXES ANDMINORITY INTEREST            |       | 10,932,334                 |       | 7,894,383 |   | 8,272,530 |   |
| Income tax  expense (Note 8)                                                           |       | 4,365,000                  |       | 3,250,000 |   | 3,316,000 |   |
| INCOME FROM CONTINUING OPERATIONS BEFORE  MINORITY INTEREST                            |       | 6,567,334                  |       | 4,644,383 |   | 4,956,530 |   |
| Minority interest in continuing operations  of Alliance Telecommunications Corporation |       |                       |       |   |   | (659,624 | ) |
| INCOME FROM  CONTINUING OPERATIONS                                                     |       | 6,567,334                  |       | 4,644,383 |   | 4,296,906 |   |
| INCOME FROM  DISCONTINUED OPERATIONS (Note 2)                                          |       |                       |       |   |   | 881,854 |   |
| NET INCOME                                                                             |       | $                          | 6,567,334  |   | $ | 4,644,383 |   | $ | 5,178,760 |   |
| BASIC NET  INCOME PER COMMON SHARE (Note 1):                                           |       |                       |       |   |   |   |   |
| Continuing operations                                                                  |       | $                          | 1.72       |   | $ | 1.28 |   | $ | 1.23 |   |
| Discontinued operations                                                                |       |                       |       |   |   | .25 |   |
|                                                                                   |       | $                          | 1.72       |   | $ | 1.28 |   | $ | 1.48 |   |
| DILUTED NET  INCOME PER COMMON SHARE (Note 1):                                         |       |                       |       |   |   |   |   |
| Continuing operations                                                                  |       | $                          | 1.61       |   | $ | 1.17 |   | $ | 1.14 |   |
| Discontinued operations                                                                |       |                       |       |   |   | .23 |   |
|                                                                                   |       | $                          | 1.61       |   | $ | 1.17 |   | $ | 1.37 |   |
| DIVIDENDS  PER SHARE                                                                   |       | $                          | .28        |   | $ | .05 |   | $ | — |   |
| AVERAGE  SHARES OUTSTANDING (Notes 1 and 10):                                          |       |                       |       |   |   |   |   |
| Common shares only                                                                     |       | 3,821,000                  |       | 3,635,000 |   | 3,487,000 |   |
| Common and potential common shares                                                     |       | 4,084,000                  |       | 3,970,000 |   | 3,765,000 |   |

 

See notes to consolidated financialstatements.

 

34

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HECTOR COMMUNICATIONS CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

 
| ** **                                                                                             | ** ** | **Year Ended December 31** | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                                             | ** ** | **2005**                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net income                                                                                             |       | $                          | 6,567,334  |   | $ | 4,644,383 |   | $ | 5,178,760 |   |
|                                                                                                   |       |                       |       |   |   |   |   |
| Other comprehensive income (loss):                                                                     |       |                       |       |   |   |   |   |
| Unrealized holding gains (losses) on  marketable securities                                            |       | 725,115                    |       | (22,824 | ) | 97,612 |   |
| Income tax (expense) benefit related to  unrealized  holding gains and losses on marketable securities |       | (290,047                   | )          | 9,130 |   | (39,053 | ) |
| Minority interest in other comprehensive  loss of  Alliance Telecommunications Corporation             |       |                       |       |   |   | 3,783 |   |
| Other comprehensive income (loss)                                                                      |       | 435,068                    |       | (13,694 | ) | 62,342 |   |
| Comprehensive income                                                                                   |       | $                          | 7,002,402  |   | $ | 4,630,689 |   | $ | 5,241,102 |   |

 

See notes to consolidated financialstatements

 

35

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HECTOR COMMUNICATIONS CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

 
| ** **                                                                    | ** ** | **Preferred  Stock** | ** ** | **Common Stock** | ** ** | **Additional  Paid-in**

**Capital** | ** ** | **Retained**

**Earnings** | ** ** | **Accumulated  Other  Comprehensive**

**Income  (Loss)** | ** ** | **Total**  | ** ** |
|-------------------------------------------------------------------------------|------------|----------------------|------------|------------------|------------|--------------------------------------|------------|----------------------------|------------|-----------------------------------------------------------|------------|------------|------------|
| ** **                                                                    | ** ** | **Shares**           | ** ** | **Amount**       | ** ** | **Shares**                           | ** ** | **Amount**                 | ** ** | ** **                                                | ** ** | ** ** | ** ** |
| BALANCE AT  DECEMBER 31, 2002                                                 |       | 220,100              |       | $                | 220,100    |                                 | 3,455,067  |                       | $          | 34,551                                                    |       | $          | 13,262,969 |   | $ | 28,742,832 |   | $ | (11,117 | ) | $ | 42,249,335 |   |
| Net income                                                                    |       |                 |       |             |       |                                 |       |                       |       |                                                      |       | 5,178,760  |       |   |   | 5,178,760 |   |
| Issuance of  common stock under  Employee Stock Purchase Plan                 |       |                 |       |             |       | 15,685                               |       | 157                        |       | 131,166                                                   |       |       |       |   |   | 131,323 |   |
| Issuance of common  stock to  Employee Stock Ownership Plan                   |       |                 |       |             |       | 11,000                               |       | 110                        |       | 139,040                                                   |       |       |       |   |   | 139,150 |   |
| Issuance of  common stock under  Employee Stock Option Plan                   |       |                 |       |             |       | 34,836                               |       | 348                        |       | 299,572                                                   |       |       |       |   |   | 299,920 |   |
| Purchase and  retirement of  common stock                                     |       |                 |       |             |       | (1,106                               | )          | (11                        | )          | (4,333                                                    | )          | (12,818    | )          |   |   | (17,162 | ) |
| Change in  unrealized gains on  marketable securities, net of  deferred taxes |       |                 |       |             |       |                                 |       |                       |       |                                                      |       |       |       | 62,342 |   | 62,342 |   |
| BALANCE AT  DECEMBER 31, 2003                                                 |       | 220,100              |       | 220,100          |       | 3,515,482                            |       | 35,155                     |       | 13,828,414                                                |       | 33,908,774 |       | 51,225 |   | 48,043,668 |   |
| Net income                                                                    |       |                 |       |             |       |                                 |       |                       |       |                                                      |       | 4,644,383  |       |   |   | 4,644,383 |   |
| Dividends                                                                     |       |                 |       |             |       |                                 |       |                       |       |                                                      |       | (194,040   | )          |   |   | (194,040 | ) |
| Conversion of  preferred stock to  common stock                               |       | (62,300              | )          | (62,300          | )          | 62,300                               |       | 623                        |       | 61,677                                                    |       |       |       |   |   | 0 |   |
| Issuance of  common stock under  Employee Stock Purchase Plan                 |       |                 |       |             |       | 10,951                               |       | 109                        |       | 133,575                                                   |       |       |       |   |   | 133,684 |   |
| Issuance of  common stock to  Employee Stock Ownership Plan                   |       |                 |       |             |       | 20,467                               |       | 205                        |       | 286,753                                                   |       |       |       |   |   | 286,958 |   |
| Issuance of  common stock under  Employee Stock Option Plan                   |       |                 |       |             |       | 114,190                              |       | 1,142                      |       | 1,310,629                                                 |       |       |       |   |   | 1,311,771 |   |
| Change in  unrealized gains on  marketable securities, net of  deferred taxes |       |                 |       |             |       |                                 |       |                       |       |                                                      |       |       |       | (13,694 | ) | (13,694 | ) |
| BALANCE AT  DECEMBER 31, 2004                                                 |       | 157,800              |       | 157,800          |       | 3,723,390                            |       | 37,234                     |       | 15,621,048                                                |       | 38,359,117 |       | 37,531 |   | 54,212,730 |   |
| Net income                                                                    |       |                 |       |             |       |                                 |       |                       |       |                                                      |       | 6,567,334  |       |   |   | 6,567,334 |   |
| Dividends                                                                     |       |                 |       |             |       |                                 |       |                       |       |                                                      |       | (1,107,080 | )          |   |   | (1,107,080 | ) |
| Conversion of  preferred stock to  common stock                               |       | (157,800             | )          | (157,800         | )          | 157,800                              |       | 1,578                      |       | 156,222                                                   |       |       |       |   |   | 0 |   |
| Issuance of common  stock under  Employee Stock Purchase Plan                 |       |                 |       |             |       | 10,733                               |       | 107                        |       | 197,728                                                   |       |       |       |   |   | 197,835 |   |
| Issuance of  common stock to  Employee Stock Ownership Plan                   |       |                 |       |             |       | 15,861                               |       | 159                        |       | 346,316                                                   |       |       |       |   |   | 346,475 |   |
| Issuance of  common stock under  Employee Stock Option Plan                   |       |                 |       |             |       | 76,174                               |       | 762                        |       | 822,488                                                   |       |       |       |   |   | 823,250 |   |
| Purchase and  retirement of  common stock                                     |       |                 |       |             |       | (1,169                               | )          | (12                        | )          | (4,976                                                    | )          | (24,924    | )          |   |   | (29,912 | ) |
| Change in  unrealized gains on  marketable securities, net of  deferred taxes |       |                 |       |             |       |                                 |       |                       |       |                                                      |       |       |       | 435,068 |   | 435,068 |   |
| BALANCE AT  DECEMBER 31, 2005                                                 |       | —               |       | $                | —     |                                 |       | 3,982,789                  |       | $                                                         | 39,828     |       | $          | 17,138,826 |   | $ | 43,794,447 |   | $ | 472,599 |   | $ | 61,445,700 |   |
|                                                                               |            |                      |            |                  |            |                                      |            |                            |            |                                                           |            |            |            |  |  |  |  |  |  |  |  |  |  |  |

 

See notes to consolidated financialstatements.

 

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HECTOR COMMUNICATIONS CORPORATION ANDSUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

 
| ** **                                                                                   | ** ** | **Year Ended December 31** | ** ** |
|----------------------------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                                   | ** ** | **2005**                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                        |       |                       |       |   |   |   |   |
| Net Income                                                                                   |       | $                          | 6,567,334  |   | $ | 4,644,383 |   | $ | 5,178,760 |   |
| Adjustments to reconcile net income to net  cash                                             |       |                       |       |   |   |   |   |
| provided by operating activities:                                                            |       |                       |       |   |   |   |   |
| Depreciation and amortization                                                                |       | 7,706,308                  |       | 8,007,835 |   | 8,798,414 |   |
| Minority stockholders’ interest in earnings  of Alliance Telecommunications Corporation |       |                       |       |   |   | 976,023 |   |
| Gain on split-up of Alliance  Telecommunications Corporation                                 |       |                       |       |   |   | (348,505 | ) |
| Gains on sales of cable television systems  and other business                               |       |                       |       | (85,271 | ) | (1,080,723 | ) |
| Income from Midwest Wireless Holdings LLC                                                    |       | (4,681,888                 | )          | (2,765,887 | ) | (2,533,703 | ) |
| Income from other unconsolidated affiliates                                                  |       | (199,462                   | )          | (482,847 | ) | (272,917 | ) |
| Cash distributions from Midwest Wireless  Holdings LLC                                       |       | 1,994,960                  |       | 734,499 |   | 905,051 |   |
| Cash distributions from other  unconsolidated affiliates                                     |       | 196,595                    |       | 277,630 |   | 239,544 |   |
| Noncash patronage refunds                                                                    |       | (43,587                    | )          | (207,951 | ) | (192,669 | ) |
| Noncash investment income                                                                    |       | (59,137                    | )          | (46,920 | ) |   |   |
| Changes in assets and liabilities net of  effects of discontinued operations:                |       |                       |       |   |   |   |   |
| Accounts receivable                                                                          |       | 338,879                    |       | 1,122,483 |   | (259,394 | ) |
| Materials, supplies and inventories                                                          |       | 24,900                     |       | 124,018 |   | 64,449 |   |
| Other current assets                                                                         |       | 3,094                      |       | 34,795 |   | (64,130 | ) |
| Accounts payable                                                                             |       | (785,175                   | )          | 514,753 |   | (379,206 | ) |
| Accrued expenses                                                                             |       | 283,943                    |       | (15,441 | ) | 547,399 |   |
| Income taxes payable                                                                         |       | 1,001,243                  |       | (1,490,129 | ) | 1,361,111 |   |
| Deferred investment tax credits                                                              |       | (702                       | )          | (5,659 | ) | (18,555 | ) |
| Deferred income taxes                                                                        |       | (444,449                   | )          | 52,924 |   | 1,058 |   |
| Deferred compensation                                                                        |       | 52,988                     |       | 50,874 |   | 30,558 |   |
| Net cash provided by operating activities                                                    |       | 11,955,844                 |       | 10,464,089 |   | 12,952,565 |   |
|                                                                                         |       |                       |       |   |   |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                        |       |                       |       |   |   |   |   |
| Purchases of property, plant and equipment                                                   |       | (4,997,969                 | )          | (4,182,687 | ) | (3,912,756 | ) |
| Decrease (increase) in construction fund                                                     |       | 3,188,424                  |       | (704,611 | ) | (2,577,844 | ) |
| Proceeds from sales of cable television  systems and other business                          |       |                       |       | 241,301 |   | 1,665,782 |   |
| Investments in other unconsolidated  affiliates                                              |       |                       |       | (45,510 | ) | (23,191 | ) |
| Purchases of other investments                                                               |       | (1,101,968                 | )          | (453,144 | ) | (443,742 | ) |
| Proceeds from other investments                                                              |       | 772,370                    |       | 476,036 |   | 1,538,423 |   |
| Decrease (increase) in other assets                                                          |       | 17,000                     |       | (17,000 | ) | (130,696 | ) |
| Cash effect of split-up of Alliance  Telecommunications Corporation                          |       |                       |       |   |   | (5,214,465 | ) |
| Net cash used in investing activities                                                        |       | (2,122,143                 | )          | (4,685,615 | ) | (9,098,489 | ) |
|                                                                                         |       |                       |       |   |   |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                        |       |                       |       |   |   |   |   |
| Repayment of notes payable and long-term  debt                                               |       | (6,953,622                 | )          | (6,523,531 | ) | (32,517,635 | ) |
| Proceeds from issuance of notes payable and  long-term debt                                  |       | 2,500,680                  |       | 2,892,833 |   | 32,810,607 |   |
| Issuance of common stock                                                                     |       | 1,021,085                  |       | 1,445,455 |   | 431,243 |   |
| Cash dividends                                                                               |       | (1,107,080                 | )          | (194,040 | ) |   |   |
| Purchase of stock                                                                            |       | (29,912                    | )          |   |   | (17,162 | ) |
| Net cash provided by (used in) financing  activities                                         |       | (4,568,849                 | )          | (2,379,283 | ) | 707,053 |   |
| NET INCREASE IN CASH AND CASH EQUIVALENTS                                                    |       | 5,264,852                  |       | 3,399,191 |   | 4,561,129 |   |
| CASH AND CASH EQUIVALENTS AT BEGINNING OF  YEAR                                              |       | 19,980,506                 |       | 16,581,315 |   | 12,020,186 |   |
| CASH AND CASH EQUIVALENTS AT END OF YEAR                                                     |       | $                          | 25,245,358 |   | $ | 19,980,506 |   | $ | 16,581,315 |   |
|                                                                                         |       |                       |       |   |   |   |   |
| SUPPLEMENTAL DISCLOSURES OF CASH FLOW  INFORMATION:                                          |       |                       |       |   |   |   |   |
| Interest paid                                                                                |       | $                          | 3,120,718  |   | $ | 3,156,583 |   | $ | 4,338,703 |   |
| Income taxes paid                                                                            |       | 3,829,704                  |       | 4,318,608 |   | 3,491,394 |   |

 

See notes to consolidated financialstatements.

 

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HECTOR COMMUNICATIONS CORPORATION ANDSUBSIDIARIES

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

**Description of business:**Hector CommunicationsCorporation owns a 100% interest in five local exchange telephone subsidiariesand one cable television subsidiary. The Company also owns a 100% interest inAlliance Telecommunications Corporation, which owns and operates four localexchange telephone companies. At December 31, 2005, the Company’s subsidiariesprovided telephone service to 29,407 access lines in 28 rural communities inMinnesota, Wisconsin and North Dakota and cable television services to 7,923subscribers in Minnesota. The Company is also an investor in partnerships andcorporations providing wireless telephone and other telecommunications relatedservices.

 

Prior to July 7, 2003 Alliance Telecommunications Corporation(“Alliance”) was 68% owned by Hector. Golden West TelecommunicationsCooperative, Inc. (“Golden West”) of Wall, South Dakota and AllianceCommunications Cooperative, Inc. (“ACCI”) of Garretson, South Dakota owned theremaining interests in Alliance. Effective July 7, 2003 Alliance wasreorganized under Section 355 of the Internal Revenue Code (“the Split-UpTransactions’). In the Split-Up Transactions, Golden West exchanged itsminority ownership interest in Alliance for all of the outstanding stock ofSioux Valley Telephone Company, its pro rata share of Alliance’s ownershipinterest in Midwest Wireless Holdings, LLC and certain other Alliance assets.ACCI exchanged its minority ownership interest in Alliance for all of theoutstanding stock of Hills Telephone Company, its pro rata share of Alliance’sownership interest in Midwest Wireless Holdings, LLC and certain other Allianceassets (Note 2).

 

**Basis of presentation:** Certain amounts in the2004 and 2003 financial statements have been reclassified to conform to the2005 financial statement presentation. These reclassifications had no effect onnet income or stockholders’ equity as previously reported.

 

**Principles of consolidation:** The consolidatedfinancial statements include the accounts of Hector Communications Corporationand its subsidiaries (“Hector” or the “Company”). All material intercompanytransactions and accounts have been eliminated.

 

**Regulatory accounting:** Accounting practicesprescribed by regulatory authorities have been considered in the preparation ofthe financial statements and formulation of accounting policies for telephonesubsidiaries. These policies conform to accounting principles generallyaccepted in the United States of America as applied to regulated publicutilities in accordance with Statement of Financial Accounting Standards No.71, “Accounting for the Effects of Certain Types of Regulation” (SFAS 71).

 

**Estimates:**The presentation of financialstatements in conformity with accounting principles generally accepted in theUnited States of America requires management to make estimates and assumptionsthat affect the reported amounts of assets, liabilities, and disclosure ofcontingent assets and liabilities at the balance sheet date, and the reportedamounts of revenues and expenses during the reporting period. The estimates andassumptions used in the accompanying consolidated financial statements arebased upon management’s evaluation of the relevant facts and circumstances asof the time of the financial statements. Actual results could differ from thoseestimates. The Company’s financial statements are also affected by depreciationrates prescribed by regulators, which may result in different depreciationrates than for an unregulated enterprise.

 

**Revenue recognition:**Revenues are recognizedwhen earned, regardless of the period in which they are billed. Network accessrevenues are furnished in conjunction with interexchange carriers and aredetermined by cost separation studies and nationwide average schedules.Revenues include estimates pending finalization of cost studies. Network accessrevenues are based upon interstate tariffs filed with the FederalCommunications Commission by the National Exchange Carriers Association andstate tariffs filed with state regulatory agencies. Management believesrecorded revenues are reasonable based on estimates of final cost separationstudies, which are typically settled within two years.

 

**Income taxes and investment tax credits:** Theprovision for income taxes consists of an amount for taxes currently payableand a provision for tax consequences deferred to future periods. For financialstatement purposes, deferred investment tax credits are being amortized as areduction of the provision for income taxes over the estimated useful lives ofthe related property, plant and equipment.

 

38

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**Net income per share:**Basic net income percommon share is based on the weighted average number of common sharesoutstanding during each year. Diluted net income per common share takes intoeffect the dilutive effect of potential common shares outstanding. TheCompany’s potential common shares outstanding include preferred stock, stockoptions and warrants. The calculation of the Company’s net income per share isincluded in Exhibit 11 of this form 10-K.

 

**Stock compensation:**The Company has stockplans under which stock options, stock appreciation rights, restricted stock ordeferred stock may be granted to officers, key employees and nonemployeedirectors. Employees may also participate in an employee stock purchase planwhich allows them to purchase shares through payroll deductions on favorableterms. These plans are described more fully in Note 10. The Company has electedto apply APB Opinion No. 25, “Accounting for Stock Issued to Employees” formeasurement and recognition of stock-based transactions with its employees anddirectors. If the Company had elected to recognize compensation cost for itsstock-based transactions based on the fair value of the options methodprescribed by SFAS No. 123 (see Note 10), net income and net income per sharewould have been as follows:

 
| ** **                                                                                                   | ** ** | **2005** | ** ** | **2004** | ** ** | **2003**  | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|-----------|------------|
| Net income as reported                                                                                       |       | $        | 6,567,334  |     | $          | 4,644,383 |       | $ | 5,178,760 |   |
| Less: Total stock-based employee compensation  expense determined under the fair value method for all awards |       | (664,617 | )          | (602,259 | )          | (472,941  | )          |
| Pro forma net income                                                                                         |       | $        | 5,902,717  |     | $          | 4,042,124 |       | $ | 4,705,819 |   |
|                                                                                                         |       |     |       |     |       |      |       |
| Basic net income per share:                                                                                  |       |     |       |     |       |      |       |
| As reported                                                                                                  |       | $        | 1.72       |     | $          | 1.28      |       | $ | 1.48 |   |
| Pro forma                                                                                                    |       | $        | 1.54       |     | $          | 1.11      |       | $ | 1.35 |   |
| Diluted net income per share:                                                                                |       |     |       |     |       |      |       |
| As reported                                                                                                  |       | $        | 1.61       |     | $          | 1.17      |       | $ | 1.34 |   |
| Pro forma                                                                                                    |       | $        | 1.45       |     | $          | 1.02      |       | $ | 1.25 |   |

 

**Cash and cash equivalents:**The Companyconsiders temporary cash investments with an original maturity of three monthsor less to be cash equivalents. The Company places its cash investments withhigh credit quality financial institutions. The Company maintains its cash inbank deposit accounts. The account balances at times exceed the federallyinsured limits. The Company has not experienced losses in these accounts anddoes not believe they are exposed to any significant credit risk.

 

**Accounts receivable:**Receivables are stated atthe amount the Company expects to collect from outstanding balances. TheCompany provides for probable uncollectible amounts through a charge toearnings and a credit to a valuation allowance based on its assessment of thecurrent status of individual accounts. Balances that are still outstandingafter the Company has used reasonable collection efforts are written offthrough a charge to the valuation allowance and a credit to the receivableaccounts.

 

A significant portion of the Company’s revenues is received from longdistance carriers in the telephone industry. Consequently, the Company isdirectly affected by the financial well-being of that industry. The credit riskassociated with these accounts is minimized due to the large number of longdistance carriers.

 

**Materials, supplies and inventories:**Materials,supplies and inventories are valued at the lower of average cost or market.

 

**Property, plant and equipment:** Property, plantand equipment is recorded at cost. Depreciation is computed using principallythe straight-line method. Depreciation included in costs and expenses fromcontinuing operations was $7,665,246, $7,966,772 and $7,828,067 for 2005, 2004and 2003, respectively. Depreciation included in costs and expenses from discontinuedoperations for 2003 was $938,095. Maintenance and repairs are charged tooperations and additions or improvements are capitalized. Items of propertysold, retired or otherwise disposed of in the ordinary course of business areremoved from assets and any gains or losses are included in accumulateddepreciation.

 

39

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**Investments in unconsolidated affiliates:** TheCompany is a co-investor with other rural ILECS in Midwest Wireless HoldingsLLC (Note 5) and several other partnerships and limited liability corporations(Note 6). The Company’s percentage of ownership in these joint ventures rangesfrom 5% to 20%. The Company uses the equity method of accounting for theseinvestments, which reflects original cost and recognition of the Company’sshare of operating income or losses from the respective operations.

 

**Other investments:** The Company owns RuralTelephone Bank stock, CoBank stock, long-term certificates of deposit, andinvestments in the stock of other telecommunications service providers.Long-term investments in corporations that are not intended for resale or arenot readily marketable and in which the Company does not exercise significantinfluence are valued using the cost method. The cost method requires theCompany to periodically evaluate these investments for impairment and ifimpairment is found, reduce the investment’s valuation to its net realizablevalue. No impairment charges have been taken against these investments in thelast three years.

 

**Other assets:**Other assets owned by theCompany include cable television franchises, customer lists and other deferredcharges. In accordance with SFAS 142, intangible assets determined to have anindefinite useful life are not amortized. Intangible assets with a determinablelife are amortized over the useful life. Amortization included in expenses fromcontinuing operations was $23,445, $23,444 and $23,444 for 2005, 2004 and 2003,respectively (Note 4).

 

**Financial instruments: The** Company has a longterm investment in Rural Telephone Bank (“RTB”) stock. It is expected the RTBwill be dissolved in 2006 and outstanding RTB stock will be redeemed at parvalue. At December 31, 2005 the par value of the Company’s RTB stock is$11,610,000 and the carrying value is $1,269,000.

 

The Company also has a long-term investment in units of MidwestWireless Holdings, LLC. Midwest Wireless and Alltel Corporation (“Alltel”) haveentered into a definitive agreement for Alltel to purchase Midwest Wireless.(U.S. Cellular Corporation has filed motions at the FCC and in Delaware Statecourt contesting the definitive agreement.) The Company estimates its pretax share of the sale proceeds will be$64,900,000. Carrying value of the Company’s investment at December 31, 2005is  $18,067,000.

 

The fair value of the Company’s remaining financial instrumentsapproximates carrying value except for long-term investments in other companiesand long-term debt. Other long-term investments are not intended for resale andnot readily marketable, thus a reasonable estimate of fair value is notpracticable (except for investments in RTB stock and Midwest Wireless). Thefair value of long-term debt (including the current portion) was $53,533,000and $56,865,000 at December 31, 2005 and 2004, respectively. Fair values wereestimated based on current rates offered to the Company for debt with similarterms and maturities.

 

**New accounting principles:**In December 2004,the FASB issued SFAS No. 123R, “Shared-Based Payment”. SFAS 123R requires allshare-based payments to employees, including grants of employee stock options,to be valued at fair value on the date of grant and expensed over theapplicable vesting period. Compensation expense for outstanding unvested awardswill be measured based on the fair value of the awards as previously calculateddeveloping the pro forma disclosures previously permitted under SFAS 123R. OnApril 14, 2005 the SEC issued a rule that changed the effective date of SFAS123R for public companies to the first annual period or interim period in thefirst fiscal year beginning after June 15, 2005. The Company has chosen themodified prospective basis of the Black-Scholes option pricing model tocalculate future stock compensation expense, using a fair value method asprescribed under SFAS 123R. The valuation of equity instruments underlyingstock-based compensation and the period in which the related expense isrecognized will be based on various assumptions including the estimated life ofequity instruments, stock volatility, interest rates and vesting terms. TheCompany has assessed the impact of adopting SFAS 123R and determined that thedisclosures made in Notes 1 and 10 of the Notes to Consolidated FinancialStatements provide a reasonable expectation of future expense.

 

40

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**NOTE 2 – SPLIT-UP OF ALLIANCE TELECOMMUNICATIONS CORPORATION**

 

Effective July 7, 2003, Alliance was reorganized under Section 355 ofthe Internal Revenue Code. As a result of the Split-Up Transactions, GoldenWest exchanged its 20% minority ownership interest in Alliance for all of theoutstanding stock of Sioux Valley Telephone Company, which included a pro ratashare of Alliance’s ownership interest in Midwest Wireless Holdings, LLC andcertain other Alliance assets. ACCI exchanged its 12% minority ownershipinterest in Alliance for all of the outstanding stock of Hills TelephoneCompany, which included a pro rata share of Alliance’s ownership interest inMidwest Wireless Holdings, LLC and certain other Alliance assets. Hector becamethe 100% owner of all the remaining Alliance operations and assets. TheCompany’s operating results have been restated to separately reflect thecontinuing and discontinued Alliance operations. Operating results for thediscontinued operations in the 2003 period were as follows:

 
| ** **                                                                                | ** ** | **Six Months Ended  June 30, 2003** | ** ** |
|-------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| Revenues                                                                                  |       | $                                   | 4,750,877  |   |
| Operating costs and expenses                                                              |       | 2,919,858                           |       |
| Operating income                                                                          |       | 1,831,019                           |       |
|                                                                                      |       |                                |       |
| Other income and (expenses):                                                              |       |                                |       |
| Interest expense                                                                          |       | (680,059                            | )          |
| Interest and dividend income                                                              |       | 45,911                              |       |
| Income from investments in unconsolidated  affilates:                                     |       |                                |       |
| Midwest Wireless Holdings, LLC                                                            |       | 385,259                             |       |
| Other unconsolidated affiliates                                                           |       | 176,618                             |       |
| Other expense, net                                                                        |       | (72,271                             | )          |
|                                                                                      |       |                                |       |
| Income before income taxes and minority  interest                                         |       | 1,758,748                           |       |
|                                                                                      |       |                                |       |
| Income tax expense                                                                        |       | 770,000                             |       |
| Income before minority interest                                                           |       | 988,748                             |       |
|                                                                                      |       |                                |       |
| Minority interest in discontinued  operations of  Alliance Telecommunications Corporation |       | (316,399                            | )          |
| Gain on split-up of Alliane Telecommunications  Corporation, net of income taxes          |       | 209,505                             |       |
| Income from discontinued operations                                                       |       | $                                   | 881,854    |   |

 

The Company accounted for this transaction using the purchase method.The Company recognized a gain on the transaction to the extent that the fairvalue of the assets transferred to Golden West and ACCI exceeded book value.The gain was recorded as follows:

 
| Fair value of the Company’s 68% ownership  interest in assets and liabilities transferred to Golden West and ACCI in  Split-Up Transactions |   | $           | 12,351,908 |   |
|--------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------|------------|--------|
| Less: Recorded value of assets and  liabilities transferred to Golden West and ACCI in Split-Up Transactions                                     |   | (12,003,403 | )          |
| Gain on disposal before income taxes                                                                                                             |   | 348,505     |       |
| Deferred income tax expense                                                                                                                      |   | (139,000    | )          |
| Net gain                                                                                                                                         |   | $           | 209,505    |   |

 

41

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**NOTE 3 - PROPERTY, PLANT AND EQUIPMENT**

 

The cost of property, plant and equipment and the estimated usefullives are as follows:

 
| ** **                     | ** ** | **Estimated**   | ** ** | **December 31** | ** ** |
|--------------------------------|------------|-----------------|------------|-----------------|------------|
| ** **                     | ** ** | **useful life** | ** ** | **2005**        | ** ** | **2004** | ** ** |
| Land                           |       |            |       | $               | 447,638    |   | $ | 447,638 |   |
| Buildings                      |       | 5-40 years      |       | 5,707,743       |       | 5,633,898 |   |
| Machinery  and equipment       |       | 3-15 years      |       | 4,173,175       |       | 4,126,976 |   |
| Furniture  and fixtures        |       | 5-10 years      |       | 1,220,775       |       | 1,205,834 |   |
| Telephone  plant               |       | 5-33 years      |       | 85,974,219      |       | 81,948,811 |   |
| Cable  television plant        |       | 10-15 years     |       | 7,597,515       |       | 7,306,199 |   |
| Construction  in progress      |       |            |       | 199,910         |       | 252,155 |   |
|                           |       |            |       | 105,320,975     |       | 100,921,511 |   |
| Less  accumulated depreciation |       |            |       | 67,939,405      |       | 60,881,018 |   |
|                           |       |            |       | $               | 37,381,570 |   | $ | 40,040,493 |   |

 

**NOTE 4 – GOODWILL AND INTANGIBLE ASSETS**

 

The Company accounts for goodwill and other intangible assets underSFAS No. 142, “Goodwill and Other Intangible Assets”. Under the provisions ofthis accounting standard, goodwill and intangible assets with indefinite usefullives are no longer amortized but are instead tested for impairment on at leastan annual basis and when changes in circumstances indicate that the value ofgoodwill may be below its carrying value.

 

The Company performed its most recent annual impairment test ofgoodwill during the third quarter of 2005. The determined fair value of thereporting units was sufficient to pass the first step impairment test, and noimpairment was recorded. Changes in the Company’s goodwill by segment are asfollows:

 
| ** **                                                                                      | ** ** | **POTS**    | ** ** | **Other Services** | ** ** | **Consolidated** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|-------------|------------|--------------------|------------|------------------|------------|
| Balance December 31, 2002                                                                       |       | $           | 46,768,996 |               | $          | 2,305,997        |       | $ | 49,074,993 |   |
|                                                                                            |       |        |       |               |       |             |       |
| Cable television system sales                                                                   |       |        |       | (970,673           | )          | (970,673         | )          |
| Split-up of Alliance Telecommunications  Corporation:                                           |       |        |       |               |       |             |       |
| Goodwill included in discontinued  operations                                                   |       | (13,315,447 | )          |               |       | (13,315,447      | )          |
| Eliminate previously recorded goodwill  related to the minority interest acquired               |       | (11,005,952 | )          |               |       | (11,005,952      | )          |
| Excess fair value allocated to goodwill in acquisition  of minority interest                    |       | 7,909,006   |       |               |       | 7,909,006        |       |
| Balance December 31, 2003                                                                       |       | 30,356,603  |       | 1,335,324          |       | 31,691,927       |       |
| Reduction in goodwill recorded following completion  of minority interest acquisition appraisal |       | (770,833    | )          |               |       | (770,883         | )          |
| Balance December 31, 2004                                                                       |       | 29,585,770  |       | 1,335,324          |       | 30,921,094       |       |
| Balance December 31, 2005                                                                       |       | $           | 29,585,770 |               | $          | 1,335,324        |       | $ | 30,921,094 |   |

 

The Company’s other intangible assets consist of deferred loanorigination fees, cable television franchises and internet customer lists.Amortization expense for the next five years is estimated as follows: 2006 -$40,600, 2007 - $31,000, 2008 - $17,600, 2009 - $17,600, 2010 - $17,600.

 

42

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Changes in the Company’s intangible assets and other assets are asfollows:

 
| ** **                        | ** ** | **Intangible Assets** | ** ** | **Other Assets** | ** ** | **Consolidated** | ** ** |
|-----------------------------------|------------|----------------------------|------------|-----------------------|------------|------------------|------------|
| Balance December 31,  2002   |       | $                          | 106,751    |                  | $          | 304,748          |       | $ | 411,499 |   |
| Additions                         |       | 167,845                    |       |                  |       | 167,845          |       |
| Disposals                         |       |                       |       | (14,993               | )          | (14,993          | )          |
| Amortization                      |       | (32,052                    | )          |                  |       | (32,052          | )          |
| Distributed  in Alliance split-up |       |                       |       | (122,635              | )          | (122,635         | )          |
| Balance December 31,  2003   |       | 242,544                    |       | 167,120               |       | 409,664          |       |
| Additions                         |       | 17,000                     |       |                  |       | 17,000           |       |
| Amortization                      |       | (41,063                    | )          |                  |       | (41,063          | )          |
| Disposals                         |       |                       |       | (3,279                | )          | (3,279           | )          |
| Balance December 31,  2004   |       | 218,481                    |       | 163,841               |       | 382,322          |       |
| Amortization                      |       | (41,062                    | )          |                  |       | (41,062          | )          |
| Disposals                         |       | (17,000                    | )          | (8,354                | )          | (25,354          | )          |
| Balance December 31,  2005   |       | $                          | 160,419    |                  | $          | 155,487          |       | $ | 315,906 |   |

 

**NOTE 5 – MIDWEST WIRELESS HOLDINGS LLC**

 

At December 31, 2005 the Company owned 8.0% of Midwest WirelessHoldings LLC, which provides cellular service to rural service areas inMinnesota, Wisconsin and Iowa and the Rochester, Minnesota MSA. The Company’sownership is recorded on the equity method of accounting, which reflectsoriginal cost and recognition of the Company’s share of income or losses. Theexcess of cost over the Company’s share of equity in Midwest Wireless at thetime of acquisition was $5,595,000 at December 31, 2005. At December 31,2005, the Company’s cumulative share of income from Midwest Wireless was$18,140,000, of which $11,186,000 was undistributed.

 

Midwest Wireless has loan agreements with the Rural Telephone FinanceCooperative (“RTFC”) that place restrictions on distributions to members.

 

On November 17, 2005 Midwest Wireless and Alltel Corporation (“Alltel”)entered into a definitive agreement for Alltel to purchase Midwest Wireless.Compensation paid by Alltel would total $1.075 billion, including payments toMidwest Wireless shareholders, payments to minority interest holders in certainMidwest properties and assumption of Midwest Wireless’ outstanding debt. TheCompany estimates its pretax share of the proceeds will be $64,900,000. U.S.Cellular Corporation has initiated proceedings at the FCC and in Delaware Statecourt contesting the definitive agreement. Midwest Wireless expects to closethe transaction in 2006, subject to settlement of U.S. Cellular’s claims,satisfaction of customary conditions and receipt of regulatory approvals.

 

Summarized audited financial information for Midwest Wireless for 2005,2004 and 2003 is as follows:

 
| ** **              | ** ** | **Year Ended December 31** | ** ** |
|-------------------------|------------|-------------------------------------------|------------|
| ** **              | ** ** | **2005**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| Current  assets         |       | $                                         | 33,104,932 |   | $ | 27,685,169 |   | $ | 22,017,707 |   |
| Noncurrent  assets      |       | 362,172,494                               |       | 366,455,303 |   | 360,331,919 |   |
| Current  liabilities    |       | 40,753,598                                |       | 54,760,003 |   | 42,224,377 |   |
| Noncurrent  liabilities |       | 120,351,115                               |       | 142,767,502 |   | 172,862,375 |   |
| Minority  interest      |       | 19,146,185                                |       | 14,919,971 |   | 11,617,812 |   |
| Members’  equity   |       | 215,026,528                               |       | 181,692,996 |   | 155,645,062 |   |
| Revenues                |       | 264,013,168                               |       | 220,679,372 |   | 179,563,840 |   |
| Operating  income       |       | 73,851,914                                |       | 44,700,128 |   | 38,208,082 |   |
| Net income              |       | 58,232,113                                |       | 35,215,044 |   | 26,695,403 |   |
|                         |            |                                           |            |  |  |  |  |  |  |  |

 

43

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**NOTE 6 –INVESTMENTS IN UNCONSOLIDATED AFFILIATES**

 

The Company is a co-investor with other rural ILECS in several otherpartnerships and limited liability corporations. These joint ventures make itpossible to offer certain services to customers, including directory services,centralized switching or fiber optic transport of messaging, that the Companycould not afford to offer on its own. These joint ventures also make itpossible to invest in new technologies with a lower level of financial risk.The Company recognizes income and losses from these investments on the equitymethod of accounting. The following table summarizes the Company’s ownershippercentage, current investment and income or loss from these investments in2005, 2004 and 2003:

 
| ** **                | ** ** | **Ownership****Interest** | ** ** | **Book Value at  December 31** | ** ** | **Income (Loss) on Investment** | ** ** |
|---------------------------|------------|---------------------------|------------|-----------------------------------------------|------------|------------------------------------------------|------------|
|                      |       | ** **                | **2005**   | ** **                                    | **2004**   | ** **                                     | **2005**   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Broadband  Visions        |       | 16.7                      | %          | $                                             | 644,845    |                                           | $          | 673,425 |   | $ | (28,580 | ) | $ | (10,548 | ) | $ | (14,182 | ) |
| Communications  Mgmt Grp  |       | 6.5                       | %          | 251,456                                       |       | 232,215                                        |       | 19,241 |   | 35,915 |   | 20,058 |   |
| Desktop  Media            |       | 17.0                      | %          | 144,792                                       |       | 152,938                                        |       | (3,146 | ) |   |   | (167,036 | ) |
| Independent  Pinnacle     |       | 7.9                       | %          | 530,371                                       |       | 471,892                                        |       | 82,012 |   | 235,743 |   |   |   |
| Northern  Transport Group |       | 20.0                      | %          | 131,236                                       |       | 234,699                                        |       | (103,463 | ) | (79,880 | ) | (38,860 | ) |
| NW Minnesota  Spec Access |       | 5.3                       | %          | 34,606                                        |       | 47,396                                         |       | 17,210 |   | 19,671 |   | 19,113 |   |
| South  Central Switching  |       |                      |       |                                          |       |                                           |       |   |   |   |   | 1,894 |   |
| 702  Communications       |       | 18.1                      | %          | 1,376,101                                     |       | 1,289,003                                      |       | 205,160 |   | 270,980 |   | 236,813 |   |
| West Central  Transport   |       | 5.0                       | %          | 194,186                                       |       | 203,158                                        |       | 11,028 |   | 10,966 |   | 38,499 |   |
|                      |       |                      |       | $                                             | 3,307,593  |                                           | $          | 3,304,726 |   | $ | 199,462 |   | $ | 482,847 |   | $ | 96,299 |   |
|                           |            |                           |            |                                               |            |                                                |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

**NOTE 7 - MARKETABLE SECURITIES AND GAINS ONSALES OF INVESTMENTS**

 

Marketable securities consist principally of equity securities of othertelecommunications companies. The Company’s marketable securities portfolio wasclassified as available-for-sale at December 31, 2005 and December 31,2004. The cost and fair values of available-for-sale investment securities wereas follows:

 
| ** **              | ** ** | **Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** |
|-------------------------|------------|----------|------------|------------------------------|------------|-------------------------------|------------|-----------------|------------|
| December 31,  2005 |       | $        | 1,102,009  |                         | $          | 844,188                       |       | $               | (56,522    | ) | $ | 1,889,675 |   |
| December 31,  2004 |       | $        | 447,483    |                         | $          | 79,586                        |       | $               | (17,035    | ) | $ | 510,034 |   |

 

Net unrealized gains on marketable securities, net of related deferredtaxes, are included in stockholders’ equity as accumulated other comprehensiveincome at December 31, 2005 and 2004 as follows:

 
|                    |   | **Net  Unrealized  Gains** | ** ** | **Deferred  Income  Taxes** | ** ** | **Accumulated  Comprehensive  Income** |   |
|-------------------------|--------|----------------------------|------------|-----------------------------|------------|----------------------------------------|--------|
| December 31,  2005 |   | $                          | 787,666    |                        | $          | (315,067                               | )      | $ | 472,599 |   |
| December 31,  2004 |   | $                          | 62,551     |                        | $          | (25,020                                | )      | $ | 37,531 |   |

 

These amounts have no cash effect and are not included in the statementof cash flows.

 

**NOTE 8 - INCOME TAXES**

 

Before completion of the split-up of Alliance TelecommunicationsCorporation, Hector Communications Corporation and its wholly ownedsubsidiaries filed a consolidated tax return separate from the consolidatedreturn for Alliance and its subsidiaries. Since the split-up date allsubsidiary companies are included in Hector’s consolidated return. Income taxexpenses (benefits) from continuing operations on the last three years were:

 

44

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| ** **                       | ** ** | **Year Ended December 31** | ** ** |
|----------------------------------|------------|-------------------------------------------|------------|
|                             |       | **2005**                                  | ** ** | **2004** | ** ** | **2003** |   |
| Currently  payable taxes:        |       |                                      |       |   |   |   |   |
| Federal                          |       | $                                         | 3,950,000  |   | $ | 2,318,000 |   | $ | 2,434,000 |   |
| State                            |       | 1,060,000                                 |       | 884,000 |   | 1,039,000 |   |
|                             |       | 5,010,000                                 |       | 3,202,000 |   | 3,473,000 |   |
|                             |       |                                      |       |   |   |   |   |
| Deferred  income taxes (benefit) |       | (644,000                                  | )          | 53,000 |   | (138,000 | ) |
| Deferred  investment tax credits |       | (1,000                                    | )          | (5,000 | ) | (19,000 | ) |
|                             |       | $                                         | 4,365,000  |   | $ | 3,250,000 |   | $ | 3,316,000 |   |

 

Deferred tax assets and liabilities as of December 31 related tothe following:

 
| ** **                       | ** ** | **2005**  | ** ** | **2004**  | ** ** |
|----------------------------------|------------|-----------|------------|-----------|------------|
| Deferred tax  liabilities:       |       |      |       |      |       |
| Accelerated  depreciation        |       | $         | 3,948,152  |      | $          | 4,893,554 |   |
| Partnership  and LLC investments |       | 1,721,000 |       | 1,798,000 |       |
| Marketable  securities           |       | 315,000   |       | 25,000    |       |
| Other                            |       | 163,000   |       | 188,000   |       |
|                             |       | 6,147,152 |       | 6,904,544 |       |
|                             |       |      |       |      |       |
| Deferred tax  assets:            |       |      |       |      |       |
| Deferred  compensation           |       | 330,000   |       | 292,000   |       |
| Intangibles                      |       | 77,000    |       | 127,000   |       |
| Accrued  expenses                |       | 271,000   |       | 245,000   |       |
| Bad debts                        |       | 11,000    |       | 406,000   |       |
| Other                            |       | 152,000   |       | 374,000   |       |
|                             |       | 841,000   |       | 1,444,000 |       |
| Net deferred  tax liability      |       | $         | 5,306,152  |      | $          | 5,460,554 |   |

 

The provision for income taxes varied from the federal statutory taxrate as follows:

 
| ** **                                  | ** ** | **Year Ended December 31** | ** ** |
|---------------------------------------------|------------|-------------------------------------------|------------|
|                                        |       | **2005**                                  | ** ** | **2004** | ** ** | **2003** |   |
| Tax at U.S.  statutory rate                 |       | 35.0                                      | %          | 35.0 | % | 35.0 | % |
| Surtax  exemption                           |       | (1.0                                      | )          | (1.0 | ) | (.9 | ) |
| State income  taxes, net of federal benefit |       | 6.1                                       |       | 7.1 |   | 6.2 |   |
| Investment  tax credits                     |       | —                                    |       | — |   | (.2 | ) |
| Other                                       |       | (.2                                       | )          | .1 |   | — |   |
| Effective  tax rate                         |       | 39.9                                      | %          | 41.2 | % | 40.1 | % |

 

**NOTE 9 - NOTES PAYABLE AND LONG-TERM DEBT**

 
| ** **                                                                                                                                                                                                                      | ** ** | **December 31** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------|------------|
|                                                                                                                                                                                                                            |       | **2005**             | ** ** | **2004** |   |
| Notes  payable to CoBank by Hector Communications Corporation in quarterly  installments, average interest rate of 6.9%, due 2006 to 2013                                                                                       |       | $                    | 20,625,000 |   | $ | 23,375,000 |   |
|                                                                                                                                                                                                                            |       |                 |       |   |   |
| Rural  Utilities Service (“RUS”) and Rural Telephone Bank (“RTB”) mortgage notes,  payable by telephone company subsidiaries in monthly and quarterly  installments, average rate of 5.0%, due 2006 to 2028 |       | 35,358,538           |       | 36,915,059 |   |
|                                                                                                                                                                                                                            |       |                 |       |   |   |
| Notes  payable to former owners of Felton Telephone Company by Hector Communications  Corporation in monthly installments, interest rate of 8.25%, due 2005                                                                     |       |                 |       | 146,421 |   |
|                                                                                                                                                                                                                            |       | 55,983,538           |       | 60,436,480 |   |
| Less current  portion                                                                                                                                                                                                           |       | 6,527,400            |       | 6,352,000 |   |
|                                                                                                                                                                                                                            |       | $                    | 49,456,138 |   | $ | 54,084,480 |   |

 

45

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The Rural Utilities Service (RUS) and the Rural Telephone Bank (RTB)are the Company’s primary sources of long-term financing for additions totelephone plant and equipment. The RUS has made long-term, low-interest loansto telephone companies since 1949 for the purpose of improving telephoneservice in rural areas. The RUS is authorized to make hardship loans at a 5%interest rate and cost-of-money loans at a rate reflecting the government’scost of money for a like term. The RTB advances funds at the average U.S.government cost-of-money for the year for like maturities. In some cases RTBloans are made concurrently with RUS loans.

 

Substantially all of the telephone plant of the LEC subsidiaries ispledged or is subject to mortgages to secure obligations to the RUS and RTB. AtDecember 31, 2005, the Company’s local exchange carrier subsidiaries hadunadvanced loan commitments under the RUS and RTB programs aggregatingapproximately $57,615,000. These loan funds can be drawn down to finance RUSand RTB approved capital additions in future years.

 

As a condition of maintaining the Company’s loan with CoBank, theCompany owns stock in the bank. At December 31, 2005, investment in CoBankstock was $2,739,000.

 

CoBank is a cooperative, owned and controlled by its customers. Eachcustomer borrowing from the bank on a patronage basis shares in the bank’s netincome through payment of patronage refunds. Patronage refunds included incontinuing operations were $218,000, $245,000 and $219,000 in 2005, 2004 and2003, respectively. Approximately 50% of patronage refunds are received in cash,with the balance in stock in the bank. The accrued patronage refund isreflected in the Company’s operating statement as a reduction of interestexpense. The Company cannot predict what patronage refunds might be in futureyears.

 

Pledges of the parent company assets and the stock of the Company’ssubsidiaries secure CoBank’s loan. Interest rates on long-term portions of theloan are fixed through 2007, while the non-fixed portion floats at short-termmarket rates. The average rate on the total loan was approximately 6.9% at December 31,2005. Principal payments are made quarterly and will continue until April 2013.

 

The amount of dividends on common stock that may be paid by thesubsidiaries to the Company is limited by certain financial covenants set forthin the RUS, RTB and CoBank mortgages. At December 31, 2005, $20,804,000 ofsubsidiaries’ retained earnings was available for dividend payments to Hector.At December 31, 2005, $42,152,000 of Hector’s retained earnings was notavailable to pay dividends to shareholders due to restrictions in the debtagreements.

 

The Company is continuing its construction program to upgrade itstelephone and cable television properties. Planned expenditures for Hector andAlliance properties in 2006 are $4,234,000. The Company intends to use RUS andRTB loan funds to help finance these projects. Loan funds received aredeposited in construction fund accounts and disbursements are restricted,subject to RUS approval, to construction costs authorized by the loan agreements.

 

Until July 7, 2003 the Company had a term loan and a $5,000,000revolving line of credit from Rural Telephone Finance Cooperative (“RTFC”). Part ofthe proceeds of the Company’s term loan from CoBank was used to repay the RTFCloan and terminate the revolving line of credit.

 

The annual requirements for principal payments on notes payable andlong-term debt are as follows:

 
| 2006 |   | $         | 6,527,400 |   |
|------|--------|-----------|-----------|--------|
| 2007 |   | 6,312,400 |      |
| 2008 |   | 6,409,100 |      |
| 2009 |   | 6,584,800 |      |
| 2010 |   | 6,852,500 |      |

 

46

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**NOTE 10 - STOCKHOLDERS’ EQUITY**

 

Preferred stock is entitled to share ratably with common shareholdersin any dividends or distributions paid by the Company, but are not entitled toany dividend distribution separate from common shareholders. Preferredshareholders have no voting rights. Each share of preferred stock isconvertible into one share of common stock.

 

Common shares are reserved for issuance in connection with stock optionplans under which 1,100,000 shares may be issued pursuant to stockoptions, stock appreciation rights, restricted stock or deferred stock grantedto officers and key employees. Exercise prices of stock options under the plancannot be less than fair market value of the stock on the date of grant. Rules andconditions governing awards of stock options, stock appreciation rights andrestricted or deferred stock are determined by the Compensation Committee ofthe Board of Directors, subject to certain limitations incorporated into theplan. Another provision of the plans automatically grants 3,000 shares ofnonqualified stock options per year to each nonemployee director. Optionsissued under this provision have a ten-year term and an exercise price not lessthan fair market value at date of grant. At December 31, 2005, 109,333shares were available to be issued under the plans. Changes in outstandingemployee and director stock options during the three years ended December 31,2005 are as follows:

 
|                                   |   | **Number of  shares** | ** ** | **Average  exercise price  per share** | ** ** |
|----------------------------------------|--------|-----------------------|------------|----------------------------------------|------------|
| Outstanding  at December 31, 2002 |   | 446,175               |       | $                                      | 11.28      |   |
| Granted                                |   | 115,850               |       | 12.18                                  |       |
| Exercised                              |   | (67,125               | )          | 10.22                                  |       |
| Canceled                               |   | (23,583               | )          | 11.86                                  |       |
| Outstanding  at December 31, 2003 |   | 471,317               |       | 11.62                                  |       |
| Granted                                |   | 123,850               |       | 18.63                                  |       |
| Exercised                              |   | (140,800              | )          | 10.83                                  |       |
| Canceled                               |   | (2,800                | )          | 10.61                                  |       |
| Outstanding  at December 31, 2004 |   | 451,567               |       | 13.80                                  |       |
| Granted                                |   | 51,750                |       | 22.48                                  |       |
| Exercised                              |   | (107,525              | )          | 12.48                                  |       |
| Canceled                               |   | (9,200                | )          | 16.01                                  |       |
| Outstanding  at December 31, 2005 |   | 386,592               |       | $                                      | 15.27      |   |

 

The Company receives an income tax benefit related to the gainsreceived by employees who make disqualifying dispositions of stock received onexercise of qualified incentive stock options. The amount of tax benefitreceived by the Company was $179,000, $247,000 and $23,000 in 2005, 2004 and2003 respectively. The tax benefit amounts have been credited to additionalpaid-in capital.

 

Options issued to officers and key employees are subject to vesting.Options issued in 2005 vested and became exercisable six months from the dateof issue. Options issued prior to 2005 are vested and become exercisableone-third at the date of issue, one-third one year from date of issue andone-third two years from date of issue. At December 31, 2005, 356,000stock options are currently exercisable at an average price of $15.00 pershare. The following table summarizes the status of stock options outstandingat December 31, 2005:

 
| **Range of Exercise Prices** | ** ** | **Shares** | ** ** | **Weighted Average  Remaining  Option Life** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|------------------------------|------------|------------|------------|---------------------------------------------------|------------|---------------------------------------|------------|
| $ 7.25 to  $9.99        |       | 3,000      |       | 1.0 years                                         |       | $                                     | 8.08       |   |
| $ 10.00 to  $12.00      |       | 115,492    |       | 1.8 years                                         |       | 11.17                                 |       |
| $ 12.01 to  $15.00      |       | 111,550    |       | 3.1 years                                         |       | 13.30                                 |       |
| $ 15.01 to  $20.00      |       | 95,900     |       | 4.2 years                                         |       | 18.49                                 |       |
| $ 20.01 to  $24.31      |       | 60,650     |       | 5.5 years                                         |       | 21.96                                 |       |
|                              |            |            |            |                                                   |            |                                       |            |  |

 

47

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100,000 shares are reserved for issuance under the 2003 Employee StockPurchase Plan (“ESPP”). Under terms of the plan, eligible employees may acquireshares of common stock through payroll deductions of not more than 10% ofcompensation. The price of shares purchased by the employees is 85% of thelower of fair market value for such shares on one of two specified dates ineach plan year. A participant is limited to the acquisition in any plan year tothe number of shares which their payroll deductions for the year would purchasebased on the market price on the first day of the year or $25,000, whichever isless. Shares issued to employees under the plan were 10,733 and 10,951 in 2005and 2004 respectively. Shares issued to employees under the 1990 Employee StockPurchase Plan in 2003 were 15,685. There were no employee subscriptions foradditional shares outstanding at December 31, 2005.

 

The Company has adopted the disclosure provisions of SFAS No. 123,“Accounting for Stock-Based Compensation”, but applies APB Opinion No. 25,“Accounting for Stock Issued to Employees” for measurement and recognition ofstock-based transactions with its employees. If the Company had elected torecognize compensation cost for its stock based transactions using the methodprescribed by SFAS No. 123, net income and earnings per share would havebeen as follows:

 
| ** **                    | ** ** | **Year Ended December 31** | ** ** |
|-------------------------------|------------|-------------------------------------------|------------|
|                          |       | **2005**                                  | ** ** | **2004** | ** ** | **2003** |   |
| Net income                    |       | $                                         | 5,902,717  |   | $ | 4,042,124 |   | $ | 4,705,819 |   |
| Basic net  income per share   |       | $                                         | 1.54       |   | $ | 1.11 |   | $ | 1.35 |   |
| Diluted net  income per share |       | $                                         | 1.45       |   | $ | 1.02 |   | $ | 1.25 |   |

 

The fair value of the Company’s stock options and Employee StockPurchase Plan transactions used to compute pro forma net income and net incomeper share disclosures is the estimated present value at grant date using theBlack-Scholes option-pricing model. The following table displays theassumptions used in the model:

 
| ** **                                | ** ** | **Year Ended December 31** | ** ** |
|-------------------------------------------|------------|-------------------------------------------|------------|
|                                      |       | **2005**                                  | ** ** | **2004** | ** ** | **2003** |   |
| Expected  volatility                      |       | 31.7                                      | %          | 28.8 | % | 29.6 | % |
| Risk free  interest rate                  |       | 4.2                                       | %          | 2.9 | % | 2.9 | % |
| Expected  holding period – employees |       | 4 years                                   |       | 4 years |   | 4 years |   |
| Expected  holding period – directors |       | 7 years                                   |       | 7 years |   | 7 years |   |
| Dividend  yield                           |       | .9                                        | %          | 0 | % | 0 | % |

 

Pro forma stock-based compensation cost was $664,617, $602,259 and$472,941 in 2005, 2004 and 2003, respectively. Fair value of all options issuedwas $380,593, $712,191 and $453,450 in 2005, 2004 and 2003, respectively.

 

Hector paid cash dividends totaling $.28 and $.05 per share on itscommon stock and preferred stock in 2005 and 2004 respectively. The amount andtiming of future dividends will be determined at the discretion of the Board ofDirectors. Hector has no obligation to pay dividends on its preferred stockexcept that preferred stock receives the same per share dividend as commonstock.

 

The Company’s Board of Directors has authorized the purchase andretirement, from time to time, of shares of the Company’s stock on the openmarket, or in private transactions consistent with overall market and financialconditions. The Company purchased and retired 1,169 and 1,106 shares in 2005and 2003 respectively. No shares were repurchased in 2004. Cost of therepurchased shares was $30,000 and $17,000 in 2005 and 2003 respectively. At December 31,2005, 213,800 shares could be repurchased under outstanding Boardauthorizations.

 

48

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Effective August 1, 1990, the Board of Directors adopted anemployee stock ownership plan (“ESOP”). Contributions to the ESOP aredetermined by the Board on an annual basis and can be made in cash or byissuing shares of the Company’s common stock. ESOP expense reflects the marketvalue of company stock contributed to the accounts of eligible employees at thetime of the contribution. ESOP expense was $307,600, $328,100 and $284,600 for2005, 2004 and 2003, respectively. At December 31, 2005, the ESOP held112,460 shares of the Company’s common stock, all of which had been allocatedto the accounts of participating employees. An additional 10,220 shares ofcommon stock, representing the Company’s 2005 contribution, were issued to theplan in March 2006. All eligible employees of Hector CommunicationsCorporation and its subsidiaries participate in the plan after completing oneyear of service. Contributions are allocated to each participant based oncompensation and vest 30% after three years of service and incrementallythereafter, with full vesting after seven years.

 

In 1999 the Board of Directors adopted a shareholders’ rights plan.Under the plan, the Board of Directors declared a distribution of one right pershare of common stock. Each right entitles the holder to purchase 1/100thof a share of a new series of Junior Participating Preferred Stock of theCompany at an initial exercise price of $65. The rights expire on July 27,2009. The rights will become exercisable only following the acquisition by aperson or group, without the prior consent of the Board of Directors, of 15% ormore of the Company’s voting stock, or following the announcement of a tenderoffer or exchange offer to acquire an interest of 15% or more. If the rightsbecome exercisable, each rightholder will be entitled to purchase, at theexercise price, common stock with a market value equal to twice the exerciseprice. Should the Company be acquired, each right would entitle the holder topurchase, at the exercise price, common stock of the acquiring company with amarket value equal to twice the exercise price. Any rights owned by theacquiring person or group would become void.

 

**NOTE 11 - EMPLOYEE BENEFIT PLANS**

 

The Company has 401(k) savings plans for its employees. Employees whomeet certain age and service requirements may contribute up to 15% oftheir salaries to the plan on a pretax basis. The Company matches a portion ofemployee contributions. Contributions to the plan by the Company’s continuingoperations for 2005, 2004 and 2003 were approximately $156,000, $159,000 and$166,000 respectively.

 

Alliance had a deferred compensation agreement with two former officersof Ollig Utilities, Inc. Under the agreement, the salaries of theseofficers were continued after their retirement based on a formula stated in theagreement. Under the terms of the split-up agreement, the Company isresponsible for 68% of the remaining deferred compensation, Golden West isresponsible for 20% and ACCI is responsible for 12%. Deferred compensationexpense included in continuing operations was $120,000, $116,000 and $98,000 in2005, 2004 and 2003 respectively. Payments made under the agreement by theCompany’s continuing operations were $67,000, $65,000 and $63,000 in 2005, 2004and 2003 respectively.

 

**NOTE 12 - TRANSACTIONS WITH AFFILIATES**

 

Transactions between the Company and Communications Systems, Inc.(CSI), the Company’s former parent, are based on a distribution agreement,which provides for the Company’s use of certain of CSI’s staff and facilities,with related costs paid by the Company. Services provided by CSI aggregatedapproximately $241,000, $293,000 and $208,000 in 2005, 2004 and 2003respectively. Intercompany accounts with CSI are handled on an open accountbasis. Outstanding amounts payable to CSI were $51,000 and $217,000 at December 31,2005 and 2004, respectively.

 

The Company receives and provides services to various partnerships andlimited liability corporations in which it is a minority investor. Servicesreceived include transport, directory services, centralized equal access anddigital television signals. Services provided include commissioned sales,transport, accounting and management. Revenues from transactions with theseaffiliates were $1,469,000, $1,533,000 and $1,676,000 in 2005, 2004 and 2003respectively. Expenses from transactions with the affiliates were $1,020,000,$980,000 and $1,276,000 in 2005, 2004 and 2003 respectively.

 

Costs of services the Company receives from affiliated parties may notbe indicative of the costs of such services had they been obtained fromdifferent parties.

 

49

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**NOTE 13 - SEGMENT INFORMATION**

 

The Company’s segment information is presented on a product line basis.The majority of the Company’s operations consist of providing basic telephoneservices (often referred to as “plain old telephone service” or “POTS”) toresidential and business customers within its service territories. POTSrevenues consist mainly of fees for local service which are billed directly tocustomers and access revenues which are received for intrastate and interstateexchange services provided to long distance carriers. POTS revenues are subjectto regulation by a number of state and federal government agencies.

 

The Company also provides a number of nonregulated telecommunicationsservices to customers. These services include cable television or videoservice, internet access services, lease of fiber optic transport facilities,billing and collection services to long distance carriers, telephone directoryservices and equipment rental. The Company also makes retail sales of consumertelecommunications equipment and sells wireless telephone services on acommission basis.

 

No single customer accounted for a material portion of the Company’srevenues in any of the last three years. Segment information presents onlycontinuing operations except where noted:

 
| ** **                             | ** ** | **POTS**   | ** ** | **Other Services** | ** ** | **Consolidated** | ** ** |
|----------------------------------------|------------|------------|------------|-------------------------|------------|------------------|------------|
| **Year  Ended December 31, 2005** | ** ** | ** ** | ** ** | ** **              | ** ** | ** **       | ** ** |
| Revenues                               |       | $          | 21,963,150 |                    | $          | 10,410,325       |       | $ | 32,373,475 |   |
| Costs and  expenses                    |       | 16,361,143 |       | 8,022,619               |       | 24,383,762       |       |
| Operating  income                      |       | $          | 5,602,007  |                    | $          | 2,387,706        |       | $ | 7,989,713 |   |
|                                   |       |       |       |                    |       |             |       |
| Depreciation  and amortization:        |       |       |       |                    |       |             |       |
| Charged to  operations                 |       | $          | 6,116,020  |                    | $          | 1,572,671        |       | $ | 7,688,691 |   |
| Charged to  interest expense           |       |       |       | 17,617                  |       | 17,617           |       |
|                                   |       | $          | 6,116,020  |                    | $          | 1,590,288        |       | $ | 7,706,308 |   |
|                                   |       |       |       |                    |       |             |       |
| Total assets                           |       | $          | 90,447,583 |                    | $          | 37,306,708       |       | $ | 127,754,291 |   |
|                                   |       |       |       |                    |       |             |       |
| Capital  expenditures                  |       | $          | 4,260,960  |                    | $          | 737,009          |       | $ | 4,997,969 |   |
|                                   |       |       |       |                    |       |             |       |
| **Year  Ended December 31, 2004** | ** ** | ** ** | ** ** | ** **              | ** ** | ** **       | ** ** |
| Revenues                               |       | $          | 21,524,422 |                    | $          | 10,045,348       |       | $ | 31,569,770 |   |
| Costs and  expenses                    |       | 16,245,236 |       | 8,342,354               |       | 24,587,590       |       |
| Operating  income                      |       | $          | 5,279,186  |                    | $          | 1,702,994        |       | $ | 6,982,180 |   |
|                                   |       |       |       |                    |       |             |       |
| Depreciation  and amortization:        |       |       |       |                    |       |             |       |
| Charged to  operations                 |       | $          | 6,275,688  |                    | $          | 1,714,528        |       | $ | 7,990,216 |   |
| Charged to  interest expense           |       |       |       | 17,618                  |       | 17,618           |       |
|                                   |       | $          | 6,275,688  |                    | $          | 1,732,146        |       | $ | 8,007,834 |   |
|                                   |       |       |       |                    |       |             |       |
| Total assets                           |       | $          | 93,816,150 |                    | $          | 31,106,693       |       | $ | 124,922,843 |   |
|                                   |       |       |       |                    |       |             |       |
| Capital  expenditures                  |       | $          | 3,371,071  |                    | $          | 811,616          |       | $ | 4,182,687 |   |

 

50

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| ** **                                   | ** ** | **POTS**   | ** ** | **Other Services** | ** ** | **Consolidated** | ** ** |
|----------------------------------------------|------------|------------|------------|-------------------------|------------|------------------|------------|
| **Year  Ended December 31, 2003**       | ** ** | ** ** | ** ** | ** **              | ** ** | ** **       | ** ** |
| Revenues  from continuing operations         |       | $          | 22,192,492 |                    | $          | 10,129,936       |       | $ | 32,322,428 |   |
| Costs and  expenses                          |       | 15,897,022 |       | 8,468,760               |       | 24,365,782       |       |
| Operating  income from continuing operations |       | 6,295,470  |       | 1,661,176               |       | 7,956,646        |       |
|                                         |       |       |       |                    |       |             |       |
| Depreciation  and amortization:              |       |       |       |                    |       |             |       |
| Charged to  operations                       |       | $          | 6,178,096  |                    | $          | 1,673,415        |       | $ | 7,851,511 |   |
| Charged to  interest expense                 |       |       |       | 8,808                   |       | 8,808            |       |
|                                         |       | $          | 6,178,096  |                    | $          | 1,682,223        |       | 7,860,319 |   |
| Discontinued  operations                     |       |       |       |                    |       | 938,095          |       |
|                                         |       |       |       |                    |       | $                | 8,798,414  |   |
|                                         |       |       |       |                    |       |             |       |
| Total assets                                 |       | $          | 92,086,084 |                    | $          | 30,973,271       |       | $ | 123,059,355 |   |
|                                         |       |       |       |                    |       |             |       |
| Capital  expenditures                        |       | $          | 2,926,738  |                    | $          | 729,123          |       | $ | 3,655,861 |   |
| Discontinued  operations                     |       |       |       |                    |       | 256,895          |       |
|                                         |       |       |       |                    |       | $                | 3,912,756  |   |

 

**NOTE 14 – SALES OF CABLE TELEVISION SYSTEMSAND OTHER BUSINESS**

 

In 2004 the Company sold the assets of Hastad Engineering Company toFinley Engineering Company. Proceeds from the sale totaled $48,390 and theCompany recorded a gain of $12,805. Effective June 30, 2004 the Companysold the assets of the cable television system serving Hudson Township, WI toBaldwin Telecom Inc. for $193,000 of cash and a note receivable of $395,000.The Company recorded a gain on the sale of $72,466.

 

Alliance completed sales of two groups of cable television systemsduring 2003. Alliance sold four systems in rural North Dakota serving 930subscribers to MLGC, LLC for $200,000 of cash and a note receivable of$650,000. Alliance sold systems serving 1,150 subscribers in three communitiessurrounding the Fargo, ND – Moorhead, MN area to Cable One, Inc. for$1,545,000 of cash. Effect of the asset sales was as follows:

 
| Sales Price                                |   | $        | 2,395,032 |   |
|--------------------------------------------|--------|----------|-----------|--------|
| Less:  Property, plant and equipment (net) |   | (343,636 | )         |
| Less:  Intangible assets (goodwill)        |   | (970,673 | )         |
| Gain on sale  of cable assets              |   | $        | 1,080,723 |   |

 

**NOTE 15 – COMMITMENTS AND CONTINGENCIES**

 

The Company has entered into employment agreements or change in controlagreements with officers and key employees of the Company. The agreementsprovide for severance payments in the event of a change in control of theCompany and employment termination for reasons other than cause.

 

**NOTE 16 – PENDING TRANSACTIONS**

 

In 2005, the Board of Directors of the RTB approved resolutions toliquidate the bank and redeem the stock. Congress removed legal restrictions onthe redemption of RTB stock in 2005. It is expected the RTB will be dissolvedin 2006 and outstanding RTB stock will be redeemed at par value. At December 31,2005 the par value of the Company’s RTB stock is $11,610,000 and the carryingvalue is $1,269,000.

 

51

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**(b) SUPPLEMENTAL FINANCIAL INFORMATION**

 

**UnauditedQuarterly Operating Results**

(in thousands except per shareamounts)

 
| ** **                    | ** ** | **Quarter Ended** | ** ** |
|-------------------------------|------------|------------------------|------------|
| ** **                    | ** ** | **March 31**      | ** ** | **June 30** | ** ** | **Sept 30** | ** ** | **Dec 31** | ** ** |
| 2005                          |       |                   |       |   |   |   |   |   |   |
| Revenues                      |       | $                      | 7,649      |   | $ | 7,858 |   | $ | 8,133 |   | $ | 8,733 |   |
| Operating  income             |       | 1,813                  |       | 1,716 |   | 2,078 |   | 2,383 |   |
| Net income                    |       | 1,386                  |       | 1,493 |   | 1,677 |   | 2,011 |   |
| Basic net  income per share   |       | $                      | .37        |   | $ | .40 |   | $ | .44 |   | $ | .51 |   |
| Diluted net  income per share |       | $                      | .34        |   | $ | .37 |   | $ | .41 |   | $ | .49 |   |
|                          |       |                   |       |   |   |   |   |   |   |
| 2004                          |       |                   |       |   |   |   |   |   |   |
| Revenues                      |       | $                      | 7,946      |   | $ | 7,992 |   | $ | 7,806 |   | $ | 7,826 |   |
| Operating  income             |       | 1,981                  |       | 1,452 |   | 1,923 |   | 1,626 |   |
| Net income                    |       | 1,193                  |       | 954 |   | 1,294 |   | 1,203 |   |
| Basic net  income per share   |       | $                      | .34        |   | $ | .26 |   | $ | .35 |   | $ | .33 |   |
| Diluted net  income per share |       | $                      | .31        |   | $ | .24 |   | $ | .32 |   | $ | .30 |   |

 

**ITEM 9. CHANGES IN AND DISAGREEMENTS WITHACCOUNTANTS ON ACCOUNTING**

 

**AND FINANCIAL DISCLOSURE**

 

Not applicable.

 

**ITEM 9A. CONTROLS AND PROCEDURES**

** **

**(a) Evaluation of Disclosure Controlsand Procedures**

 

The Company, under the supervision and withthe participation of management, including the Chief Executive Officer (“CEO”)and Chief Financial Officer (“CFO”), evaluated the effectiveness of the designand operation of the Company’s disclosure controls and procedures (as definedin Rule 13a – 15(e) under the Securities Exchange Act of 1934) as ofthe end of the period covered by this report. Based on that evaluation, the CEOand CFO concluded that, as of the end of the period covered by this report, theCompany’s disclosure controls and procedures are operating effectively and areadequately designed to ensure that information required to be disclosed in thereports filed or submitted under the Exchange Act is recorded, processed, summarizedand reported, within the time periods specified in the applicable rules andforms and is accumulated and communicated to management, including the CEO andCFO, as appropriate to allow timely decisions regarding required disclosure.

 

**(b) Changes in Internal Control**

 

During the period covered by this Reportthere was no change in the Company’s internal control over financial reporting(as defined in Rule 13a-15(f) under the Exchange Act) that materiallyaffected, or is reasonably likely to materially affect, the Company’s internalcontrol over financial reporting.

 

**ITEM 9B. OTHER INFORMATION**

 

None.

 

52

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**PART III**

 

**ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OFTHE REGISTRANT**

 

Information Incorporated by Reference

 

The information required by Item 401 under Regulation S-K, to theextent applicable to directors, will be set forth under the caption “Electionof Directors” in the Company’s definitive proxy material for its May 25,2006 Annual Meeting of Shareholders to be filed within 120 days from the end ofthe Registrant’s fiscal year, which information is expressly incorporated byreference herein. The information called for by paragraph (b) of Item 401with respect to officers is set forth under Item 1(a)(c) herein. Theinformation called for by Item 405 under Regulation S-K regarding Exchange Act Section 16acompliance, to the extent applicable, will be set forth under the caption “CertainTransactions” in the Company’s above referenced definitive proxy material,which information is expressly incorporated by reference herein.

 

Code of Ethics

 

The Company has adopted a Code of Ethics and Business Conductapplicable to all officers of the Company as well as certain other keyaccounting personnel. A copy of the Code of Ethics can be obtained free ofcharge upon written request directed to Hector’s Assistant Secretary at theexecutive offices of the Company.

 

**ITEM 11. EXECUTIVE COMPENSATION**

 

The information called for by Item 402 under Regulation S-K to theextent applicable, will be set forth under the caption “Executive Compensation”in the Company’s definitive proxy materials for its May 25, 2006 AnnualMeeting to be filed within 120 days from the end of the Registrant’s fiscalyear, which information is expressly incorporated herein by reference.

 

**ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENTAND RELATED STOCKHOLDER MATTERS**

 

The information called for by Item 403 under Regulation S-K will be setforth under the captions “Security Ownership of Certain Beneficial Owners andManagement” and “Election of Directors” in the Company’s definitive proxymaterials for its May 25, 2006 Annual Meeting to be filed within 120 daysfrom the end of the Registrant’s fiscal year, which information is expresslyincorporated herein by reference. 

 

The following table presents information about the Company’s equitycompensation plans, under which equity securities of the Company are authorizedfor issuance, as of December 31, 2005:

 

53

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**SecuritiesAuthorized For Issuance Under Equity Compansations Plans**

 
| ** **                                                   | ** ** | **(a)**                                                                                                                                                                 | ** ** | **(b)**                                                                                                     | ** ** | **(c)**                                                                                                                                                                                                              | ** ** |
|--------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| **Plan Category (1)**                              | ** ** | **Number of shares of  common stock to be  issued upon exercise  of outstanding  options, warrants and  rights** | ** ** | **Weighted-average  exercise price of  outstanding options,  warrants and rights** | ** ** | **Number of shares of  common stock remaining  available for future  issuance under equity  compensation plans  (excluding shares in  column (a))** | ** ** |
|                                                         |       |                                                                                                                                                                    |       |                                                                                                        |       |                                                                                                                                                                                                                 |       |
| **Equity  compensation plans approved by security holders:** |       |                                                                                                                                                                    |       |                                                                                                        |       |                                                                                                                                                                                                                 |       |
| 1990 Stock  Plan                                             |       | 20,000                                                                                                                                                                  |       | $                                                                                                           | 11.22      |                                                                                                                                                                                                                 | —     |   |
| 1999 Stock  Plan                                             |       | 366,592                                                                                                                                                                 |       | $                                                                                                           | 15.49      |                                                                                                                                                                                                                 | 109,333    |   |
| 2003  Employee Stock Purchase Plan                           |       | —                                                                                                                                                                  |       | —                                                                                                      |       | 78,316                                                                                                                                                                                                               |       |

 

**Equity compensationplans not approved by security holders:**

None

 

----

(1)          The Companydoes not have individual compensation arrangements involving the granting ofoptions, warrants and rights.

 

**ITEM 13. CERTAIN RELATIONSHIPS AND RELATEDTRANSACTIONS**

 

The information called for by Item 404 under Regulation S-K will be setforth under the caption “Certain Transactions” in the Company’s definitiveproxy materials for its May 25, 2006 Annual Meeting to be filed within 120days from the end of the Registrant’s fiscal year, which information isexpressly incorporated herein by reference.

 

**ITEM 14. PRINCIPAL ACCOUNTANT FEES ANDSERVICES**

 

The information called for by Item 14 of Form 10-K and by Item 9(e) ofSchedule 14A will be set forth under the caption “The Company’s Auditors”in the Company’s definitive proxy materials for its May 25, 2006 AnnualMeeting to be filed within 120 days from the end of the Registrant’s fiscalyear, which information is expressly incorporated herein by reference.

 

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**PART IV**

 

**ITEM15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES**

** **

(a)          (1) **Consolidated Financial Statements**

 

The following Consolidated Financial Statements ofHector Communications Corporation and subsidiaries appear at pages 31 to51 herein:

 
|   | Report of  Independent Registered Public Accounting Firm for the years ended  December 31, 2005, 2004 and 2003 |   |   |
|--------|---------------------------------------------------------------------------------------------------------------------|--------|--------|
|   |                                                                                                                |   |   |
|   | Consolidated Balance  Sheets as of December 31, 2005 and 2004                                                  |   |   |
|   |                                                                                                                |   |   |
|   | Consolidated  Statements of Income for the years ended December 31, 2005, 2004 and  2003                       |   |   |
|   |                                                                                                                |   |   |
|   | Consolidated  Statements of Comprehensive Income for the years ended  December 31, 2005, 2004 and 2003         |   |   |
|   |                                                                                                                |   |   |
|   | Consolidated  Statements of Stockholders’ Equity for the years ended  December 31, 2005, 2004 and 2003    |   |   |
|   |                                                                                                                |   |   |
|   | Consolidated  Statements of Cash Flows for the years ended December 31, 2005, 2004 and  2003                   |   |   |
|   |                                                                                                                |   |   |
|   | Notes to  Consolidated Financial Statements                                                                         |   |   |

 

(a) (2)                 **Financial StatementSchedules**

 
| The following  financial statement schedules are being filed as part of this Form 10-K  Report:                                                   |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                        |
|                                                                                                                                                        | Report  of Independent Registered Public Accounting Firm on financial statement  schedules for the years ended December 31, 2005, 2004 and 2003 |   |   |
|                                                                                                                                                        |   |   |   |
|                                                                                                                                                        | Schedule I - Condensed  Financial Information of Registrant |   |   |
|                                                                                                                                                        | Schedule II – Valuation  and Qualifying Accounts and Reserves |   |   |
|                                                                                                                                                        |   |   |   |
| All other  schedules are omitted as the required information is inapplicable or the  information is presented in the financial statements or related notes. |
|                                                                                                                                                        |   |   |   |
|                                                                                                                                                        | Separate financial statements of Midwest  Wireless Holdings LLC, a 50 percent or less owned equity method  investment,  included as this entity  constitutes a “significant subsidiary” pursuant to the provisions of  Regulation S-X, Article 3-09. |   |   |

 

(a)  (3)              **Exhibits**

 

The exhibits which accompanyor are incorporated by reference in this report, including all exhibitsrequired to be filed with this report by Item 601 of Regulation S-K, includingeach management contract or compensatory plan or arrangement are described onthe Exhibit Index which appears on page 81 of the sequentialnumbering system used in this report.

 

55

----

 

**SIGNATURES**

 

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the Registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.

 
|                        | HECTOR  COMMUNICATIONS CORPORATION                    |
|-----------------------------|-------------------------------------------------------|
|                        |                                                  |
| Dated: March 27,  2006 | /s/ Curtis A.  Sampson                                |   |
|                        | Curtis A.  Sampson, Chairman of the Board             |
|                        |   of  Directors and Chief Executive Officer |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the Registrant in thecapacities and on the dates indicated:

 
| **Signature**             | ** ** | **Title** | ** **                            | **Date** |
|---------------------------|------------|-----------|---------------------------------------|----------|
|                      |       |      |                                  |     |
| /s/Curtis A.  Sampson     |       |      | Chairman of the  Board of Directors,  |     | March 27, 2006 |
| Curtis A.  Sampson        |       |      | Chief Executive  Officer and Director |     |   |
|                      |       |      |                                  |     |   |
| /s/Steven H.  Sjogren     |       |      | President, Chief  Operating Officer,  |     | March 27, 2006 |
| Steven H.  Sjogren        |       |      | and Director                          |     |   |
|                      |       |      |                                  |     |   |
| /s/Paul N.  Hanson        |       |      | Vice President,  Treasurer and        |     | March 27, 2006 |
| Paul N. Hanson            |       |      | Director                              |     |   |
|                      |       |      |                                  |     |   |
| /s/Charles A.  Braun      |       |      | Chief Financial  Officer and          |     | March 27, 2006 |
| Charles A. Braun          |       |      | Principal  Accounting Officer         |     |   |
|                      |       |      |                                  |     |   |
| /s/Ronald J.  Bach        |       |      | Director                              |     | March 27, 2006 |
| Ronald J. Bach            |       |      |                                  |     |   |
|                      |       |      |                                  |     |   |
| /s/James O.  Ericson      |       |      | Director                              |     | March 27, 2006 |
| James O. Ericson          |       |      |                                  |     |   |
|                      |       |      |                                  |     |   |
| /s/Luella Gross  Goldberg |       |      | Director                              |     | March 27, 2006 |
| Luella Gross  Goldberg    |       |      |                                  |     |   |
|                      |       |      |                                  |     |   |
| /s/Paul A. Hoff           |       |      | Director                              |     | March 27, 2006 |
| Paul A. Hoff              |       |      |                                  |     |   |
|                      |       |      |                                  |     |   |
| /s/Gerald D.  Pint        |       |      | Director                              |     | March 27, 2006 |
| Gerald D. Pint            |       |      |                                  |     |   |
|                      |       |      |                                  |     |   |
| /s/Wayne E.  Sampson      |       |      | Director                              |     | March 27, 2006 |
| Wayne E. Sampson          |       |      |                                  |     |   |

 

56

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**HECTOR COMMUNICATIONS CORPORATION**

**FINANCIAL STATEMENT SCHEDULES**

 

**REPORT OF INDEPENDENT REGISTEREDPUBLIC ACCOUNTING FIRM**

**ON FINANCIALSTATEMENT SCHEDULES**

** **

Shareholders and Board ofDirectors

Hector CommunicationsCorporation

 

The audit of theconsolidated financial statements of Hector Communications Corporation andsubsidiaries referred to in our opinion dated February 17, 2006, includedthe related financial statement schedules as listed in item 15(a) 2. Inour opinion, these financial statement schedules, when considered in relationto the basic consolidated financial statements, present fairly in all materialrespects the information set forth therein.

 
| /s/ Olsen  Thielen and Co., Ltd. |   |
|----------------------------------|--------|
| Olsen Thielen  and Co., Ltd.     |
| St. Paul,  Minnesota             |
| February 17,  2006          |

 

57

----

 

HECTOR COMMUNICATIONS CORPORATION

SCHEDULE I -CONDENSED FINANCIAL INFORMATION OF REGISTRANT

HECTOR COMMUNICATIONS CORPORATION (PARENT COMPANY)

 

BALANCE SHEETS

 
| ** **                                                                                                                   | ** ** | **December 31** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                                                                   | ** ** | **2005**             | ** ** | **2004** | ** ** |
|                                                                                                                         |       |                 |       |   |   |
| Assets:                                                                                                                      |       |                 |       |   |   |
| Cash                                                                                                                         |       | $                    | 3,011,784  |   | $ | 310,226 |   |
| Investment in subsidiaries                                                                                                   |       | 72,260,791           |       | 64,518,405 |   |
| Other current assets                                                                                                         |       | 773,779              |       | 2,240,322 |   |
| Property, plant and equipment, net                                                                                           |       | 540,311              |       | 736,967 |   |
| Accounts with subsidiaries                                                                                                   |       | 2,146,061            |       | 9,138,554 |   |
| Investment in Midwest Wireless Holdings, LLC                                                                                 |       | 2,626,882            |       |   |   |
| Other investments                                                                                                            |       | 3,196,104            |       | 3,242,052 |   |
| Other assets                                                                                                                 |       | 124,808              |       | 142,023 |   |
| Total Assets                                                                                                                 |       | $                    | 84,680,520 |   | $ | 80,328,549 |   |
|                                                                                                                         |       |                 |       |   |   |
| Liabilities and Stockholders’ Equity:                                                                                   |       |                 |       |   |   |
| Accounts payable                                                                                                             |       | $                    | 260,165    |   | $ | 282,765 |   |
| Other current liabilities                                                                                                    |       | 2,349,655            |       | 2,311,633 |   |
| Current portion of long-term debt                                                                                            |       | 2,750,000            |       | 2,896,000 |   |
| Long-term debt                                                                                                               |       | 17,875,000           |       | 20,625,421 |   |
| Total Liabilities                                                                                                            |       | 23,234,820           |       | 26,115,819 |   |
|                                                                                                                         |       |                 |       |   |   |
| Stockholders’ equity:                                                                                                   |       |                 |       |   |   |
| Preferred stock, par value $1.00 per share; 3,000,000  shares authorized:                                                    |       |                 |       |   |   |
| Convertible Series A, 0 and 157,800 shares  issued and outstanding                                                      |       |                 |       | 157,800 |   |
| Common stock, par value $.01 per share; 10,000,000  shares authorized; 3,982,789 and 3,723,390 shares issued and outstanding |       | 39,828               |       | 37,234 |   |
| Additional paid-in capital                                                                                                   |       | 17,138,826           |       | 15,621,048 |   |
| Retained earnings                                                                                                            |       | 43,794,447           |       | 38,359,117 |   |
| Accumulated other comprehensive income                                                                                       |       | 472,599              |       | 37,531 |   |
| Total Stockholders’ Equity                                                                                              |       | 61,445,700           |       | 54,212,730 |   |
| Total Liabilities and Stockholders’ Equity                                                                              |       | $                    | 84,680,520 |   | $ | 80,328,549 |   |

 

See notes to condensed financial statements of registrant.

 

58

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STATEMENT OF INCOME AND COMPREHENSIVE INCOME

 
| ** **                                                                                                            | ** ** | **Year Ended December 31** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                            | ** ** | **2005**                        | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenues:                                                                                                             |       |                            |       |   |   |   |   |
| Sales                                                                                                                 |       | $                               | 285,789    |   | $ | 340,957 |   | $ | 184,881 |   |
| Operating expenses                                                                                                    |       | 698,702                         |       | 438,170 |   | 342,980 |   |
| Operating loss                                                                                                        |       | (412,913                        | )          | (97,213 | ) | (158,099 | ) |
|                                                                                                                  |       |                            |       |   |   |   |   |
| Other income (expenses):                                                                                              |       |                            |       |   |   |   |   |
| Equity in earnings of Midwest Wireless Holdings LLC                                                                   |       | 283,257                         |       |   |   |   |   |
| Income (loss) from other investments                                                                                  |       | (14,262                         | )          | (5,275 | ) | (7,094 | ) |
| Interest expense, net                                                                                                 |       | (1,119,124                      | )          | (955,721 | ) | (694,419 | ) |
| Income tax benefit                                                                                                    |       | 534,301                         |       | 550,494 |   | 358,773 |   |
| Net other expenses                                                                                                    |       | (315,828                        | )          | (410,502 | ) | (342,740 | ) |
|                                                                                                                  |       |                            |       |   |   |   |   |
| Loss before equity in earnings of subsidiaries                                                                        |       | (728,741                        | )          | (507,715 | ) | (500,839 | ) |
|                                                                                                                  |       |                            |       |   |   |   |   |
| Equity in earnings of subsidiaries                                                                                    |       | 7,296,075                       |       | 5,152,098 |   | 5,679,599 |   |
| Net income                                                                                                            |       | 6,567,334                       |       | 4,644,383 |   | 5,178,760 |   |
|                                                                                                                  |       |                            |       |   |   |   |   |
| Other comprehensive income (loss):                                                                                    |       |                            |       |   |   |   |   |
| Unrealized holding gains (losses) of subsidiaries on  marketable securities                                           |       | 725,115                         |       | (22,824 | ) | 97,612 |   |
| Income tax (expense) benefit related to unrealized  holding gains and losses of subsidiaries on marketable securities |       | (290,047                        | )          | 9,130 |   | (39,053 | ) |
| Minority interest in other comprehensive loss of  subsidiaries                                                        |       |                            |       |   |   | 3,783 |   |
|                                                                                                                  |       |                            |       |   |   |   |   |
| Other comprehensive income (loss)                                                                                     |       | 435,068                         |       | (13,694 | ) | 62,342 |   |
|                                                                                                                  |       |                            |       |   |   |   |   |
| Comprehensive income                                                                                                  |       | $                               | 7,002,402  |   | $ | 4,630,689 |   | $ | 5,241,102 |   |

 

See notes to condensed financial statements of registrant.

 

59

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STATEMENTS OF CASH FLOWS

 
| ** **                                                                                   | ** ** | **Year Ended December 31** | ** ** |
|----------------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                   | ** ** | **2005**                        | ** ** | **2004** | ** ** | **2003** | ** ** |
| Cash flows from operating activities:                                                        |       |                            |       |   |   |   |   |
| Net income                                                                                   |       | $                               | 6,567,334  |   | $ | 4,644,383 |   | $ | 5,178,760 |   |
| Adjustments to reconcile net income to net cash  provided by (used in) operating activities: |       |                            |       |   |   |   |   |
| Equity in earnings of Midwest Wireless Holdings LLC                                          |       | (283,257                        | )          |   |   |   |   |
| Cash distributions from Midwest Wireless Holdings  LLC                                       |       | 99,892                          |       |   |   |   |   |
| Loss from other investments                                                                  |       | 14,262                          |       | 5,275 |   | 7,094 |   |
| Noncash patronage refund                                                                     |       | (43,587                         | )          | (207,951 | ) | (12,368 | ) |
| Equity in earnings of subsidiaries                                                           |       | (7,296,075                      | )          | (5,152,098 | ) | (5,679,599 | ) |
| Depreciation and amortization                                                                |       | 223,770                         |       | 158,875 |   | 86,492 |   |
| Changes in assets and liabilities:                                                           |       |                            |       |   |   |   |   |
| Other current assets                                                                         |       | 1,474,038                       |       | (825,856 | ) | (1,199,393 | ) |
| Accounts with subsidiaries                                                                   |       | 4,548,976                       |       | 3,019,018 |   | (3,251,012 | ) |
| Accounts payable                                                                             |       | (22,600                         | )          | (22,973 | ) | 265,462 |   |
| Other current liabilities                                                                    |       | 384,497                         |       | 397,847 |   | 1,465,357 |   |
| Net cash provided by (used in) operating activities                                          |       | 5,667,250                       |       | 2,016,520 |   | (3,139,207 | ) |
|                                                                                         |       |                            |       |   |   |   |   |
| Cash flows from investing activities:                                                        |       |                            |       |   |   |   |   |
| Purchases of property, plant and equipment                                                   |       | (9,899                          | )          | (117,519 | ) | (225,118 | ) |
| Purchases of other investments                                                               |       | (15,300                         | )          | (30,000 | ) | (2,554,925 | ) |
| Cash proceeds from other investments                                                         |       | 71,835                          |       | 203,082 |   | 126,567 |   |
| Decrease (increase) in other assets                                                          |       |                            |       |   |   | (167,845 | ) |
| Investments in affiliates                                                                    |       |                            |       |   |   | (17,999,944 | ) |
| Net cash provided by (used in) investing activities                                          |       | 46,636                          |       | 55,563 |   | (20,821,265 | ) |
|                                                                                         |       |                            |       |   |   |   |   |
| Cash flows from financing activities:                                                        |       |                            |       |   |   |   |   |
| Repayment of long-term debt                                                                  |       | (2,896,421                      | )          | (3,306,497 | ) | (3,141,633 | ) |
| Proceeds from issuance of notes payable and  long-term debt                                  |       |                            |       |   |   | 26,812,500 |   |
| Issuance of common stock                                                                     |       | 1,021,085                       |       | 1,445,455 |   | 431,243 |   |
| Purchase of stock                                                                            |       | (29,912                         | )          |   |   | (17,162 | ) |
| Cash dividends                                                                               |       | (1,107,080                      | )          | (194,040 | ) |   |   |
| Net cash provided by (used in) financing activities                                          |       | (3,012,328                      | )          | (2,055,082 | ) | 24,084,948 |   |
|                                                                                         |       |                            |       |   |   |   |   |
| Net increase in cash and cash equivalents                                                    |       | 2,701,558                       |       | 17,001 |   | 124,476 |   |
|                                                                                         |       |                            |       |   |   |   |   |
| Beginning cash and cash equivalents                                                          |       | 310,226                         |       | 293,225 |   | 168,749 |   |
| Ending cash and cash equivalents                                                             |       | $                               | 3,011,784  |   | $ | 310,226 |   | $ | 293,225 |   |
|                                                                                         |       |                            |       |   |   |   |   |
| Supplemental disclosures of cash flow information:                                           |       |                            |       |   |   |   |   |
| Interest paid                                                                                |       | $                               | 1,287,572  |   | $ | 1,210,618 |   | $ | 524,940 |   |
| Income taxes paid                                                                            |       | 3,708,000                       |       | 3,640,000 |   | 1,446,590 |   |

 

See notes to condensed financial statements of registrant.

 

60

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NOTESTO CONDENSED FINANCIAL STATEMENTS OF REGISTRANT

 

Note 1– Basis of Presentation

 

Pursuant to the rules andregulations of the Securities and Exchange Commission, the Condensed FinancialStatements of the Registrant do not include all of the information and notesnormally included in financial statements prepared in accordance with generallyaccepted accounting principles. It is suggested that these Condensed FinancialStatements be read in conjunction with the Consolidated Financial Statementsand Notes thereto included in the Registrant’s Annual Report as referenced in Form 10-K,Part II, Item 8.

 

Note 2 – Investment inSubsidiaries

 

In 2003 the Companyacquired the 32% minority interest in Alliance Telecommunications Corporation. In2004 the Company received noncash dividends from its subsidiaries totaling$8,739,000. The dividend was recorded in the Company’s accounts with itssubsidiaries. In 2005 a subsidiary transferred its ownership interest inMidwest Wireless Holdings, LLC to the Company. The transfer was recorded in theCompany’s accounts with its subsidiaries.

 

Note 3 – Long Term Debt

 
| ** **                                                                                                            | ** ** | **December 31** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                                                            | ** ** | **2005**             | ** ** | **2004** | ** ** |
|                                                                                                                  |       |                 |       |   |   |
| Note payable to  CoBank in quarterly installments, interest rate of 6.9%, due 2013                                    |       | $                    | 20,625,000 |   | $ | 23,375,000 |   |
|                                                                                                                  |       |                 |       |   |   |
| Notes payable to former owners of Felton Telephone  Company in monthly installments, interest rate of 8.25%, due 2005 |       |                 |       | 146,421 |   |
| Less current  portion                                                                                                 |       | (2,750,000           | )          | (2,896,000 | ) |
|                                                                                                                  |       | $                    | 17,875,000 |   | $ | 20,625,421 |   |

 

The annual requirementsfor principal payments on notes payable and long-term debt are as follows:

 

| 2006 |   | $         | 2,750,000 |   |
|------|--------|-----------|-----------|--------|
| 2007 |   | 2,750,000 |      |
| 2008 |   | 2,750,000 |      |
| 2009 |   | 2,750,000 |      |
| 2010 |   | 2,750,000 |      |

 

HECTOR COMMUNICATIONS CORPORATION AND SUBSIDIARIES

Schedule II -Valuation and Qualifying Accounts and Reserves

 
| **Description**                   | ** ** | **Balance at  Beginning of  Period** | ** ** | **Additions  Charged to  Revenues** | ** ** | **Additions  Charged to  Expense** | ** ** | **Deductions  from  Reserves** | ** ** | **Balance  at End  of Period** | ** ** |
|-----------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|------------------------------------|------------|--------------------------------|------------|--------------------------------|------------|
|                              |       |                                 |       |                                |       |                               |       |                           |       |                           |       |
| Allowance for  doubtful accounts: |       |                                 |       |                                |       |                               |       |                           |       |                           |       |
|                              |       |                                 |       |                                |       |                               |       |                           |       |                           |       |
| Year ended:                       |       |                                 |       |                                |       |                               |       |                           |       |                           |       |
|                              |       |                                 |       |                                |       |                               |       |                           |       |                           |       |
| December 31, 2005            |       | $                                    | 37,000     |                                |       |                               | $          | 52,000                         |       | $                              | 63,000     | (A) | $ | 26,000 |   |
|                              |       |                                 |       |                                |       |                               |       |                           |       |                           |       |
| December 31, 2004            |       | $                                    | 35,000     |                                |       |                               | $          | 336,000                        |       | $                              | 334,000    | (A) | $ | 37,000 |   |
|                              |       |                                 |       |                                |       |                               |       |                           |       |                           |       |
| December 31, 2003            |       | $                                    | 20,000     |                                | $          | 93,000                             |       |                           |       | $                              | 78,000     | (A) | $ | 35,000 |   |
|                                   |            |                                      |            |                                     |            |                                    |            |                                |            |                                |            |  |  |  |  |  |

 

----

(A)  Accounts determined to be uncollectible and charged offagainst reserve.

 

61

----

 

**MidwestWireless**

 

**Holdings L.L.C.**

 

**Consolidated Financial Statements**

 

**December 31, 2005, 2004 and 2003**

 

62

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**Midwest Wireless Holdings L.L.C.**

**Index**

**December 31, 2005, 2004 and 2003**

 
| **Report  of Independent Auditors**                         |   |
|-------------------------------------------------------------|--------|
|                                                        |   |
| **Financial Statements**                                    |   |
|                                                        |   |
| Consolidated  Statements of Financial Position              |   |
|                                                        |   |
| Consolidated  Statements of Operations                      |   |
|                                                        |   |
| Consolidated  Statements of Changes in Members’ Equity |   |
|                                                        |   |
| Consolidated  Statements of Cash Flows                      |   |
|                                                        |   |
| Notes  to Consolidated Financial Statements                 |   |

 

63

----

 

**Report of IndependentAuditors**

** **

To the Board of Managersand Members of

Midwest Wireless HoldingsL.L.C.

 

In our opinion, theaccompanying consolidated statements of financial position and the relatedconsolidated statements of operations, changes in members’ equity, and cashflows present fairly, in all material respects, the financial position of MidwestWireless Holdings L.L.C. (the “Company”) and its subsidiaries at December 31,2005 and 2004, and the results of their operations and their cash flows foreach of the three years in the period ended December 31, 2005, inconformity with accounting principles generally accepted in the United Statesof America. These financial statements are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these financialstatements based on our audits. We conducted our audits of these statements inaccordance with auditing standards generally accepted in the United States ofAmerica. Those standards require that we plan and perform the audit toobtain reasonable assurance about whether the financial statements are free ofmaterial misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements, assessingthe accounting principles used and significant estimates made by management,and evaluating the overall financial statement presentation. We believe thatour audits provide a reasonable basis for our opinion.

 

As discussed in Note 2 tothe financial statements, the Company adopted Statement of Financial AccountingStandards No. 143, *Accounting for Asset RetirementObligations*, on January 1, 2003.

 

 
| /s/PricewaterhouseCoopers  LLP |   |
|--------------------------------|--------|
| Minneapolis,  Minnesota        |
| March 7,  2006            |

 

64

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**MidwestWireless Holdings L.L.C.**

**ConsolidatedStatements of Financial Position**

**December 31,2005 and 2004**

** **
| ** **                                                                                                         | ** ** | **2005**    | ** **  | **2004**    | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|-------------|-------------|-------------|------------|
|                                                                                                               |       |        |        |        |       |
| **Assets**                                                                                                         |       |        |        |        |       |
| Current assets                                                                                                     |       |        |        |        |       |
| Cash and cash equivalents                                                                                          |       | $           | 2,182,293   |        | $          | 1,174,378 |   |
| Accounts receivable, less allowance for doubtful  accounts of $806,478 and $716,100 in 2005 and 2004, respectively |       | 24,326,774  |        | 20,348,616  |       |
| Inventories                                                                                                        |       | 4,979,295   |        | 4,385,157   |       |
| Other current assets                                                                                               |       | 1,616,570   |        | 1,777,018   |       |
| Total current assets                                                                                               |       | 33,104,932  |        | 27,685,169  |       |
| Property, cellular plant and equipment, net                                                                        |       | 127,416,622 |        | 127,835,566 |       |
| FCC licenses                                                                                                       |       | 212,201,696 |        | 212,347,514 |       |
| Goodwill and other intangible assets, net                                                                          |       | 15,259,285  |        | 17,151,736  |       |
| Investments in cooperatives                                                                                        |       | 7,294,891   |        | 9,120,487   |       |
| Total assets                                                                                                       |       | $           | 395,277,426 |        | $          | 394,140,472 |   |
| **Liabilities and Members’ Equity**                                                                           |       |        |        |        |       |
| Current liabilities                                                                                                |       |        |        |        |       |
| Current portion of long-term debt                                                                                  |       | $           | 1,188,255   |        | $          | 22,590,500 |   |
| Revolving loan                                                                                                     |       | 2,917,176   |        | —      |       |
| Accounts payable                                                                                                   |       | 10,164,177  |        | 7,350,406   |       |
| Other accrued expenses                                                                                             |       | 18,056,019  |        | 16,848,298  |       |
| Deferred revenue                                                                                                   |       | 8,427,971   |        | 7,970,799   |       |
| Total current liabilities                                                                                          |       | 40,753,598  |        | 54,760,003  |       |
| Other liabilities                                                                                                  |       | 4,821,349   |        | 4,021,692   |       |
| Long-term debt                                                                                                     |       | 115,529,766 |        | 138,745,810 |       |
| Total liabilities                                                                                                  |       | 161,104,713 |        | 197,527,505 |       |
| Minority interest                                                                                                  |       | 19,146,185  |        | 14,919,971  |       |
| Commitments and contingencies (Notes 8 and 11)                                                                     |       |        |        |        |       |
| Members’ equity                                                                                               |       | 215,026,528 |        | 181,692,996 |       |
| Total liabilities and members’ equity                                                                         |       | $           | 395,277,426 |        | $          | 394,140,472 |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

65

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**MidwestWireless Holdings L.L.C.**

**ConsolidatedStatements of Operations**

**YearsEnded December 31, 2005, 2004 and 2003**

 
| ** **                                                                                  | ** ** | **2005**    | ** **  | **2004**    | ** ** | **2003**    | ** ** |
|---------------------------------------------------------------------------------------------|------------|-------------|-------------|-------------|------------|-------------|------------|
|                                                                                        |       |        |        |        |       |        |       |
| Operating revenues                                                                          |       |        |        |        |       |        |       |
| Subscriber service                                                                          |       | $           | 193,943,656 |        | $          | 171,410,835 |       | $ | 140,823,140 |   |
| Roamer service                                                                              |       | 38,220,125  |        | 29,540,968  |       | 28,107,407  |       |
| Other operating revenues                                                                    |       | 31,849,387  |        | 19,727,569  |       | 10,633,293  |       |
|                                                                                        |       | 264,013,168 |        | 220,679,372 |       | 179,563,840 |       |
| Operating expenses                                                                          |       |        |        |        |       |        |       |
| Operations and maintenance (exclusive of items shown  separately below)                     |       | 51,283,804  |        | 44,906,175  |       | 33,987,898  |       |
| Cost of equipment sold                                                                      |       | 25,267,051  |        | 26,858,490  |       | 12,115,073  |       |
| Home roamer costs                                                                           |       | 31,841,915  |        | 29,485,393  |       | 31,280,458  |       |
| Depreciation                                                                                |       | 29,083,836  |        | 28,140,602  |       | 22,593,187  |       |
| Amortization of intangible assets                                                           |       | 2,110,500   |        | 1,712,858   |       | 267,278     |       |
| Selling, general and administrative                                                         |       | 50,574,148  |        | 44,875,726  |       | 41,111,864  |       |
|                                                                                        |       | 190,161,254 |        | 175,979,244 |       | 141,355,758 |       |
| Operating income                                                                            |       | 73,851,914  |        | 44,700,128  |       | 38,208,082  |       |
| Other income (expense)                                                                      |       |        |        |        |       |        |       |
| Interest expense                                                                            |       | (8,303,958  | )           | (7,584,944  | )          | (7,204,744  | )          |
| Interest and dividend income                                                                |       | 299,262     |        | 6,453       |       | 2,887       |       |
| Gain on disposal of FCC licenses                                                            |       | —      |        | 2,616,674   |       | —      |       |
| Other                                                                                       |       | (233,570    | )           | (59,388     | )          | (61,529     | )          |
| Total other expense                                                                         |       | (8,238,266  | )           | (5,021,205  | )          | (7,263,386  | )          |
| Minority interest                                                                           |       | (7,381,535  | )           | (4,463,879  | )          | (3,494,303  | )          |
| Income before cumulative effect of change in  accounting principle                          |       | 58,232,113  |        | 35,215,044  |       | 27,450,393  |       |
| Cumulative effect of change in accounting principle  net of minority interest (Note 2) |       | —      |        | —      |       | (754,990    | )          |
| Net income                                                                                  |       | $           | 58,232,113  |        | $          | 35,215,044  |       | $ | 26,695,403 |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

66

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**MidwestWireless Holdings L.L.C.**

**ConsolidatedStatements of Changes in Members’ Equity**

**YearsEnded December 31, 2005, 2004 and 2003**

 
| ** **                                                       | ** ** | **Capital  Contributions** | ** ** | **Accumulated  Income** | ** ** | **Total  Members’  Equity** | ** ** |
|------------------------------------------------------------------|------------|----------------------------|------------|-------------------------|------------|----------------------------------|------------|
|                                                             |       |                       |       |                    |       |                             |       |
| **Balances at December 31, 2002**                           |       | $                          | 84,713,099 |                    | $          | 51,786,783                       |       | $ | 136,499,882 |   |
| Issuance of units related to the acquisition of Iowa  properties |       | 1,941,468                  |       | —                  |       | 1,941,468                        |       |
| Distributions to members                                         |       | —                     |       | (9,491,691              | )          | (9,491,691                       | )          |
| Net income                                                       |       | —                     |       | 26,695,403              |       | 26,695,403                       |       |
| **Balances at December 31, 2003**                           |       | 86,654,567                 |       | 68,990,495              |       | 155,645,062                      |       |
| Distributions to members                                         |       | —                     |       | (9,167,110              | )          | (9,167,110                       | )          |
| Net income                                                       |       | —                     |       | 35,215,044              |       | 35,215,044                       |       |
| **Balances at December 31, 2004**                           |       | 86,654,567                 |       | 95,038,429              |       | 181,692,996                      |       |
| Distributions to members                                         |       | —                     |       | (24,898,581             | )          | (24,898,581                      | )          |
| Net income                                                       |       | —                     |       | 58,232,113              |       | 58,232,113                       |       |
| **Balances at December 31, 2005**                           |       | $                          | 86,654,567 |                    | $          | 128,371,961                      |       | $ | 215,026,528 |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

67

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**MidwestWireless Holdings L.L.C.**

**ConsolidatedStatements of Cash Flows**

**YearsEnded December 31, 2005, 2004 and 2003**

** **
| ** **                                                                        | ** ** | **2005**     | ** ** | **2004**    | ** ** | **2003**    | ** ** |
|-----------------------------------------------------------------------------------|------------|--------------|------------|-------------|------------|-------------|------------|
|                                                                              |       |         |       |        |       |        |       |
| **Cash flows from operating activities**                                          |       |         |       |        |       |        |       |
| Net income                                                                        |       | $            | 58,232,113 |        | $          | 35,215,044  |       | $ | 26,695,403 |   |
| Adjustments to reconcile net income to net cash provided  by operating activities |       |         |       |        |       |        |       |
| Net income allocated to minority interest                                         |       | 7,381,535    |       | 4,463,879   |       | 3,398,600   |       |
| Provision for bad debts                                                           |       | 1,587,846    |       | 1,605,361   |       | 1,327,703   |       |
| Depreciation                                                                      |       | 29,966,794   |       | 28,140,602  |       | 22,593,187  |       |
| Amortization of intangibles                                                       |       | 2,110,500    |       | 1,712,858   |       | 267,278     |       |
| Gain on disposal of assets                                                        |       | (58,113      | )          | (2,643,653  | )          | (125,277    | )          |
| Patronage received in form of cooperative stock                              |       | (411,666     | )          | (298,301    | )          | (361,318    | )          |
| Appreciation Rights Plan compensation                                             |       | 2,423,707    |       | 1,618,494   |       | 1,359,360   |       |
| Cumulative effect of accounting change                                            |       | —       |       | —      |       | 850,693     |       |
| Changes in assets and liabilities                                                 |       |         |       |        |       |        |       |
| Accounts receivable                                                               |       | (5,566,004   | )          | (5,705,896  | )          | (2,434,724  | )          |
| Inventories                                                                       |       | (594,138     | )          | (1,805,514  | )          | (1,168,070  | )          |
| Other assets                                                                      |       | 331,606      |       | (475,402    | )          | 234,808     |       |
| Accounts payable                                                                  |       | 925,333      |       | 1,213,435   |       | 493,555     |       |
| Deferred revenue and accrued expenses                                             |       | 1,664,893    |       | 3,474,365   |       | (1,179,906  | )          |
| Other liabilities                                                                 |       | (1,624,050   | )          | 639,798     |       | 1,863,618   |       |
| Net cash provided by operating activities                                         |       | 96,370,356   |       | 67,155,070  |       | 53,814,910  |       |
|                                                                              |       |         |       |        |       |        |       |
| **Cash flows from investing activities**                                          |       |         |       |        |       |        |       |
| Acquisition of cellular properties                                                |       | —       |       | —      |       | (42,780,847 | )          |
| Payments for property, cellular plant and equipment                               |       | (29,748,633  | )          | (33,835,896 | )          | (29,234,491 | )          |
| Proceeds from the disposal of fixed assets                                        |       | 87,738       |       | 359,193     |       | 518,573     |       |
| Proceeds from the disposal of FCC licenses                                        |       | 145,818      |       | 2,832,456   |       | —      |       |
| Purchase of intangible assets                                                     |       | (218,049     | )          | (1,286,877  | )          | —      |       |
| Redemption of cooperative stock                                                   |       | 2,237,262    |       | 282,481     |       | 421,527     |       |
| Net cash used in investing activities                                             |       | (27,495,864  | )          | (31,648,643 | )          | (71,075,238 | )          |
|                                                                              |       |         |       |        |       |        |       |
| **Cash flows from financing activities**                                          |       |         |       |        |       |        |       |
| Proceeds (payments) on revolving loan                                             |       | 2,917,176    |       | —      |       | (25,000,000 | )          |
| Book overdraft                                                                    |       | 1,888,438    |       | —      |       | —      |       |
| Proceeds from long-term debt                                                      |       | 146,659,941  |       | —      |       | 68,297,657  |       |
| Payments on long-term debt                                                        |       | (191,278,230 | )          | (25,891,585 | )          | (14,815,075 | )          |
| Distributions to members                                                          |       | (24,898,581  | )          | (9,167,110  | )          | (9,491,691  | )          |
| Distribution from subsidiary to minority interest                                 |       | (3,155,321   | )          | (1,161,720  | )          | (1,209,407  | )          |
| Net cash (used in) provided by financing activities                               |       | (67,866,577  | )          | (36,220,415 | )          | 17,781,484  |       |
| Net change in cash and cash equivalents                                           |       | 1,007,915    |       | (713,988    | )          | 521,156     |       |
|                                                                              |       |         |       |        |       |        |       |
| **Cash and cash equivalents**                                                     |       |         |       |        |       |        |       |
| Beginning of year                                                                 |       | 1,174,378    |       | 1,888,366   |       | 1,367,210   |       |
| End of year                                                                       |       | $            | 2,182,293  |        | $          | 1,174,378   |       | $ | 1,888,366 |   |
|                                                                              |       |         |       |        |       |        |       |
| **Supplemental disclosure**                                                       |       |         |       |        |       |        |       |
| Cash paid during the year for interest                                            |       | $            | 10,500,120 |        | $          | 7,993,662   |       | $ | 8,165,844 |   |
| Equity units issued for acquisitions                                              |       | —       |       | —      |       | 1,941,468   |       |
|                                                                              |       |         |       |        |       |        |       |
| **Noncash investing activities**                                                  |       |         |       |        |       |        |       |
| Equipment acquired under capital leases                                           |       | —       |       | 1,386,246   |       | 3,244,433   |       |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

68

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**MidwestWireless Holdings L.L.C.**

**Notes toConsolidated Financial Statements**

**December 31,2005, 2004 and 2003**

** **

**1.**                          BusinessDescription

** **

MidwestWireless Holdings L.L.C. (the “Company”) was formed in November 1999 as aDelaware limited liability company to acquire and operate cellularcommunications properties in the Midwest portion of the United States ofAmerica. Upon its formation, the Company exchanged its equity units forapproximately 86% of the equity units of Midwest Wireless Communications L.L.C.

 

**2.**                          Summary ofSignificant Accounting Policies

** **

**Consolidation**

Theconsolidated financial statements include the Company’s wholly ownedsubsidiaries, Midwest Wireless Iowa L.L.C. and Midwest Wireless WisconsinL.L.C., as well as its majority owned subsidiary, Midwest WirelessCommunications L.L.C. All significant intercompany balances and transactionshave been eliminated in consolidation.

 

**Use ofEstimates**

Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities at the date of the financial statements and disclosure ofcontingent assets and liabilities at the date of the financial statements. Estimatesalso affect the reported amounts of revenues and expenses during the periodsreported. Actual results could differ from those estimates.

 

**Concentrationof Credit Risk**

TheCompany provides cellular service and cellular telephones to a diversifiedgroup of consumers within a concentrated geographical area. The Companyperforms credit evaluations of its customers and requires a deposit when deemednecessary. Receivables are generally due within 30 days.

 

**Cash andCash Equivalents**

Cash andcash equivalents include cash on deposit and highly liquid investments withoriginal maturities of three months or less that are readily convertible tocash. The Company has funds on deposit with financial institutions that exceedfederally insured limits as of December 31, 2005 and 2004.

 

**Inventories**

Inventoriesconsist primarily of cellular phones and accessories held for resale. Inventoriesare stated at the lower of cost or market, with cost determined using thespecific identification method. Losses on sales of cellular phones arerecognized in the period in which sales are made as a cost of acquiringsubscribers.

 

69

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**MidwestWireless Holdings L.L.C.**

**Notes toConsolidated Financial Statements**

**December 31,2005, 2004 and 2003**

** **

**Property,Cellular Plant and Equipment**

Property,cellular plant and equipment is stated at its original cost. Depreciation andamortization are provided on a straight-line basis over the estimated usefullives of the assets. The estimated useful lives of property, cellular plant andequipment are as follows:

 
| Building and improvements            |   | 3–30 years |   |
|--------------------------------------|--------|-----------------|--------|
| Other equipment                      |   | 2–20 years |   |
| Communication and network  equipment |   | 7–15 years |   |
| Vehicles                             |   | 3 years         |   |
| Computer equipment                   |   | 3 years    |   |

 

Majorrenewals or betterments are capitalized, while repair and maintenanceexpenditures are charged to operations as incurred. Interest costs related toqualifying construction projects are capitalized. The cost and accumulateddepreciation of property, cellular plant and equipment disposed of or sold areeliminated from their respective accounts, and the resulting gain or loss isrecorded in operations.

 

**AssetRetirement Obligation**

On January 1,2003, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 143,*Accounting for Asset Retirement Obligations*.This statement relates to the costs of closing facilities and removing assets. SFASNo. 143 requires entities to record the fair value of a legal liabilityfor an asset retirement obligation (“ARO”) in the period it is incurred if areasonable estimate of fair value can be made. This cost is initiallycapitalized and amortized over the remaining life of the underlying asset. Oncethe obligation is ultimately settled, any difference between the final cost andthe recorded liability is recognized as a gain or loss. For the Company, an AROincludes those costs associated with removing component equipment that issubject to retirement from cell sites that reside upon leased property. As aresult of adopting SFAS No. 143, on January 1, 2003, the Companyrecorded an ARO of $1,266,744 and a cumulative effect of the change inaccounting principle of $850,693. The cumulative effect of this change resultedfrom accumulated accretion and depreciation of the ARO and related asset forthe period from January 1, 1998 through December 31, 2002. After aminority interest effect of $95,703, the net charge was $754,990. Accretion anddepreciation expenses related to the ARO for the years ended December 31,2005, 2004 and 2003, were $195,704, $192,748 and $186,161, respectively.

 

**IntangibleAssets and Other Long-Lived Assets**

FCClicenses consist of the cost of acquiring cellular, personal communicationservices (“PCS”), and local multi-point distribution licenses. It also includesthe value assigned to cellular licenses acquired through the acquisitions ofoperating cellular systems. The Company ceased amortization of its FCC licenseseffective January 1, 2002, with the adoption of SFAS No. 142, *Goodwill and Other Intangible Assets* (Note 3). Customerrelationships are amortized on a straight-line basis over their useful liveswhich range from two to six years.

 

70

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TheCompany reviews goodwill and FCC licenses for impairment annually, or morefrequently if changes in circumstances or the occurrence of events suggest animpairment exists. The test for impairment of goodwill and other intangibleassets requires the Company to make estimates about fair value.

 

TheCompany periodically reviews customer relationships and other long-lived assetsfor impairment whenever events or changes in circumstances indicate that the carryingvalue of the assets may not be recoverable. If the future cash flows(undiscounted and without interest) expected to result from the use of therelated assets are less than the carrying value of such assets, an impairment may havebeen incurred and any loss is recognized, if necessary, to reduce the carryingvalue of the customer relationships or long-lived assets to fair value, whichis determined using discounted estimated future cash flows.

 

**Investmentsin Cooperatives**

Investmentsin cooperatives are recorded using the cost method as the Company does not havethe ability to exercise significant influence over the financial and operatingpolicies of the investees. The investments were originally purchased pursuantto the terms of loan agreements with Rural Telephone Finance Cooperative andCoBank, ACB (Note 7). Changes in the investment balances are due to thereceipt of additional shares of stock of the investees from noncash patronagerefunds net of the redemption of certain shares held by the Company.

 

**RevenueRecognition**

Subscriberservice revenue consists of the base monthly service fee and airtime charges toour customers. Base monthly service fees are billed one month in advance andare recognized in the month earned. Roamer service revenue includes charges toother wireless providers’ customers who use the Company’s network. Airtime androamer revenues are recognized when the service is provided. Billings inadvance of the delivery of service are recorded as deferred revenue. TheCompany recognizes equipment revenue when the equipment is delivered tocustomers.

 

**IncomeTaxes**

Noprovision for income taxes has been recorded since all income, losses and taxcredits are allocated to the members for inclusion in their respective incometax returns.

 

**Advertising**

Advertisingcosts are expensed as incurred. Total advertising expenses were $4,108,218,$4,584,877 and $3,310,758 for the years ended December 31, 2005, 2004 and2003, respectively.

 

**Unit-BasedCompensation**

TheCompany accounts for unit-based compensation using the intrinsic value method. Accordingly,compensation cost for unit options granted to employees is measured as theexcess, if any, of the fair value of the unit at the date of grant over theamount an employee must pay to acquire the units. Such compensation costs areamortized over the underlying option’s vesting term. No such compensationexpense was recognized in the financial statements for the years ended December 31,2005, 2004 and 2003.

 

71

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If theCompany had elected to recognize compensation expense for options granted usingthe fair value method, net income would have been as follows:

 
| ** **                                                                                                      | ** ** | **2005** | ** ** | **2004** | ** ** | **2003**   | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|------------|------------|
| Net income, as reported                                                                                         |       | $        | 58,232,113 |     | $          | 35,215,044 |       | $ | 26,695,403 |   |
| Deduct: Total unit-based employee compensation  expense determined under fair value based method for all awards |       | (138,730 | )          | (143,395 | )          | (199,789   | )          |
| Pro forma net income                                                                                            |       | $        | 58,093,383 |     | $          | 35,071,649 |       | $ | 26,495,614 |   |

 

Forpurposes of the pro forma disclosures above, the weighted average fair valueper unit option granted in 2005, 2004 and 2003 was $0, $19.48 and $10.67,respectively. The fair value for each option was estimated at the date of grantusing the minimum value method with the following weighted average assumptions:

 
| ** **              | ** ** | **Fiscal Year** | ** ** |
|-------------------------|------------|-----------------|------------|
| ** **              | ** ** | **2005**        | ** ** | **2004** | ** ** | **2003** | ** ** |
|                    |       |            |       |   |   |   |   |
| Dividend yield          |       | 7.35            | %          | 3.36 | % | 3.46 | % |
| Risk-free interest rate |       | 4.29            | %          | 4.50 | % | 4.07 | % |
| Expected holding period |       | 10 years        |       | 10 years |   | 10 years |   |

 

**3.**                          FCCLicenses, Goodwill and Other Intangible Assets

** **

EffectiveJanuary 1, 2002, the Company adopted SFAS No. 142. Effective with theadoption of this standard, the Company ceased amortizing FCC licenses, whichprovide the Company with the exclusive right to utilize certain radio frequencyspectrum to provide wireless communication services. Although the FCC licensesare issued for only a fixed time, generally ten years, they are subject torenewal by the FCC; and renewals have occurred routinely and at nominal cost. Moreover,there are currently no legal, regulatory, contractual, competitive, economic,or other factors that limit the useful lives of these licenses. As a result,FCC licenses are treated as indefinite-lived intangible assets and are notamortized, but rather are tested annually for impairment. The Company evaluatesthe useful life determination for FCC licenses each reporting period in orderto determine whether events and circumstances continue to support an indefinitelife.

 

TheCompany completed the required annual impairment assessments of its FCClicenses and goodwill on December 31, 2005 and 2004, and determined thatthere were no impairments.

 

On October 15,2003, the Company acquired various cellular communications properties(Note 5). The Company allocated the excess purchase price over the fairvalue of the net assets acquired, including identifiable intangible assets, togoodwill. As a result of this acquisition, $9,426,669 of goodwill was recorded.

 

72

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**Midwest Wireless Holdings L.L.C.**

**Notes to Consolidated Financial Statements**

**December 31, 2005, 2004 and 2003**

** **

Indefinite-lived intangible assetsconsist of the following at December 31:

 
| ** **                     | ** ** | **2005**   | ** **  | **2004**   | ** ** |
|--------------------------------|------------|------------|-------------|------------|------------|
|                           |       |       |        |       |       |
| FCC licenses                   |       | $          | 222,115,094 |       | $          | 222,260,912 |   |
| Less: Accumulated amortization |       | (9,913,398 | )           | (9,913,398 | )          |
|                           |       | $          | 212,201,696 |       | $          | 212,347,514 |   |

 

The changes in the carrying amount ofgoodwill and FCC licenses for the year ended December 31, 2005, are asfollows:

 
| ** **                                           | ** ** | **Goodwill** | ** ** | **FCC Licenses** | ** ** |
|------------------------------------------------------|------------|--------------|------------|------------------|------------|
|                                                 |       |         |       |             |       |
| Balances as of December 31, 2003                     |       | $            | 9,426,669  |             | $          | 212,093,566 |   |
| Assets acquired or finally allocated during the year |       | 18,321       |       | 395,363          |       |
| FCC License sold or disposed of during the year      |       | —       |       | (141,415         | )          |
| Balances as of December 31, 2004                     |       | 9,444,990    |       | 212,347,514      |       |
| FCC License sold or disposed of during the year      |       | —       |       | (145,818         | )          |
| Balances as of December 31, 2005                     |       | $            | 9,444,990  |             | $          | 212,201,696 |   |

 

Definite-lived intangible assetsconsist of the following at December 31:

 
| ** **                     | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|--------------------------------|------------|------------|------------|------------|------------|
|                           |       |       |       |       |       |
| Customer relationships         |       | $          | 9,904,931  |       | $          | 9,686,882 |   |
| Less: Accumulated amortization |       | (4,090,636 | )          | (1,980,136 | )          |
|                           |       | $          | 5,814,295  |       | $          | 7,706,746 |   |

 

Amortization expense related todefinite-lived intangible assets was $2,110,500, $1,712,858 and $267,278 in2005, 2004 and 2003, respectively.

 

Estimated amortization expense ofdefinite-lived intangible assets for the next five years is as follows:

 
| 2006   |   | $         | 1,705,962 |   |
|--------|--------|-----------|-----------|--------|
| 2007   |   | 1,450,000 |      |
| 2008   |   | 1,450,000 |      |
| 2009   |   | 1,208,333 |      |
| 2010   |   | —    |      |
|   |   | $         | 5,814,295 |   |

 

73

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**4.**                          SelectAccount Information

** **

**Property, Cellular Plant andEquipment**

 
| ** **                                      | ** ** | **2005**     | ** **  | **2004**     | ** ** |
|-------------------------------------------------|------------|--------------|-------------|--------------|------------|
|                                            |       |         |        |         |       |
| Land                                            |       | $            | 6,211,250   |         | $          | 6,343,474 |   |
| Plant in service                                |       | 250,251,001  |        | 224,173,596  |       |
| Plant under construction                        |       | 12,777,960   |        | 9,563,128    |       |
|                                            |       | 269,240,211  |        | 240,080,198  |       |
| Less: Accumulated depreciation and amortization |       | (141,823,589 | )           | (112,244,632 | )          |
|                                            |       | $            | 127,416,622 |         | $          | 127,835,566 |   |

 

The Company capitalized interest inthe amount of $655,371, $532,961 and $385,157 for the years endedDecember 31, 2005, 2004 and 2003, respectively. Property, cellular plantand equipment at December 31, 2005, includes plant in service under leasewith a cost basis of $4,564,532 and accumulated amortization of $1,976,006.Property, cellular plant and equipment at December 31, 2004, includesplant in service under lease with a cost basis of $4,564,532 and accumulatedamortization of $919,284.

 

**Other Accrued Expenses**

 
| ** **                              | ** ** | **2005**  | ** ** | **2004**  | ** ** |
|-----------------------------------------|------------|-----------|------------|-----------|------------|
|                                    |       |      |       |      |       |
| Accrued commissions, wages and benefits |       | $         | 8,969,001  |      | $          | 6,508,103 |   |
| Property and pass-through taxes payable |       | 1,918,662 |       | 1,742,375 |       |
| Interest payable                        |       | 40,619    |       | 1,581,410 |       |
| Other accrued expenses                  |       | 7,127,737 |       | 7,016,410 |       |
|                                    |       | $         | 18,056,019 |      | $          | 16,848,298 |   |

 

**5.**                          Acquisition

** **

On October 15, 2003, theCompany, through its wholly owned subsidiary, Midwest Wireless Iowa L.L.C.,completed an acquisition of cellular communications properties providingservices to a 17-county area of Iowa.

 

The acquisition was accounted for asa purchase. Accordingly, the Company allocated the excess purchase price overthe fair value of the net tangible assets acquired to FCC licenses, goodwilland customer relationships. The fair value of the acquired intangible assetswas based on an independent appraisal of the FCC licenses and customerrelationships. The Company is amortizing the value of customer relationshipsover six years. The consolidated financial statements include the operationsrelated to the acquisition beginning at the acquisition date.

 

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The following table presents thecomputation of the purchase price, the estimated fair value of tangible assets,FCC licenses, customer relationships acquired, and the amount allocated togoodwill. Amounts were allocated to tangible assets and liabilities based upontheir fair values as of the date of acquisition. The fair value of property,cellular plant and equipment was based upon an independent appraisal.

 
| Cash                                               |   | $          | 41,018,532 |   |
|----------------------------------------------------|--------|------------|------------|--------|
| Equity units issued                                |   | 1,941,468  |       |
| Acquisition costs                                  |   | 1,092,858  |       |
| Liabilities assumed and resulting from acquisition |   |       |       |
| Accounts payable  and accrued liabilities          |   | 19,250     |       |
| Customer  deposits                                 |   | 64,450     |       |
| Deferred revenue                                   |   | 425,393    |       |
| Allowance for  customer conversion                 |   | 1,337,230  |       |
| Total purchase  price                              |   | 45,899,181 |       |
| Estimated fair value of tangible assets acquired   |   |       |       |
| Accounts  receivable                               |   | 816,334    |       |
| Prepaid expenses  and unbilled revenue             |   | 103,315    |       |
| Investment in  cooperatives                        |   | 158,029    |       |
| Property,  cellular plant and equipment            |   | 9,694,834  |       |
| Total tangible  assets                             |   | 10,772,512 |       |
| Estimated fair value of intangible assets acquired |   |       |       |
| Customer  relationships                            |   | 8,700,000  |       |
| FCC licenses                                       |   | 17,000,000 |       |
| Total intangible  assets                           |   | 25,700,000 |       |
| Net assets  acquired                               |   | 36,472,512 |       |
| Goodwill                                           |   | $          | 9,426,669  |   |

 

**6.**                          Members’Capital

** **

Members’ capital includes capitalcontributions made by the members and the accumulated income resulting fromoperations less distributions to members. Company income or loss is allocatedto the individual members based upon their ownership percentage, as defined inthe Limited Liability Company Agreement (the “Agreement”). Pursuant to theAgreement, members are not obligated for the debts and obligations of theCompany, including accumulated losses in excess of capital contributions.

 

Under the Agreement certainrestrictions exist that dictate the specific terms of any transfer or sale ofunits. Upon receipt of a bona fide offer in writing from a third party, theother members and then the Company have the right to purchase all, but not lessthan all, of the units at the bona fide offer price within a specified timeframe.

 

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The Agreement also contains the rightof co-sale under which no member may transfer its units to an acquiring person,as defined in the Agreement, who after such transfer would be an acquiring personwithout assuring that each of the other members may participate in the transferof units under the same terms and conditions. The right of co-sale wouldterminate in the event the Company completes a sale of securities pursuant to asecurities act and if the Company’s market capitalization would exceed$200,000,000.

 

Each member is entitled to one votefor each unit owned. Certain restrictions on voting rights exist when units aresold to an acquiring person. Distributions to members of $24,898,581, $9,167,110and $9,491,691 were declared and paid during 2005, 2004 and 2003, respectively.

 

**7.**                          Long-TermDebt

 

Long-term debt consists of thefollowing:

 
| ** **                  | ** ** | ** **   | ** ** | **Rate at  December 31** | ** ** | **Balance at  December 31** | ** ** |
|-----------------------------|------------|--------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                  | ** ** | **Maturity** | ** ** | **2005**                 | ** ** | **2004**                    | ** ** | **2005** | ** ** | **2004** | ** ** |
|                        |       |         |       |                     |       |                        |       |   |   |   |   |
| RTFC note,  variable rate   |       | 5/12/09      |       | —                   |       | 6.15                        | %          | $ | — |   | $ | 7,127,106 |   |
| RTFC note,  variable rate   |       | 4/30/09      |       | —                   |       | 6.15                        | %          | — |   | 14,916,540 |   |
| RTFC note,  variable rate   |       | 7/29/08      |       | —                   |       | 6.15                        | %          | — |   | 4,083,636 |   |
| RTFC note,  variable rate   |       | 7/28/08      |       | —                   |       | 6.15                        | %          | — |   | 3,736,044 |   |
| RTFC note,  variable rate   |       | 3/2/10       |       | —                   |       | 6.15                        | %          | — |   | 62,165,934 |   |
| RTFC note,  variable rate   |       | 2/3/15       |       | —                   |       | 6.15                        | %          | — |   | 6,726,973 |   |
| CoBank note,  variable rate |       | 1/31/07      |       | 6.3125                   | %          | 5.375                       | %          | 114,000,000 |   | 55,000,000 |   |
| CoBank note,  variable rate |       | 6/30/09      |       | —                   |       | 5.50                        | %          | — |   | 4,000,000 |   |
| Farm Credit  Leasing        |       | 10/16/06     |       | 3.82                     | %          | 3.82                        | %          | 841,672 |   | 1,332,160 |   |
| Farm Credit  Leasing        |       | 12/1/08      |       | 4.00                     | %          | 4.00                        | %          | 706,117 |   | 861,671 |   |
| Farm Credit  Leasing        |       | 12/21/09     |       | 4.98                     | %          | 4.98                        | %          | 1,170,232 |   | 1,386,246 |   |
|                        |       |         |       |                     |       |                        |       | 116,718,021 |   | 161,336,310 |   |
| Less: Current  maturities   |       |         |       |                     |       |                        |       | (1,188,255 | ) | (22,590,500 | ) |
|                        |       |         |       |                     |       |                        |       | $ | 115,529,766 |   | $ | 138,745,810 |   |

 

The Company entered into variousagreements (the “Agreements”) with the Rural Telephone Finance Cooperative(“RTFC”). In 2000, the Company entered into an agreement to fund theacquisitions of certain Iowa and Wisconsin cellular markets and theconstruction of a new headquarters building. The principal and interest on thenotes were payable in quarterly installments. The variable interest rate wasbased on RTFC’s cost of capital and was adjusted monthly. Substantially allassets of the Company were pledged as collateral under the Agreements. Asdescribed below, in July 2005, the Company repaid all notes outstandingunder the Agreements with RTFC.

 

On October 22, 2001, the Companyentered into an agreement with CoBank, ACB (“CoBank”) to fund the acquisitionof various PCS licenses, capital expenditures and operating funds. The originalagreement provided for borrowings of up to $40,000,000. On November 22,2002, the Company amended the agreement to provide for borrowings of up to$65,000,000, changed the interest rate, and extended the expiration date toOctober 20, 2003. On October 15, 2003, the Company amended

 

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the agreement to provide forborrowings up to $80,000,000 including a single draw term loan of $55,000,000and a $20,000,000 revolving loan (“Revolver B”) each with interest atLIBOR

 

plus a variable margin of 3.0% to3.5% or prime plus a variable margin of 2.0% to 2.5%, and a $5,000,000 cashmanagement revolving loan (“Revolver A”) with interest at prime plus0.75%. The total facility matures on June 30, 2009. The term facility hasscheduled principal payments that begin in the first quarter of 2005.Revolver B has mandatory commitment reductions beginning in the firstquarter of 2007. On July 27, 2005, the Company amended the agreement toprovide for borrowings of up to $160,000,000, and to amend the interest rateand accelerated the maturity to January 31, 2007 (the “Amended Facility”).The Amended Facility provides for a revolving loan of up to $155,000,000 withinterest at LIBOR plus 1.75% and a $5,000,000 cash management revolving loanwith interest at the higher of the Prime Rate or the Federal Funds Rate plus0.75%. The proceeds from the Amended Facility were used in July 2005 torepay all existing RTFC notes and the outstanding balances on the CoBank notesfrom October 2003.

 

Consistent with the guidance ofEmerging Issues Task Force Issue No. 96-19, *Debtor’sAccounting for a Modification or Exchange of Debt Instruments*, therepayment of the RTFC notes and the outstanding balances on the CoBank notesfrom October 2003 has been accounted for as an extinguishment of debt.During 2005, the Company recognized a loss from extinguishment of debt of$759,843. The loss from extinguishment, which is included in interest expense,resulted from the write off of the remaining debt issuance costs on the debtthat was extinguished and other early retirement expenses.

 

The CoBank loan is subject to variouscovenants including a limit on the ratio of indebtedness to annualizedoperating cash flow and a minimum ratio of operating cash flow to interestpaid. Substantially all the assets of the Company are pledged as collateralunder the agreement with CoBank.

 

On October 10, 2003, the Companyentered into a lease agreement with Farm Credit Leasing. The Company enteredinto a lease under the agreement on October 15, 2003, for the lease of aswitch and related equipment located in Des Moines, Iowa. The cost of theequipment leased was $2,000,000. The lease provides for monthly payments of$48,385 for 36 months. On December 24, 2003, the Company entered into asecond lease under the agreement for the lease of network equipment. The costof the equipment was $1,040,177. The lease provides for monthly payments of$15,963 for 60 months. On December 21, 2004, the Company entered into athird lease under the agreement for the lease of network equipment. The cost ofthe equipment was $1,386,246. The lease provides for monthly payments of$21,960 for 60 months. All three of these leases have been recorded as capitalleases and therefore the assets subject to the leases have been capitalized andthe present value of the lease obligations have been recorded as long-termdebt.

 

Maturities of debt are as follows:

 
| 2006       |   | $           | 1,188,255   |   |
|------------|--------|-------------|-------------|--------|
| 2007       |   | 114,394,831 |        |
| 2008       |   | 607,541     |        |
| 2009       |   | 527,394     |        |
| 2010       |   | —      |        |
| Thereafter |   | —      |        |
|       |   | $           | 116,718,021 |   |

 

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**8.**                          OperatingLease Commitments

** **

Future minimum rental paymentsrequired under operating leases, principally for real estate related to towersites, and other contractual commitments that have initial or remainingnoncancellable terms in excess of one year at December 31, 2005, are asfollows:

 
| 2006       |   | $         | 1,579,974 |   |
|------------|--------|-----------|-----------|--------|
| 2007       |   | 1,247,805 |      |
| 2008       |   | 842,504   |      |
| 2009       |   | 542,328   |      |
| 2010       |   | 358,786   |      |
| Thereafter |   | 1,280,489 |      |
|       |   | $         | 5,851,886 |   |

 

Rental expense under operating leaseswas $3,738,073, $3,452,526 and $2,079,076 for the years ended December 31,2005, 2004 and 2003, respectively.

 

**9.**                          TransactionsBetween Related Parties

** **

The Company has various transactionswith members and entities related to the Company’s members. Revenuetransactions relate primarily to the sale of the Company’s services andequipment. Operating expense transactions relate primarily to commissionsearned for signing up new Company customers and for charges for use of themembers’ networks. Related party transactions for the years endedDecember 31, 2005, 2004 and 2003, were as follows:

 
| ** **         | ** ** | **2005**  | ** ** | **2004**  | ** ** | **2003**  | ** ** |
|--------------------|------------|-----------|------------|-----------|------------|-----------|------------|
|               |       |      |       |      |       |      |       |
| Operating revenues |       | $         | 506,432    |      | $          | 1,633,992 |       | $ | 1,812,829 |   |
| Operating expenses |       | 5,391,035 |       | 6,167,157 |       | 4,228,098 |       |
|                    |            |           |            |           |            |           |            |  |  |  |

 

**10.**                   EmployeeBenefits

** **

The Company established the MidwestWireless Holdings L.L.C. and Subsidiary Companies 401(k) Profit Sharing Planand Trust (formerly the Midwest Wireless Communications L.L.C. Profit SharingPlan and Trust) (the “401(k) Plan”) for all employees who meet certain serviceand age requirements. The 401(k) Plan is comprised of an employer matchingcontribution component and a profit sharing component. Employer matchingcontributions to this component of the plan were $700,947, $614,909 and$493,124 for the years ended December 31, 2005, 2004 and 2003,respectively. Employer matching contributions vest over one year. Profitsharing contribution expenses were $1,133,430, $788,605 and $597,716 for theyears ended December 31, 2005, 2004 and 2003, respectively. Profit sharingcontributions are 100% vested after five years of employment.

 

Effective January 1, 1997, theCompany established the Midwest Wireless Holdings L.L.C. Appreciation RightsPlan, as amended (formerly the Midwest Wireless Communications L.L.C.Appreciation Rights Plan) (the “Plan”) for certain key employees. The Plan isdesigned to create two classes of appreciation rights, Class A andClass B, which become fully vested three years and five years,respectively, after the first day of the year the rights are granted. Participantsin the Plan are eligible to receive awards based on defined increases inmembers’ equity from the date of grant

 

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through the end of the vestingperiod. The Board of Managers granted both Class A and Class Bappreciation rights in 1997. Under the terms of the Plan, initially noadditional Class B appreciation rights could be granted, but additionalClass A appreciation rights could be granted at the discretion of theBoard of Managers. However, effective January 1, 2002, the Plan wasamended to enable additional Class B appreciation rights to be granted in2002. The Company recognized $2,423,707, $1,618,494 and $1,359,360 incompensation expense related to the Plan for the years ended December 31,2005, 2004 and 2003, respectively. Accrued compensation related to the Plan was$4,554,017 and $3,183,430 at December 31, 2005 and 2004, respectively.

 

Upon a change in control of theCompany, which includes the sale agreement discussed in Note 12, outstandingappreciation rights will be paid out at their fair value.

 

**11.**                   Option Plan

** **

During 2000, the Company’s Board ofManagers and members adopted and approved the Midwest Wireless Holdings L.L.C.Unit Option Plan (the “Option Plan”), as amended. Under the Option Plan,options to purchase up to 46,742 of the Company’s membership units may begranted to employees with terms and vesting periods determined by the Company’sBoard of Managers at the date of grant. The exercise price is equal to the fairvalue of the units at the time the option is granted as determined by the Boardof Managers. Options granted under the plan expire ten years from the date ofgrant. The options granted vest 100% three years after they are granted.

 
| ** **                    | ** ** | **Options  Outstanding**  | ** ** |
|-------------------------------|------------|---------------------------|------------|
| ** **                    | ** ** | **Available  for  Grant** | ** ** | **Number  of Units** | ** ** | **Weighted  Average  Price Per  Unit** | ** ** |
| ** **                    | ** ** | ** **                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Balances at December 31, 2002 |       | 33,131                    |       | 13,611 |   | $ | 321.60 |   |
| Granted                       |       | (2,788                    | )          | 2,788 |   | $ | 263.84 |   |
| Balances at December 31, 2003 |       | 30,343                    |       | 16,399 |   | $ | 311.78 |   |
| Granted                       |       | (3,345                    | )          | 3,345 |   | $ | 260.87 |   |
| Cancelled                     |       | 200                       |       | (200 | ) | $ | 331.16 |   |
| Balances at December 31, 2004 |       | 27,198                    |       | 19,544 |   | $ | 302.87 |   |
| Granted                       |       | (3,314                    | )          | 3,314 |   | $ | 260.87 |   |
| Balances at December 31, 2005 |       | 23,884                    |       | 22,858 |   | $ | 296.78 |   |

 

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**MidwestWireless Holdings L.L.C.**

**Notes toConsolidated Financial Statements**

**December 31,2005, 2004 and 2003**

** **

Thefollowing table summarizes information about unit options outstanding andexercisable at December 31, 2005:

 
| ** **          | ** ** | **Options Outstanding** | ** ** | **Options Exercisable**                             | ** ** |
|---------------------|------------|-------------------------|------------|-----------------------------------------------------|------------|
| **Exercise Prices** | ** ** | **Number**              | ** ** | **Weighted  Average  Remaining  Contractual  Life** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| ** **          | ** ** | ** **              | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| $                   | 260.87     |                    | 6,659      |                                                | 8.66       |   | $ | 260.87 |   | — |   | — |   |
| $                   | 263.84     |                    | 2,788      |                                                | 7.01       |   | $ | 263.84 |   | 2,788 |   | $ | 263.84 |   |
| $                   | 299.06     |                    | 4,092      |                                                | 4.59       |   | $ | 299.06 |   | 4,092 |   | $ | 299.06 |   |
| $                   | 318.32     |                    | 4,610      |                                                | 5.06       |   | $ | 318.32 |   | 4,610 |   | $ | 318.32 |   |
| $                   | 344.00     |                    | 4,709      |                                                | 6.01       |   | $ | 344.00 |   | 4,709 |   | $ | 344.00 |   |
|                |       | 22,858                  |       |                                                |       |   |   | 16,199 |   |   |   |

 

**12.**                   SaleAgreement

** **

On November 17,2005, the Company entered into a definitive agreement with ALLTEL Corporation (“ALLTEL”).Under the agreement, ALLTEL will acquire all of the outstanding membershipinterests of the Company, the minority membership interests in its subsidiaryand options outstanding under the Company’s Option Plan for $1.075 billion incash, reduced by the amount of indebtedness and subject to other adjustments. Thetransaction is contingent upon regulatory approval by the FederalCommunications Commission and under the Hart-Scott-Rodino AntitrustImprovements Act. The transaction was approved by the members of the Company ata meeting held on January 18, 2006. In connection with the transaction,certain affiliates of Telephone and Data Services, Inc. which are minoritymembers of Midwest Wireless Communications L.L.C. commenced an action againstthe Company, and certain of the Company’s officers and directors. The plaintiffalleges, among other things, that they are entitled to vested rights of firstrefusal as a result of the agreement with ALLTEL and that Midwest and the namedofficers and directors breached certain agreements and duties. On March 10,2006, the court heard the plaintiffs’ motion for a preliminary injunction toenjoin consummation of the transaction. The judge has not ruled on theplaintiff’s motion and scheduled a trial for May 2006. Management believesthey have meritorious arguments, but is unable to assess the likely outcome. However,management intends to vigorously defend its position that the plaintiff is notentitled to vested rights of first refusal.

 

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**HECTORCOMMUNICATIONS CORPORATION**

**EXHIBITS**

 

Exhibit Index To

Form 10-K for the Year Ended December 31, 2005

 
| **Regulation S-K  Exhibit Table  Reference** | ** ** | **Title of Document** | ** **                                                                                                                           | **Location in Consecutive  Numbering  System as Filed With the Securities  and Exchange Commission** |
|---------------------------------------------------|------------|-----------------------|--------------------------------------------------------------------------------------------------------------------------------------|------------------------------------------------------------------------------------------------------|
|                                              |       |                  |                                                                                                                                 |                                                                                                 |
| 3.1                                               |       |                  | Articles of  Incorporation, as amended                                                                                               |                                                                                                 | Filed as Exhibit 3.1  to the Form 10 of the Company, File No. 0-18587 (the “Form 10”)  and incorporated hereby by reference. |
| 3.2                                               |       |                  | Bylaws, as  amended                                                                                                                  |                                                                                                 | Filed as Exhibit 3.2  to the Form 10 of the Company and incorporated hereby by reference. |
| 10.1                                              |       |                  | 1990 Stock Plan                                                                                                                      |                                                                                                 | Filed as Exhibit 10.1  to the Form 10 of the Company and incorporated herein by reference. |
| 10.2                                              |       |                  | 2003 Employee  Stock Purchase Plan                                                                                                   |                                                                                                 | Filed as Exhibit 4.2  to the Company’s Form S-8 dated February 24, 2004 and incorporated  herein by reference. |
| 10.3                                              |       |                  | Employee Stock  Ownership Plan                                                                                                       |                                                                                                 | Filed as Exhibit 10.3  to the Form 10 of the Company and incorporated herein by reference. |
| 10.4                                              |       |                  | Employee Savings  Plan and Trust                                                                                                     |                                                                                                 | Filed as Exhibit 10.4  to the Form 10 of the Company and incorporated herein by reference. |
| 10.5                                              |       |                  | Distribution  Agreement                                                                                                              |                                                                                                 | Filed as Exhibit 10.5  to the Form 10 of the Company and incorporated herein by reference. |
| 10.7                                              |       |                  | Flexible Benefit  Plan                                                                                                               |                                                                                                 | Filed as Exhibit 10.7  to the 1993 Form 10-K and incorporated herein by reference. |
| 10.8                                              |       |                  | Form of  Rights Agreement, dated as of July 27, 1999 between the Company and  Norwest Bank Minnesota, National Association |                                                                                                 | Filed as Exhibit 1  to the Company’s Form 8-A on August 9, 1999 and incorporated herein  by reference. |
| 10.9                                              |       |                  | 1999 Stock Plan                                                                                                                      |                                                                                                 | Filed by the  Company on Form S-8 on December 3, 1999 and incorporated herein by  reference. |
| 11                                                |       |                  | Calculation of Net  Income Per Share                                                                                                 |                                                                                                 | Filed herewith. |
| 21                                                |       |                  | Subsidiaries of  the Registrant                                                                                                      |                                                                                                 | Filed herewith. |
| 23.1                                              |       |                  | Consent of  Independent Registered Public Accounting Firm                                                                            |                                                                                                 | Filed herewith. |
| 23.2                                              |       |                  | Consent of  Independent Accountants                                                                                                  |                                                                                                 | Filed herewith. |
| 24                                                |       |                  | Power of  Attorney                                                                                                                   |                                                                                                 | Filed herewith. |
| 31.a                                              |       |                  | Certification of  the Chief Executive Officer pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002                        |                                                                                                 | Filed herewith. |
| 31.b                                              |       |                  | Certification of  the Chief Financial Officer pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002                        |                                                                                                 | Filed herewith. |
| 32                                                |       |                  | Certification  under 18 U.S.C. § 1350                                                                                      |                                                                                                 | Filed  herewith. |

 

The exhibits referred toin this Exhibit Index will be supplied to a shareholder at a charge of$.25 per page upon written request directed to Hector’s AssistantSecretary at the executive offices of the Company.

 

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