##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
 FORM 10-Q þ     QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended March 31, 2005 or o     TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934
 Commission File Number 0-556 SUREWEST COMMUNICATIONS  California
    
    68-0365195(State or Other Jurisdiction
    
    (IRS Employerof Incorporation or Organization)
    
    Identification No.)200 Vernon Street, Roseville, California
    
    95678(Address of Principal Executive Offices)
    
    (Zip Code)
 Registrants telephone number, including area code (916) 786-6141 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for
such shorter period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. Yes þ No o Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of
the Exchange Act). Yes þ No o Indicate the number of shares outstanding of each of the issuers classes of common stock, as of
the latest practicable date. As of April 29, 2005, 14,590,051 shares of the registrants Common Stock were outstanding.




---



TABLE OF CONTENTS PagePART I  FINANCIAL INFORMATIONItem 1.
    
    Financial Statements
    
    
    3Item 2.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    14Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    34Item 4.
    
    Controls And Procedures
    
    
    35PART II  OTHER INFORMATIONItem 1.
    
    Legal Proceedings
    
    
    38Item 2.
    
    Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    39Item 3.
    
    Defaults Upon Senior Securities
    
    
    39Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    39Item 5.
    
    Other Information
    
    
    39Item 6.
    
    Exhibits
    
    
    40SIGNATURES
    
    
    43EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
  2




---



##### Table of Contents



SUREWEST COMMUNICATIONS
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(Unaudited; Amounts in thousands, except per share amounts) Quarter Ended March 31,2005
    
    
    2004Operating revenues:Local service
    
    $
    16,037
    
    
    $
    17,134Network access service
    
    
    10,633
    
    
    
    11,610Directory advertising
    
    
    4,295
    
    
    
    4,101Long distance service
    
    
    1,497
    
    
    
    1,217Wireless service
    
    
    8,388
    
    
    
    7,420Internet service
    
    
    4,313
    
    
    
    4,152Residential broadband service
    
    
    5,597
    
    
    
    3,553Business broadband service
    
    
    1,687
    
    
    
    1,270Other
    
    
    1,009
    
    
    
    1,131Total operating revenues
    
    
    53,456
    
    
    
    51,588Operating expenses:Cost of services and products (exclusive of depreciation and amortization)
    
    
    19,933
    
    
    
    18,611Customer operations and selling
    
    
    8,675
    
    
    
    8,638General and administrative
    
    
    9,566
    
    
    
    11,287Depreciation and amortization
    
    
    12,713
    
    
    
    11,294Total operating expenses
    
    
    50,887
    
    
    
    49,830Income from operations
    
    
    2,569
    
    
    
    1,758Other income (expense):Interest income
    
    
    46
    
    
    
    59Interest expense
    
    
    (1,203
    )
    
    
    (1,085
    )Other, net
    
    
    (31
    )
    
    
    (71
    )Total other expense, net
    
    
    (1,188
    )
    
    
    (1,097
    )Income before income taxes
    
    
    1,381
    
    
    
    661Income taxes
    
    
    538
    
    
    
    280Net income
    
    $
    843
    
    
    $
    381Basic and diluted earnings per share
    
    $
    0.06
    
    
    $
    0.03Dividends per share
    
    $
    0.25
    
    
    $
    0.25Shares of common stock used to calculate earnings per share:Basic
    
    
    14,542
    
    
    
    14,526Diluted
    
    
    14,595
    
    
    
    14,577
 See accompanying notes. 3




---



##### Table of Contents



SUREWEST COMMUNICATIONS
CONDENSED CONSOLIDATED BALANCE SHEETS
(Amounts in thousands) March 31,
    
    
    December 31,2005 (Unaudited)
    
    
    2004ASSETSCurrent assets:Cash and cash equivalents
    
    $
    9,489
    
    
    $
    18,119Accounts receivable, net
    
    
    22,651
    
    
    
    20,155Inventories
    
    
    5,291
    
    
    
    5,578Deferred directory costs
    
    
    4,882
    
    
    
    5,599Prepaid expenses
    
    
    3,486
    
    
    
    2,359Total current assets
    
    
    45,799
    
    
    
    51,810Property, plant and equipment, net
    
    
    372,169
    
    
    
    365,613Intangible and other assets:Wireless spectrum licenses, net
    
    
    13,566
    
    
    
    13,566Goodwill
    
    
    2,171
    
    
    
    2,171Intangible asset relating to pension plans
    
    
    802
    
    
    
    802Intangible asset relating to favorable operating leases, net
    
    
    471
    
    
    
    506Deferred charges and other assets
    
    
    718
    
    
    
    71417,728
    
    
    
    17,759$
    435,696
    
    
    $
    435,182LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Short-term borrowings
    
    $
    10,000
    
    
    $
    10,000Current portion of long-term debt
    
    
    3,744
    
    
    
    3,779Current portion of capital lease obligations
    
    
    129
    
    
    
    212Accounts payable
    
    
    3,875
    
    
    
    2,886Other accrued liabilities
    
    
    22,715
    
    
    
    22,038Current portion of contractual shareable earnings
obligations (less unamortized discount of $76 and $52 as of
March 31, 2005 and December 31, 2004, respectively)
    
    
    3,016
    
    
    
    3,040Estimated shareable earnings obligations
    
    
    418
    
    
    
    396Advance billings and deferred revenues
    
    
    10,821
    
    
    
    9,883Accrued income taxes
    
    
    2,056
    
    
    
    1,549Accrued pension benefits
    
    
    4,584
    
    
    
    3,216Accrued compensation
    
    
    4,826
    
    
    
    5,830Total current liabilities
    
    
    66,184
    
    
    
    62,829Long-term debt
    
    
    89,091
    
    
    
    89,091Long-term capital lease obligations
    
    
    38
    
    
    
    52Long-term contractual shareable earnings obligations (less
unamortized discount of $444 and $472 as of March 31, 2005 and
December 31, 2004, respectively)
    
    
    5,542
    
    
    
    6,202Deferred income taxes
    
    
    24,165
    
    
    
    24,134Other liabilities and deferred revenues
    
    
    11,854
    
    
    
    11,537Commitments and contingenciesShareholders equity:Common stock, without par value; 100,000 shares authorized,
14,590 and 14,591 shares issued and outstanding at
March 31, 2005 and December 31, 2004, respectively
    
    
    162,826
    
    
    
    161,824Deferred stock-based compensation
    
    
    (1,663
    )
    
    
    (949
    )Accumulated other comprehensive loss
    
    
    (2,126
    )
    
    
    (2,126
    )Retained earnings
    
    
    79,785
    
    
    
    82,588Total shareholders equity
    
    
    238,822
    
    
    
    241,337$
    435,696
    
    
    $
    435,182
 See accompanying notes. 4




---



##### Table of Contents



SUREWEST COMMUNICATIONS
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
DECREASE IN CASH AND CASH EQUIVALENTS
(Unaudited; Amounts in thousands) Three Months EndedMarch 31,2005
    
    
    2004Net cash provided by operating activities
    
    $
    14,243
    
    
    $
    15,636Cash flows from investing activities:Capital expenditures for property, plant and equipment, including
network parts inventory
    
    
    (19,090
    )
    
    
    (15,978
    )Changes in deferred charges and other assets
    
    
    
    
    
    
    (31
    )Net cash used in investing activities
    
    
    (19,090
    )
    
    
    (16,009
    )Cash flows from financing activities:Principal payments of long-term debt and capital lease obligations
    
    
    (135
    )
    
    
    (122
    )Dividends paid
    
    
    (3,648
    )
    
    
    (3,644
    )Net cash used in financing activities
    
    
    (3,783
    )
    
    
    (3,766
    )Decrease in cash and cash equivalents
    
    
    (8,630
    )
    
    
    (4,139
    )Cash and cash equivalents at beginning of period
    
    
    18,119
    
    
    
    39,008Cash and cash equivalents at end of period
    
    $
    9,489
    
    
    $
    34,869
 See accompanying notes. 5




---



##### Table of Contents



SUREWEST COMMUNICATIONS
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(Amounts in thousands, except share and per share amounts) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The condensed consolidated financial statements of SureWest Communications (the Company) have
been prepared in accordance with accounting principles generally accepted in the United States for
interim financial information and pursuant to the rules and regulations of the Securities and
Exchange Commission (the SEC). In the opinion of management, all adjustments (consisting only of
normal recurring adjustments) considered necessary for a fair presentation of the results for the
interim periods shown have been included. Certain information and footnote disclosures normally
included in annual financial statements prepared in accordance with U.S. generally accepted
accounting principles have been condensed or omitted pursuant to such SEC rules and regulations and
accounting principles applicable for interim periods. Management believes that the disclosures made
are adequate to make the information presented not misleading. These condensed consolidated
financial statements should be read in conjunction with the consolidated financial statements and
notes thereto included in the Companys 2004 Annual Report on Form 10-K filed with the SEC. The Company is a holding company with wholly-owned subsidiaries that provide integrated
communications services in Northern California. The Companys principal operating subsidiary is
SureWest Telephone. SureWest Directories, SureWest Long Distance, SureWest Wireless, SureWest
Broadband, SureWest Televideo and SureWest Televideo of Roseville (SureWest Broadband/Residential
Services), SureWest Internet and SureWest Custom Data Services are each subsidiaries of the
Company. The Company expects that the sources of its revenues and its cost structure may be
different in future periods, both as a result of its entry into new communications markets and
competitive forces in each of the markets in which the Company has operations. Stock-based Compensation The Company has two stock-based compensation plans. Effective January 1, 2003, the Company adopted
the fair value recognition provisions of Statement of Financial Accounting Standards (SFAS) No.
123, Accounting for Stock-Based Compensation. Under the prospective method of adoption selected by
the Company under the provisions of SFAS No. 148, Accounting for Stock-Based Compensation 
Transition and Disclosure, the fair value method of accounting was applied to all employee awards
granted, modified, or settled after January 1, 2003. Stock-based compensation associated with
employee stock options is recognized over the vesting periods (which range from 1 to 5 years) using
the graded vesting method. The fair value of the Companys employee stock options was estimated at the date of grant using the
Black-Scholes-Merton option-pricing model. The Company did not issue any stock options during the
quarters ended March 31, 2005 or 2004. The Black-Scholes-Merton option pricing model includes assumptions regarding dividend yields,
expected volatility, expected lives and risk-free interest rates. These assumptions reflect
managements best estimates, but these items involve inherent uncertainties based on market
conditions generally outside of the control of the Company. As a result, if other assumptions had
been used in the current period, actual and pro forma stock-based compensation expense could have
been materially different. If management uses different assumptions in future periods, stock-based
compensation expense could be materially impacted in future periods. 6




---



##### Table of Contents



SUREWEST COMMUNICATIONS
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (CONTINUED) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) The expense related to stock-based employee compensation included in the determination of net
income is less than that which would have been recognized if the fair value method had been applied
to all awards granted after the original effective date of SFAS No. 123. If the Company had elected
to adopt the fair value recognition provisions of SFAS No. 123 as of its original effective date,
pro forma net income and earnings per share would be as follows: Quarter Ended March 31,2005
    
    
    2004Net income, as reported
    
    $
    843
    
    
    $
    381Add: Stock-based employee compensation
expense included in reported net income,
net of related tax effects
    
    
    179
    
    
    
    161Deduct: Stock-based employee compensation
expense determined using the fair value
method for all awards, net of related tax
effects
    
    
    (201
    )
    
    
    (465
    )Pro forma net income
    
    $
    821
    
    
    $
    77Earnings per share:Basicas reported
    
    $
    0.06
    
    
    $
    0.03Basicpro forma
    
    $
    0.06
    
    
    $
    0.01Dilutedas reported
    
    $
    0.06
    
    
    $
    0.03Dilutedpro forma
    
    $
    0.06
    
    
    $
    0.01
 During the quarter ended March 31, 2005, the Company issued 45,024 restricted common stock units
(RSUs), which had a fair market value ranging from $22.43 to $28.35 per unit at the dates of
grant, to certain eligible participants. Deferred stock-based compensation of $1,015 was recorded
as a result of the issuance of these RSUs, which was determined based on the fair value of such
common units at the date of grant and is being amortized over a four-year vesting period. During
the quarter ended March 31, 2004, no RSUs were issued by the Company. During the quarter ended March 31, 2004, the Company issued 3,050 shares of the Companys
restricted common stock, which had a fair market value of $32.01 per share at the date of grant, to
certain employees. Deferred stock-based compensation of $98 was recorded as a result of the
issuance of these shares of restricted common stock, which was determined based on the fair value
of such common shares at the date of grant and is being amortized over a four-year vesting period.
During the quarter ended March 31, 2005, no shares of restricted common stock were issued by the
Company. Per Share Amounts Shares used in the computation of basic earnings per share are based on the weighted average number
of common shares and RSUs outstanding, excluding unvested restricted common shares and unvested
RSUs. Shares and RSUs used in the computation of diluted earnings per share are based on the
weighted average number of common shares and RSUs outstanding, along with other potentially
dilutive securities outstanding in each period. Cash dividends per share are based on the actual dividends per share, as declared by the Companys
Board of Directors. On each date that the Company pays a cash dividend to the holders of the
Companys common stock, the Company credits to the holders of RSUs an additional number of RSUs
equal to the total number of whole RSUs and additional RSUs previously credited to the holders
multiplied by the dollar amount of the cash dividend per share of common stock. Any fractional
RSUs resulting from such calculation are included in the additional RSUs. 7




---



##### Table of Contents



SUREWEST COMMUNICATIONS
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (CONTINUED) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Other Comprehensive Income (Loss) The Companys consolidated net income equaled its consolidated comprehensive income for the
quarters ended March 31, 2005 and 2004. As of March 31, 2005 and 2004, the accumulated other comprehensive loss was $2,126 and $261,
respectively, which consisted of minimum pension and post-retirement benefit liability adjustments,
net of income taxes. Adjustments and Reclassifications During the Companys financial statement closing process for the quarter ended September 30, 2004,
certain matters were identified related to prior financial reporting periods that necessitated the
recording of adjustments to the Companys condensed consolidated financial statements. Such
adjustments increased depreciation expense by $822 and decreased cost of sales by $39 in the
quarter ended September 30, 2004. Management believes that weaknesses in the Companys internal
controls caused the errors that resulted in these adjustments. The Company does not believe the
aforementioned amounts are material, individually or in the aggregate, to the respective prior
quarterly periods based on both quantitative and qualitative factors, including the trend of
operating results, nor does it believe the prospective correction of such amounts during the
quarter ended September 30, 2004 was material to the Companys consolidated results of operations
based on both quantitative and qualitative factors, including the trend of operating results. The
prospective correction of the aforementioned amounts relating to prior periods increased the
Companys consolidated net loss by $468, or $0.03 per basic and diluted share, for the quarter
ended September 30, 2004. Such amounts would have reduced the Companys quarterly consolidated net
income by $239, or $0.02 per basic and diluted share, and $272, or $0.02 per basic and diluted
share, for the quarters ended March 31, 2004 and June 30, 2004, respectively, had such errors been
corrected in the periods in which they originated. Certain amounts in the Companys 2004 condensed consolidated financial statements have been
reclassified to conform to the presentation of the Companys 2005 condensed consolidated financial
statements. 2. BUSINESS SEGMENTS The Company has three reportable business segments: Telecommunications (Telecom), Broadband and
Wireless. The Telecom segment includes SureWest Telephone, SureWest Directories and SureWest Long
Distance, which provide landline telecommunications services, directory advertising, Digital
Subscriber Line (DSL) service, long distance services and certain non-regulated services.
SureWest Telephone, which is the principal operating subsidiary of the Telecom segment, provides
local and toll telephone services, network access services and certain non-regulated services.
SureWest Directories publishes and distributes SureWest Telephones directory, including the sale
of yellow pages advertising. SureWest Directories is also engaged in the business of producing,
publishing and distributing directories in other Northern California communities outside of
SureWest Telephones service area. SureWest Long Distance is a reseller of long distance services. The Broadband segment provides various services, including high-speed and dial-up Internet, digital
video, local, network access and toll telephone and managed services in the greater Sacramento
area, principally to customers residing outside of SureWest Telephones service area. The Company
offers high-speed Internet, digital video and local and long distance phone service as a bundled
package referred to as fiber-to-the-premise (FTTP) (previously referred to as Triple Play). The
Broadband segment includes the Companys subsidiary SureWest Broadband and SureWest Broadband
Business Services which is comprised, in part, of a division of SureWest Telephone operating as a
Competitive Local Exchange Carrier. The Wireless segment consists of the Companys subsidiary SureWest Wireless, which provides
wireless services. SureWest Wireless derives its revenue from the provision of wireless services
and the sale of handsets and related communications equipment. Revenues include wireless voice
services, sales of handsets and related accessories, long distance, roaming service and custom
calling features. Wireless services are provided on a month-to-month basis and are generally billed
in advance for non-contract subscribers and in arrears for contract subscribers. 8




---



##### Table of Contents



SUREWEST COMMUNICATIONS
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (CONTINUED) 2. BUSINESS SEGMENTS (CONTINUED) In accordance with the provisions of SFAS No. 131, Disclosure About Segments of an Enterprise and
Related Information, the Company has aggregated certain of its operating segments within the
Telecom and Broadband segments because it believes that such operating segments share similar
economic characteristics. Corporate Operations are allocated to the appropriate segment, except for: cash; investments;
certain property, plant, and equipment; and miscellaneous other assets, which are not allocated to
the segments. However, the investment income associated with cash and investments held by Corporate
Operations is included in the results of the operations of the Companys segments. The Company
evaluates the performance of its segments based on income (loss) from operations. These segments are strategic business units that offer different products and services. The Company
accounts for intersegment revenues and expenses at prevailing market rates. The Companys business
segment information is as follows: Corporate
    
    
    IntercompanyTelecom
    
    
    Broadband
    
    
    Wireless
    
    
    Operations
    
    
    Eliminations
    
    
    ConsolidatedAs of and for the three
months ended March 31, 2005:Operating revenues from
external customers
    
    $
    33,471
    
    
    $
    11,597
    
    
    $
    8,388
    
    
    $
    
    
    
    $
    
    
    
    $
    53,456Intersegment revenues
    
    
    6,876
    
    
    
    443
    
    
    
    598
    
    
    
    
    
    
    
    (7,917
    )
    
    
    Operating expenses*
    
    
    22,269
    
    
    
    14,732
    
    
    
    9,090
    
    
    
    
    
    
    
    (7,917
    )
    
    
    38,174Depreciation and amortization
    
    
    5,995
    
    
    
    3,634
    
    
    
    3,084
    
    
    
    
    
    
    
    
    
    
    
    12,713Income (loss) from operations
    
    
    12,083
    
    
    
    (6,326
    )
    
    
    (3,188
    )
    
    
    
    
    
    
    
    
    
    
    2,569Net income (loss)
    
    
    7,073
    
    
    
    (4,101
    )
    
    
    (2,129
    )
    
    
    
    
    
    
    
    
    
    
    843Total assets
    
    $
    630,230
    
    
    $
    215,973
    
    
    $
    135,453
    
    
    $
    204,989
    
    
    $
    (750,949
    )
    
    $
    435,696As of and for the three
months ended March 31, 2004:Operating revenues from
external customers
    
    $
    35,193
    
    
    $
    8,975
    
    
    $
    7,420
    
    
    $
    
    
    
    $
    
    
    
    $
    51,588Intersegment revenues
    
    
    6,216
    
    
    
    452
    
    
    
    311
    
    
    
    
    
    
    
    (6,979
    )
    
    
    Operating expenses*
    
    
    22,817
    
    
    
    13,934
    
    
    
    8,764
    
    
    
    
    
    
    
    (6,979
    )
    
    
    38,536Depreciation and amortization
    
    
    6,179
    
    
    
    2,018
    
    
    
    3,097
    
    
    
    
    
    
    
    
    
    
    
    11,294Income (loss) from operations
    
    
    12,413
    
    
    
    (6,525
    )
    
    
    (4,130
    )
    
    
    
    
    
    
    
    
    
    
    1,758Net income (loss)
    
    
    7,271
    
    
    
    (4,191
    )
    
    
    (2,699
    )
    
    
    
    
    
    
    
    
    
    
    381Total assets
    
    $
    580,764
    
    
    $
    122,048
    
    
    $
    82,829
    
    
    $
    85,060
    
    
    $
    (435,508
    )
    
    $
    435,193
  *
 3. ESTIMATED SHAREABLE EARNINGS OBLIGATIONS Certain of the Companys rates are subject to regulation by the Federal Communications Commission
(FCC) and the California Public Utilities Commission (CPUC). Pending and future regulatory
actions may have a material impact on the Companys consolidated financial position and results of
operations. Revenues from certain telephone services are affected by rates authorized by various regulatory
agencies. Intrastate service rates are subject to regulation by the CPUC. With respect to toll
calls initiated by interexchange carriers customers, the interexchange carriers are assessed
access charges based on tariffs filed by SureWest Telephone. Interstate access rates and resultant
earnings are subject to regulation by the FCC. With respect to interstate services, SureWest
Telephone has filed its own tariff with the FCC for all elements of access services except carrier
common line charges, for which SureWest Telephone concurs with tariffs filed by the National
Exchange Carrier Association (NECA). 9




---



##### Table of Contents



SUREWEST COMMUNICATIONS
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (CONTINUED) 3. ESTIMATED SHAREABLE EARNINGS OBLIGATIONS (CONTINUED) The FCC monitors SureWest Telephones interstate earnings through the use of annual cost separation
studies prepared by SureWest Telephone, which utilize estimated cost information and projected
demand usage. The FCC establishes rules that carriers must follow in the preparation of the annual
studies. Additionally, under current FCC rules governing rate making, SureWest Telephone is
required to establish interstate rates based on projected demand usage for its various services and
determine the actual earnings from these rates once actual volumes and costs are known. Based on
preliminary cost studies, the Company recognized liabilities relating to SureWest Telephones
estimated interstate shareable earnings obligations of $80 (no effect on earnings per share) for
the quarter ended March 31, 2005, through reductions of revenues. The Company did not identify any
interstate shareable earnings obligations at SureWest Telephone during the quarter ended March 31,
2004. In 1999, SBC Communications (SBC) expressed interest in entering into a new, permanent
compensation arrangement for extended area service (EAS). At that time, SBC was paying SureWest
Telephone approximately $11,500 per year for EAS pursuant to a Settlement Transition Agreement. In
November 2000, the CPUC authorized SBC to terminate its annual EAS payments to SureWest Telephone
effective November 30, 2000. The CPUC authorized replacement funding to SureWest Telephone on an
interim basis using funds from the California High Cost Fund (CHCF). The CHCF is a program
designed by the CPUC to establish a fair and equitable local rate structure and to reduce any
disparity in the rates charged by telephone companies serving high-cost areas. The CHCF is
scheduled to expire January 1, 2009. In addition, the CPUC opened an Order Instituting
Investigation (OII) for the purpose of determining whether future recovery of all, none, or a
portion of the approximate $11,500 annual payments previously received from SBC and received
currently from the CHCF, should come from SureWest Telephones ratepayers or other regulatory
recovery mechanisms. This proceeding began in 2001, evidentiary hearings were held during 2002, and
briefing was completed in February 2003. In this proceeding, the Office of Ratepayer Advocates
(ORA) recommended that the CPUC discontinue SureWest Telephones present interim EAS funding from
the CHCF without replacement revenues from ratepayers. The CPUC has made no indication as to what,
if any, changes will be forthcoming relating to EAS revenues. The results of these proceedings and
their potential effects on SureWest Telephone cannot yet be determined. In 1996, the CPUC issued a decision in connection with SureWest Telephones general rate
proceeding, which authorized SureWest Telephone to implement a New Regulatory Framework (NRF) for
services furnished within SureWest Telephones service area in order to accommodate market and
regulatory movement toward competition and greater pricing flexibility. Under the NRF, SureWest
Telephone is subject to ongoing monitoring and reporting requirements, and it was initially
required to share earnings with customers through a reduction of revenues if its earned annual
rate-of-return exceeds that authorized by the CPUC. In accordance with the provisions of the NRF,
the Company recorded certain liabilities and reductions of revenues of $70 (no effect on earnings
per share) relating to its estimated intrastate shareable earnings obligations during the quarter
ended March 31, 2004 (none for the quarter ended March 31, 2005). The Company was involved in a proceeding at the CPUC that considered the continued need for certain
sharing requirements in the intrastate jurisdiction and, in connection with that review, also
considered the issue of whether the Company overearned in the intrastate jurisdiction in recent
monitoring periods and the amount of such overearnings that should be shared with customers. In
July 2004, the Company entered into a settlement agreement with the other parties in the
proceeding, the ORA and The Utility Reform Network (TURN), to resolve all issues in the
proceeding. In November 2004, the CPUC approved the settlement agreement. The settlement
agreement resolved existing sharing obligations and related earnings issues for the monitoring
periods 2000 through 2004, put into place a surcredit mechanism for the amount of the settlement,
and suspended the requirement for any intrastate sharing for monitoring periods from January 1,
2005 through at least December 31, 2010. 10




---



##### Table of Contents



SUREWEST COMMUNICATIONS
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (CONTINUED) 3. ESTIMATED SHAREABLE EARNINGS OBLIGATIONS (CONTINUED) In accordance with the November 2004 settlement agreement, SureWest Telephone will return
approximately $6,500, plus interest at an annual contractual rate of 2.34% and imputed rate of
3.15%, to its end users through a consumer dividend over a period of four years beginning January
1, 2005. For the quarter ended March 31, 2005, approximately $395 was returned to the end users.
In addition, SureWest Telephone will pay a one-time consumer dividend of $2,600, which includes an
annual imputed interest rate of 3.15% (no stated contractual interest rate), over two years
beginning January 1, 2005 to settle the monitoring periods 2000 to 2004. For the quarter ended
March 31, 2005, approximately $289 was returned to the consumers and was recorded as a reduction of
the Companys contractual shareable earnings obligations. At March 31, 2005, the aggregate
contractual shareable earnings obligation for these surcredits was $8,557 (which is net of an
unamortized discount pertaining to imputed interest of $520 at such date). Further, commencing January 1, 2007, SureWest Telephone will implement a permanent annual consumer
dividend of $1,300 to end-users receiving SureWest Telephone services subject to sharing on or
after that date; however, this consumer dividend is subject to reduction based upon the results of
other pending regulatory proceedings. Beginning in November 2003, SureWest Telephone began paying a consumer dividend for intrastate
overearnings relating to the year 2002. A portion of the consumers intrastate service charges was
returned to the consumers in the form of a surcredit beginning in November 2003 and ending in
February 2004, totaling $483 (of which $208 was returned during the first quarter of 2004) and was
recorded as a reduction of the Companys estimated shareable earnings obligations. As a result of periodic cost separation studies, SureWest Telephone changed its estimates for a
portion of its interstate and intrastate shareable earnings obligations during the quarters ended
March 31, 2005 and 2004. For the quarter ended March 31, 2005, these changes in estimates
increased the Companys consolidated revenues by $57 and net income by $35 (no effect on earnings
per share). For the quarter ended March 31, 2004, similar changes in estimates increased the
Companys consolidated revenues by $539 and net income by $310 ($0.02 per share). As of March 31, 2005, the Companys condensed consolidated balance sheet reflected aggregate
liabilities of $418 relating to SureWest Telephones estimated interstate shareable earnings
obligations. The calculations supporting these liabilities are very complex and involve a variety
of estimates prior to the ultimate settlement of such obligations. In addition, SureWest
Telephones interstate shareable earnings obligations lapse over time if SureWest Telephones
interexchange carrier and other customers do not claim the amounts ascribed to them. Accordingly,
it is reasonably possible that managements estimates of the Companys liabilities for interstate
shareable earnings obligations could change in the near term, and the amounts involved could be
material. 11




---



##### Table of Contents



SUREWEST COMMUNICATIONS
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (CONTINUED) 4. PENSION AND OTHER POST-RETIREMENT BENEFITS Components of Net Periodic Benefit Cost Net periodic pension costs recognized in the condensed consolidated statements of income for the
three month periods ended March 31, 2005 and 2004 under the defined benefit pension plan (Pension
Plan), Supplemental Executive Retirement Plan (SERP) and post-retirement benefits other than
pension (Other Benefits) plan included the following components: Pension Plan and SERP
    
    
    Other Benefits2005
    
    
    2004
    
    
    2005
    
    
    2004Quarter ended March 31,Service cost-benefits earned
during the period
    
    $
    1,407
    
    
    $
    1,340
    
    
    $
    117
    
    
    $
    95Interest cost on projected
benefit obligation
    
    
    1,866
    
    
    
    1,774
    
    
    
    88
    
    
    
    71Expected return on plan assets
    
    
    (2,183
    )
    
    
    (2,008
    )
    
    
    (38
    )
    
    
    (31
    )Amortization of prior service cost
    
    
    86
    
    
    
    86
    
    
    
    11
    
    
    
    9Recognized net actuarial loss
    
    
    176
    
    
    
    120
    
    
    
    
    
    
    
    Expected disbursement for life
insurance premiums
    
    
    
    
    
    
    
    
    
    
    (19
    )
    
    
    (15
    )Special termination benefits
    
    
    51
    
    
    
    
    
    
    
    740
    
    
    
    Net pension cost
    
    $
    1,403
    
    
    $
    1,312
    
    
    $
    899
    
    
    $
    129
 In December 2004, the Company initiated a voluntary enhanced early retirement program (the REWARD
program). The REWARD program was offered to certain eligible employees across all business units.
In addition to retirement benefits, eligible employees will receive enhanced medical benefits for a
specified period of time. As of December 31, 2004, 59 employees had accepted the REWARD program
and the Company recorded operating expenses of $3,768 related to the REWARD program during the
fourth quarter of 2004. During the first quarter of 2005, 13 additional employees accepted the
REWARD program. As a result, the Company recorded $791 in operating expenses during the first
quarter of 2005. Employer Contributions The Company expects to contribute $5,000 and $517 to the Pension Plan and Other Benefits plan,
respectively, in 2005. As of March 31, 2005, the Company has contributed $447 to the Other
Benefits plan (no contributions have been made to the Pension Plan). 5. RECENT ACCOUNTING PRONOUNCEMENTS In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123 (revised
2004), Share-Based Payment(SFAS No. 123(R)), which is a revision of SFAS No. 123.SFAS No.
123(R) supersedes Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to
Employees,and amends SFAS No. 95, Statement of Cash Flows.Generally, the approach in SFAS No.
123(R) is similar to the approach described in SFAS No. 123. However, SFAS No. 123(R) requires all
share-based payments to employees, including grants of employee stock options, to be recognized in
the statement of operations based on their fair values. Pro forma disclosure is no longer an
alternative. SFAS No. 123(R) as originally issued was to be effective for public companies for interim or annual
periods beginning after June 15, 2005. However, in April 2005, the SEC announced that companies
may implement SFAS No. 123(R) at the beginning of their next fiscal year (instead of their next
reporting period) beginning after June 15, 2005. The effective date of the new standard for the
Companys consolidated financial statements is January 1, 2006 (beginning with the reporting period
ending March 31, 2006). Early adoption will be permitted in periods in which financial statements
have not yet been issued. The Company expects to adopt SFAS No. 123(R) on January 1, 2006. 12




---



##### Table of Contents



SUREWEST COMMUNICATIONS
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (CONTINUED) 5. RECENT ACCOUNTING PRONOUNCEMENTS (CONTINUED) SFAS No. 123(R) permits public companies to adopt its requirements using one of two methods:  1.
    A modified prospective method in which compensation cost is recognized beginning with
the effective date (a) based on the requirements of SFAS No. 123(R) for all share-based
payments granted after the effective date and (b) based on the requirements of SFAS No. 123
for all awards granted to employees prior to the effective date of SFAS No. 123(R) that
remain unvested on the effective date.2.
    A modified retrospective method, which includes the requirements of the modified
prospective method described above, but also permits entities to restate their financial
statements based on the amounts previously recognized under SFAS No. 123 for purposes of
pro forma disclosures either for (a) all prior periods presented or (b) prior interim
periods of the year of adoption. The Company is in the process of evaluating which method of adoption it will use to adopt SFAS No.
123(R). The Company does not believe the adoption of this new guidance will have a material effect
on its consolidated financial position, results of operations or cash flows. In March 2005, the FASB issued Interpretation (FIN) No. 47, Accounting for Conditional Asset
Retirement Obligations. FIN No. 47 clarifies that the term conditional asset retirement
obligation as used in SFAS No. 143, Accounting for Asset Retirement Obligations, refers to a legal
obligation to perform an asset retirement activity in which the timing and/or method of settlement
are conditional on a future event that may or may not be within the control of the entity. FIN No.
47 requires an entity to recognize a liability for the fair value of a conditional asset retirement
obligation if the fair value of the liability can be reasonably estimated. FIN No. 47 is effective
no later than the end of fiscal years ending after December 15, 2005. The Company is currently
evaluating the effect FIN No. 47 will have on its consolidated financial position, results of
operations or cash flows. 6. COMMITMENTS AND CONTINGENCIES The Company has entered into various cable television franchise agreements with associated letters
of credit totaling $150 in the aggregate as of March 31, 2005. The Company is subject to certain legal and regulatory proceedings and examinations, Internal
Revenue Service examinations and other tax exposures, and other claims arising in the ordinary
course of its business. In the opinion of management, the ultimate outcome of these matters will
not materially affect the consolidated financial position or results of operations of the Company.   13




---



##### Table of Contents



PART I 
  ITEM 2.
    MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS. (Amounts in thousands, except selected operating metrics and per share amounts) Certain information included in the Companys quarterly report on Form 10-Q, including that which
relates to the impact on future revenue sources and potential sharing obligations of pending and
future regulatory orders, continued expansion of the telecommunications network and expected
changes in the sources of the Companys revenue and its cost structure resulting from its entrance
into new communications markets, are forward looking statements and are made pursuant to the safe
harbor provisions of the Securities Litigation Reform Act of 1995. Such forward looking statements
are subject to a number of risks, assumptions and uncertainties that could cause the Companys
actual results to differ from those projected in such forward looking statements. Important factors that could cause actual results to differ from those set forth in the forward
looking statements include, but are not limited to: advances in telecommunications technology,
changes in the telecommunications regulatory environment, changes in the financial stability of
other telecommunications providers who are customers of the Company, changes in competition in
markets in which the Company operates, adverse circumstances affecting the economy in California in
general, and in the Sacramento, California Metropolitan area in particular, the availability of
future financing, changes in the demand for services and products, new product and service
development and introductions, pending and future litigation, internal control weaknesses and
unanticipated changes in the growth of the Companys emerging businesses, including the wireless,
Internet, digital video and Competitive Local Exchange Carrier operating entities. Corporate Structure SureWest Communications (the Company) is a holding company with wholly-owned subsidiaries
operating in the Telecommunications (Telecom), Broadband and Wireless segments. The Telecom segment includes SureWest Telephone, SureWest Directories and SureWest Long Distance,
which provide landline telecommunications services, directory advertising, Digital Subscriber Line
(DSL) service, long distance services and certain non-regulated services. SureWest Telephone,
which is the principal operating subsidiary of the Telecom segment, provides local and toll
telephone services, network access services and certain non-regulated services. SureWest
Directories publishes and distributes SureWest Telephones directory, including the sale of yellow
pages advertising. SureWest Directories is also engaged in the business of producing, publishing
and distributing directories in other Northern California communities outside of SureWest
Telephones service area. SureWest Long Distance is a reseller of long distance services. The Broadband segment provides various services, including high-speed and dial-up Internet, digital
video, local, network access and toll telephone and managed services in the greater Sacramento
area, principally to customers residing outside of SureWest Telephones service area. The Company
offers high-speed Internet, digital video and local and long distance phone service as a bundled
package referred to as fiber-to-the-premise (FTTP) (previously referred to as Triple Play). The
Broadband segment includes the Companys subsidiary SureWest Broadband and SureWest Broadband
Business Services which is comprised, in part, of a division of SureWest Telephone operating as a
Competitive Local Exchange Carrier. The Wireless segment consists of the Companys subsidiary SureWest Wireless, which provides
wireless services. SureWest Wireless derives its revenue from the provision of wireless services
and the sale of handsets and related communications equipment. Revenues include wireless voice
services, sales of handsets and related accessories, long distance, roaming service and custom
calling features. Wireless services are provided on a month-to-month basis and are generally billed
in advance for non-contract subscribers and in arrears for contract subscribers. The Company expects that the sources of its revenues and its cost structure may be different in
future periods, both as a result of its entry into new communications markets and competitive
forces in each of the markets in which the Company has operations. 14




---



##### Table of Contents



Results of Operations Consolidated Overview The tables below reflect certain financial data (on a consolidated and segment basis) and selected
operating metrics for each reportable segment as of and for the quarters ended March 31, 2005 and
2004. Both the financial data and the selected operating metrics demonstrate the increasing
importance of the Companys Broadband and Wireless segments. Financial Data Quarter Ended March 31,2005
    
    
    2004
    
    
    $ Change
    
    
    % ChangeOperating revenues(1)Telecom
    
    $
    33,471
    
    
    $
    35,193
    
    
    $
    (1,722
    )
    
    
    (5
    )%Broadband
    
    
    11,597
    
    
    
    8,975
    
    
    
    2,622
    
    
    
    29Wireless
    
    
    8,388
    
    
    
    7,420
    
    
    
    968
    
    
    
    13Total operating revenues
    
    
    53,456
    
    
    
    51,588
    
    
    
    1,868
    
    
    
    4Operating income (loss)Telecom
    
    
    12,083
    
    
    
    12,413
    
    
    
    (330
    )
    
    
    (3
    )Broadband
    
    
    (6,326
    )
    
    
    (6,525
    )
    
    
    199
    
    
    
    (3
    )Wireless
    
    
    (3,188
    )
    
    
    (4,130
    )
    
    
    942
    
    
    
    (23
    )Total operating income
    
    
    2,569
    
    
    
    1,758
    
    
    
    811
    
    
    
    46Net income (loss)Telecom
    
    
    7,073
    
    
    
    7,271
    
    
    
    (198
    )
    
    
    (3
    )Broadband
    
    
    (4,101
    )
    
    
    (4,191
    )
    
    
    90
    
    
    
    (2
    )Wireless
    
    
    (2,129
    )
    
    
    (2,699
    )
    
    
    570
    
    
    
    (21
    )Total net income
    
    $
    843
    
    
    $
    381
    
    
    $
    462
    
    
    
    121
    %
  (1)
    External customers only Selected Operating Metrics Quarter Ended March 31,2005
    
    
    2004
    
    
    Change
    
    
    % ChangeTelecomILEC access lines
    
    
    131,133
    
    
    
    135,571
    
    
    
    (4,438
    )
    
    
    (3
    )%Long distance lines
    
    
    48,936
    
    
    
    43,235
    
    
    
    5,701
    
    
    
    13BroadbandDSL data subscribers (1)
    
    
    23,262
    
    
    
    20,406
    
    
    
    2,856
    
    
    
    14FTTP subscribers (2)
    
    
    16,623
    
    
    
    11,953
    
    
    
    4,670
    
    
    
    39FTTP Revenue-generating
units (3)
    
    
    38,818
    
    
    
    27,651
    
    
    
    11,167
    
    
    
    40WirelessSubscribers
    
    
    52,887
    
    
    
    47,279
    
    
    
    5,608
    
    
    
    12
    %
  (1)
    DSL subscribers are customers who receive data services within SureWest Telephones service
area.(2)
    FTTP subscribers are customers who receive digital video, voice and/or data services from
broadband residential services.(3)
    The Broadband segment can deliver multiple services to a customer. Accordingly, the Company
maintains statistical data regarding Revenue-generating units for digital video, voice and
data, in addition to the number of customers. For example, a single customer who purchases
digital video, voice and data services would be reflected as three Revenue-generating units.   15




---



##### Table of Contents



Operating revenues from external customers in the Telecom segment decreased $1,722 for the first
quarter of 2005 compared to the same period in 2004. SureWest Telephone continues to experience
decreases in local and network access as a result of competition from wireless (including SureWest
Wireless) and wireline competitors and an approximate 3% decline in access lines. The decrease in
revenues in the Telecom segment was offset in part by revenue growth of $280 in SureWest Long
Distance, resulting from an increase in minutes of use and the Infinite Access bundle program,
which was initiated during the second quarter of 2004. In addition, Directory advertising revenue
increased $194 for the quarter ended March 31, 2005, compared to the same period in 2004, due
primarily to increases in advertising rates and programs and bundled packages purchased by existing
customers. While the Telecom segment continues to generate a majority of the Companys revenues and yields
significant cash flows and net income, the Company believes that the results of the Telecom segment
in recent years support (reflected in declining revenues, net income and access lines), in part,
the Companys decision to develop its other business segments. Broadband operating revenues increased $2,622 during the first quarter of 2005 compared to the same
period in 2004. The Broadband segment experienced a 14% increase in the number of DSL data
subscribers compared to 2004. More significantly, this segment had 16,623 FTTP subscribers and
38,818 FTTP Revenue-generating units at March 31, 2005 within the broadband residential services
business. While continuing to produce significant revenue increases, the expansion of the
broadband residential services has and will continue to require significant capital and expense
commitments. Accordingly, operating and net losses for the Broadband segment remained relatively
consistent with the prior-year period. The Wireless segment reported increases in operating revenues of $968 during the first quarter of
2005 as compared to the same period in 2004. The number of wireless subscribers increased to 52,887
at March 31, 2005, representing a 12% increase from March 31, 2004. SureWest Wireless established
its market share in the Sacramento market in large part by promoting an unlimited flat rate
regional calling plan. Throughout 2004 and the first quarter of 2005, SureWest Wireless initiated a
number of new service options for customers, including additional regional plans, an unlimited
national plan, a family plan and new vertical services (such as wireless data capabilities), which
have attracted new customers. Evolution of the marketplace has prompted SureWest Wireless to open
five retail stores in its service area with plans to open a sixth store in late 2005. SureWest
Wireless is also seeking to expand its service penetration among major accounts in 2005, while
seeking to reduce customer turnover (churn) and to increase revenues from its customer base. The Companys consolidated operating expenses, excluding depreciation and amortization, decreased
$362 in 2005 compared to the prior year. General and administrative expense decreased due primarily
to the incurrence of consulting and legal fees related to the treasury investigation and audit fees
during the quarter ended March 31, 2004, offset in part by an increase in Sarbanes-Oxley compliance
costs during the current year. This decrease was further offset by an increase in cost of services
and products expense (exclusive of depreciation and amortization) associated with a larger number
of subscribers and services within the Broadband and Wireless segments. In addition, long distance
access expense increased as a result of the Infinite Access bundle program, which was initiated
during the second quarter of 2004, and an increase in the minutes of use. In December 2004, the Company initiated a voluntary enhanced early retirement program (the REWARD
program). The REWARD program was offered to certain eligible employees across all business units.
In addition to retirement benefits, eligible employees will receive enhanced medical benefits for a
specified period of time. As of December 31, 2004, 59 employees had accepted the REWARD program
and the Company recorded operating expenses of $3,768 related to the REWARD program during the
fourth quarter of 2004. During the first quarter of 2005, 13 additional employees accepted the
REWARD program. As a result, the Company recorded $791 in operating expenses during the first
quarter of 2005. Through March 31, 2005, the Company experienced an approximate savings in labor
costs of $585. The Companys consolidated depreciation and amortization expense increased $1,419 during the first
quarter in 2005 compared to the same period in 2004. This increase was primarily due to continued
network build-out within the residential broadband service territories. 16




---



##### Table of Contents



During the first quarter of 2005, the Company continued to implement a strategy for driving
efficiency and long-term growth through cost reduction and workforce consolidation. This strategic
plan entailed a reduction of operating expenses by approximately 6 percent through a realignment of
its organizational structure in order to focus on its primary customer segments. Throughout the
remainder of 2005, the Company also expects to eliminate functional redundancies, combine duplicate
or overlapping work areas, consolidate separate billing and other systems and reduce overall labor
costs. Adjustments and Reclassification During the Companys financial statement closing process for the quarter ended September 30, 2004,
certain matters were identified related to prior financial reporting periods that necessitated the
recording of adjustments to the Companys condensed consolidated financial statements. Such
adjustments increased depreciation expense by $822 and decreased cost of sales by $39 in the
quarter ended September 30, 2004. Management believes that weaknesses in the Companys internal
controls caused the errors that resulted in these adjustments. The Company does not believe the
aforementioned amounts are material, individually or in the aggregate, to the respective prior
quarterly periods based on both quantitative and qualitative factors, including the trend of
operating results, nor does it believe the prospective correction of such amounts during the
quarter ended September 30, 2004 was material to the Companys consolidated results of operations
based on both quantitative and qualitative factors, including the trend of operating results. The
prospective correction of the aforementioned amounts relating to prior periods increased the
Companys consolidated net loss by $468, or $0.03 per basic and diluted share, for the quarter
ended September 30, 2004. Such amounts would have reduced the Companys quarterly consolidated net
income by $239, or $0.02 per basic and diluted share, and $272, or $0.02 per basic and diluted
share, for the quarters ended March 31, 2004 and June 30, 2004, respectively, had such errors been
corrected in the periods in which they originated. Segment Results of Operations Telecom Quarter Ended March 31,2005
    
    
    2004
    
    
    $Change
    
    
    %ChangeLocal service
    
    $
    16,037
    
    
    $
    17,134
    
    
    $
    (1,097
    )
    
    
    (6
    )%Network access service
    
    
    10,633
    
    
    
    11,610
    
    
    
    (977
    )
    
    
    (8
    )Directory advertising
    
    
    4,295
    
    
    
    4,101
    
    
    
    194
    
    
    
    5Long distance service
    
    
    1,497
    
    
    
    1,217
    
    
    
    280
    
    
    
    23Other
    
    
    1,009
    
    
    
    1,131
    
    
    
    (122
    )
    
    
    (11
    )Total operating revenues
from external customers
    
    
    33,471
    
    
    
    35,193
    
    
    
    (1,722
    )
    
    
    (5
    )Intersegment revenues
    
    
    6,876
    
    
    
    6,216
    
    
    
    660
    
    
    
    11Operating expenses*
    
    
    22,269
    
    
    
    22,817
    
    
    
    (548
    )
    
    
    (2
    )Depreciation and amortization
    
    
    5,995
    
    
    
    6,179
    
    
    
    (184
    )
    
    
    (3
    )Operating income
    
    
    12,083
    
    
    
    12,413
    
    
    
    (330
    )
    
    
    (3
    )Net income
    
    $
    7,073
    
    
    $
    7,271
    
    
    $
    (198
    )
    
    
    (3
    )%
   17




---



##### Table of Contents



Operating Revenues Operating revenues from external customers in the Telecom segment decreased $1,722 for the quarter
ended March 31, 2005 compared to the same period in 2004. SureWest Telephone continues to
experience decreases in local and network access as a result of competition from wireless
(including SureWest Wireless) and wireline competitors and an approximate 3% decline in access
lines. In addition, revenues within the Telecom segment were also affected by changes in estimates
to the Companys intrastate and interstate shareable earnings obligations, which are discussed in
more detail below. The decrease in the Telecom segment revenues was offset in part by revenue growth of $280 in
SureWest Long Distance resulting from an increase in minutes of use and the Infinite Access bundle
program, which was initiated during the second quarter of 2004. In addition, Directory advertising
revenue increased $194 for the quarter ended March 31, 2005, compared to the same period in 2004,
due primarily to increases in advertising rates and programs and bundled packages purchased by
existing customers. Operating Expenses Operating expenses for the Telecom segment decreased $548 for the quarter ended March 31, 2005,
compared to the same period in 2004. This decrease was offset in part by approximately $640 in
operating expenses incurred during the quarter ended March 31, 2005 related to the REWARD program,
which was offered to certain eligible employees during the fourth quarter of 2004 and is described
in the Consolidated Overviewsection above. Cost of services and products (exclusive of
depreciation and amortization) increased $1,118, or 10%, for the quarter ended March 31, 2005,
compared to the same period in 2004 due primarily to increases in (i) long distance access expense
as a result of the Infinite Access bundle program and an increase in minutes of use and (ii)
network operations expense due to an increase in expensed-versus-capitalized labor. Customer operations and selling expense decreased $427, or 10%, for the quarter ended March 31,
2005, compared to the same period in 2004 due primarily to decreases in (i) sales and advertising
expense due to decreased advertising campaigns and sales force and (ii) product management and
operator services headcount. General and administrative expense decreased $1,239, or 18%, for the quarter ended March 31, 2005
compared to the same period in 2004 due primarily to the incurrence of consulting and legal fees
related to the treasury investigation and audit fees during the quarter ended March 31, 2004.
These decreases were offset in part by an increase in Sarbanes-Oxley compliance costs. Depreciation and amortization decreased $184, or 3%, for the quarter ended March 31, 2005, compared
to the same period in 2004, due primarily to the retirement of assets subsequent to March 31, 2004. Certain of the Companys customers filed for bankruptcy protection in 2002, the most notable of
which was WorldCom, Inc. (WorldCom), which, together with its affiliates, filed for bankruptcy
protection in July 2002. In April 2004, WorldCom emerged from federal bankruptcy protection.
Settlement of the Companys pending pre-bankruptcy claims against WorldCom remain subject to the
distribution terms, applicable to creditors, contained in WorldComs plan of reorganization. As of
March 31, 2005, the amount of any settled pre-bankruptcy claims could not be determined. Through
March 31, 2005, obligations owed by WorldCom to the Company for post-petition services have been
paid on a timely basis. 18




---



##### Table of Contents



Regulatory Matters Revenues from services subject to comprehensive regulation constituted approximately 50% and 56% of
the Companys total operating revenues for the quarters ended March 31, 2005 and 2004,
respectively. Such revenues, which include local and network access services, are derived from
various sources, including:  
    business and residential subscribers, for basic exchange services;
    surcharges, mandated by the California Public Utilities Commission (CPUC);
    long distance carriers, for network access service;
    competitive access providers and subscribers, for network access services;
    interstate pool settlements, from the National Exchange Carrier Association (NECA);
    support payments from the Universal Service Fund; and
    support payments from the California High Cost Fund (CHCF),
recovering costs of services including extended area service. Revenues from certain telephone services are affected by rates authorized by various regulatory
agencies. Intrastate service rates are subject to regulation by the CPUC. With respect to toll
calls initiated by interexchange carriers customers, the interexchange carriers are assessed
access charges based on tariffs filed by SureWest Telephone. Interstate access rates and resulting
earnings are subject to regulation by the Federal Communications Commission (FCC). With respect
to interstate services, SureWest Telephone has filed its own tariff with the FCC for all elements
of access services except carrier common line charges, for which SureWest Telephone concurs with
tariffs filed by NECA. The FCC monitors SureWest Telephones interstate earnings through the use of annual cost separation
studies prepared by SureWest Telephone, which utilize estimated cost information and projected
demand usage. The FCC establishes rules that carriers must follow in the preparation of the annual
studies. Additionally, under current FCC rules governing rate making, SureWest Telephone is
required to establish interstate rates based on projected demand usage for its various services and
determine the actual earnings from these rates once actual volumes and costs are known. Based on
preliminary cost studies, the Company recognized liabilities relating to SureWest Telephones
estimated interstate shareable earnings obligations of $80 (no effect on earnings per share) for
the quarter ended March 31, 2005, through reductions of revenues. The Company did not identify any
interstate shareable earnings obligations at SureWest Telephone during the quarter ended March 31,
2004. In 1999, SBC Communications (SBC) expressed interest in entering into a new, permanent
compensation arrangement for extended area service (EAS). At that time, SBC had been paying
SureWest Telephone approximately $11,500 per year for EAS pursuant to a Settlement Transition
Agreement. In November 2000, the CPUC authorized SBC to terminate its annual EAS payments to
SureWest Telephone effective November 30, 2000. The CPUC authorized replacement funding to SureWest
Telephone on an interim basis using funds from the CHCF. The CHCF is a program designed by the CPUC
to establish a fair and equitable local rate structure and to reduce any disparity in the rates
charged by telephone companies serving high-cost areas. The CHCF is scheduled to expire January 1,
2009. In addition, the CPUC opened an Order Instituting Investigation (OII) for the purpose of
determining whether future recovery of all, none, or a portion of the approximate $11,500 annual
payments previously received from SBC and received currently from the CHCF, should come from
SureWest Telephones ratepayers or other regulatory recovery mechanisms. This proceeding began in
2001, evidentiary hearings were held during 2002, and briefing was completed in February 2003. In
this proceeding, the CPUCs Office of Ratepayer Advocates (ORA) recommended that the CPUC
discontinue SureWest Telephones present interim EAS funding from the CHCF without replacement
revenues from ratepayers. The CPUC has made no indication as to what, if any, changes will be
forthcoming relating to EAS revenues. The results of these proceedings and their potential effects
on SureWest Telephone cannot yet be determined. In 1996, the CPUC issued a decision in connection with SureWest Telephones general rate
proceeding, which authorized SureWest Telephone to implement a New Regulatory Framework (NRF) for
services furnished within SureWest Telephones service area in order to accommodate market and
regulatory movement toward competition and greater pricing flexibility. Under the NRF, SureWest
Telephone is subject to ongoing monitoring and reporting 19




---



##### Table of Contents



requirements, and it was initially required to share earnings with customers through a reduction of
revenues if its earned annual rate-of-return exceeds that authorized by the CPUC. In accordance
with the provisions of the NRF, the Company recorded liabilities and reductions of revenues of $70
(no effect on earnings per share) relating to estimated intrastate shareable earnings obligation
during the quarter ended March 31, 2004 (none for the quarter ended March 31, 2005). The Company was involved in a proceeding at the CPUC that considered the continued need for certain
sharing requirements in the intrastate jurisdiction and, in connection with that review, also
considered the issue of whether the Company overearned in the intrastate jurisdiction in recent
monitoring periods and the amount of such overearnings that should be shared with customers. In
July 2004, the Company entered into a settlement agreement with the other parties in the
proceeding, the ORA and The Utility Reform Network (TURN), to resolve all issues in the
proceeding. In November 2004, the CPUC approved the settlement agreement. The settlement
agreement resolved existing sharing obligations and related earnings issues for the monitoring
periods 2000 through 2004, put into place a surcredit mechanism for the amount of the settlement,
and suspended the requirement for any intrastate sharing for monitoring periods from January 1,
2005 through at least December 31, 2010. In accordance with the November 2004 settlement agreement, SureWest Telephone will return
approximately $6,500, plus interest at an annual contractual rate of 2.34% and imputed rate of
3.15%, to its end users through a consumer dividend over a period of four years beginning January
1, 2005. For the quarter ended March 31, 2005, approximately $395 has been returned to the end
users. In addition, SureWest Telephone will pay a one-time consumer dividend of $2,600, which
includes an annual imputed interest rate of 3.15% (no stated contractual interest rate), over two
years beginning January 1, 2005 to settle the monitoring periods 2000 to 2004. For the quarter
ended March 31, 2005, approximately $289 has been returned to the end users and was recorded as a
reduction of the Companys contractual shareable earnings obligations. At March 31, 2005, the
aggregate contractual shareable earnings obligation for these surcredits was $8,557 (which is net
of an unamortized discount pertaining to imputed interest of $520 at such date). Further, commencing January 1, 2007, SureWest Telephone will implement a permanent annual consumer
dividend of $1,300 to end-users receiving SureWest Telephone services subject to sharing on or
after that date; however, this consumer dividend is subject to reduction based upon the results of
other pending regulatory proceedings. Beginning in November 2003, SureWest Telephone began paying a consumer dividend for intrastate
overearnings relating to the year 2002. A portion of the consumers intrastate service charges was
returned to the consumers in the form of a surcredit beginning in November 2003 and ending in
February 2004, totaling $483 (of which $208 was returned during 2004) and was recorded as a
reduction of the Companys estimated intrastate shareable earnings obligations. As a result of periodic cost separation studies, SureWest Telephone changed its estimates for a
portion of its interstate and intrastate shareable earnings obligations during the quarters ended
March 31, 2005 and 2004. For the quarter ended March 31, 2005, these changes in estimates
increased the Companys consolidated revenues by $57 and net income by $35 (no effect on earnings
per share). For the quarter ended March 31, 2004, similar changes in estimates increased the
Companys consolidated revenues by $539 and net income by $310 ($0.02 per share). As of March 31, 2005, the Companys condensed consolidated balance sheet reflected aggregate
liabilities of $418 relating to SureWest Telephones estimated interstate shareable earnings
obligations. The calculations supporting these liabilities are very complex and involve a variety
of estimates prior to the ultimate settlement of such obligations. In addition, SureWest
Telephones interstate shareable earnings obligations lapse over time if SureWest Telephones
interexchange carrier and other customers do not claim the amounts ascribed to them. Accordingly,
it is reasonably possible that managements estimates of the Companys liabilities for interstate
shareable earnings obligations could change in the near term, and the amounts involved could be
material. 20




---



##### Table of Contents



Broadband Quarter Ended March 31,2005
    
    
    2004
    
    
    $Change
    
    
    %ChangeInternet service
    
    $
    4,313
    
    
    $
    4,152
    
    
    $
    161
    
    
    
    4
    %Residential Broadband
service
    
    
    5,597
    
    
    
    3,553
    
    
    
    2,044
    
    
    
    58Business Broadband service
    
    
    1,687
    
    
    
    1,270
    
    
    
    417
    
    
    
    33Total operating revenues
from external customers
    
    
    11,597
    
    
    
    8,975
    
    
    
    2,622
    
    
    
    29Intersegment revenues
    
    
    443
    
    
    
    452
    
    
    
    (9
    )
    
    
    (2
    )Operating expenses*
    
    
    14,732
    
    
    
    13,934
    
    
    
    798
    
    
    
    6Depreciation and
amortization
    
    
    3,634
    
    
    
    2,018
    
    
    
    1,616
    
    
    
    80Operating loss
    
    
    (6,326
    )
    
    
    (6,525
    )
    
    
    199
    
    
    
    (3
    )Net loss
    
    $
    (4,101
    )
    
    $
    (4,191
    )
    
    $
    90
    
    
    
    (2
    )%
   Operating Revenues Operating revenues from external customers in the Broadband segment increased $2,622 for the
quarter ended March 31, 2005, compared to the same period in 2004. The increase in Broadband
revenues was due to the combined effects of (i) a 39% increase in the number of FTTP subscribers of
broadband residential services, (ii) a 14% increase in the residential and business DSL data
subscriber customer base and (iii) the continued expansion of the Business Broadband Services,
resulting in a 29% increase in ending access lines. Operating Expenses Total operating expenses in the Broadband segment increased $798 for the quarter ended March 31,
2005, compared to the same period in 2004. This increase was due in part to the incurrence of
approximately $120 in operating expenses during the quarter ended March 31, 2005 related to the
REWARD program, which was offered to certain eligible employees during 2004 and is described in the
Consolidated Overviewsection above. Cost of services and products (exclusive of depreciation and
amortization) increased $634, or 8%, during the quarter ended March 31, 2005, compared to the same
period in 2004, due primarily to (i) an increase in programming and transport costs related to the
39% increase in FTTP subscriber growth of broadband residential services and (ii) an increase in
engineering and network administration expenses resulting from an increase in subscriber and
network growth. These increases were offset in part by a decrease in repairs and maintenance
costs. Customer operations expense increased $631, or 31%, during the quarter ended March 31, 2005,
compared to the same period in 2004 due primarily to an increase in (i) sales and advertising costs
due to the increase in marketable homes passed and the expansion of bundled services into the
cities of Roseville, Lincoln and Elk Grove, California and (ii) customer service costs resulting
from increased call volume caused by the FTTP subscriber growth. General and administrative expense decreased $467, or 13%, during the quarter ended March 31, 2005,
compared to the same period in 2004 due primarily to (i) the incurrence in the prior year period of
professional and legal expense related to the treasury investigation and audit fees and (ii) a
decrease in information management expenses due to a decrease in maintenance and service agreements
and an increase in capitalized labor costs. These decreases were offset in part by an increase in
Sarbanes-Oxley compliance costs. Depreciation and amortization increased $1,616, or 80%, during the quarter ended March 31, 2005,
compared to the same period in 2004 primarily due to continued network build-out within the
residential broadband service territories. 21




---



##### Table of Contents



Wireless Quarter Ended March 31,2005
    
    
    2004
    
    
    $Change
    
    
    %ChangeWireless revenues from
external customers
    
    $
    8,388
    
    
    $
    7,420
    
    
    $
    968
    
    
    
    13
    %Intersegment revenues
    
    
    598
    
    
    
    311
    
    
    
    287
    
    
    
    92Operating expenses*
    
    
    9,090
    
    
    
    8,764
    
    
    
    326
    
    
    
    4Depreciation and
amortization
    
    
    3,084
    
    
    
    3,097
    
    
    
    (13
    )
    
    
    Operating loss
    
    
    (3,188
    )
    
    
    (4,130
    )
    
    
    942
    
    
    
    (23
    )Net loss
    
    $
    (2,129
    )
    
    $
    (2,699
    )
    
    $
    570
    
    
    
    (21
    )%
   Operating Revenues Operating revenues from external customers in the Wireless segment increased $968 for the quarter
ended March 31, 2005, compared to the same period in 2004 due primarily to (i) a 12% increase in
Wireless subscriber base, (ii) an increase in feature revenues, including voicemail and text and
picture messaging and (iii) an increase in local number portability recovery fees, which were
implemented during the second quarter of 2004. Operating Expenses Total operating expenses for the Wireless segment increased $326 for the quarter ended March 31,
2005, compared to the same period in 2004. Cost of services and products (exclusive of
depreciation and amortization) increased $411, or 8%, for the quarter ended March 31, 2005,
compared to the same period in 2004 primarily due to increases in (i) handset costs and
interconnection expenses due to an increase in the subscriber base and the number of handsets sold
and (ii) long distance expense due to an increase in the minutes of use and the introduction of
additional unlimited calling plans. Customer operations expense decreased $101, or 4%, for the
quarter ended March 31, 2005, compared to the same period in 2004 due primarily to decreases in (i)
sales and advertising expense due to the timing of promotional campaigns and (ii) dealer
commissions, resulting from a shift in the percentage of sales from dealer channels to the
Companys retail stores. Local Number Portability Effective November 24, 2003, the FCC mandated that wireless carriers provide for local number
portability (LNP). LNP allows subscribers to keep their wireless phone numbers while switching to
a different service provider. Although the Company has experienced favorable porting activity, the
implementation of LNP has not had a material effect on the Companys consolidated financial
position or results of operations. 22




---



##### Table of Contents



Non-operating Items Other Income and Expense, Net Interest expense increased $118 during the quarter ended March 31, 2005, compared to the same
period in 2004 due primarily to a decrease in capitalized interest. A decline in capital
expenditures for plant under construction and an increase in the turnover rate of construction
projects contributed to lower capitalized interest costs. Income Taxes Income taxes for the quarter ended March 31, 2005, increased $258, compared to the same period in
2004, due primarily to corresponding increases in income subject to tax. The effective federal and
state income tax rates were approximately 39.0% and 42.4% for the quarters ended March 31, 2005 and
2004, respectively. The decrease in the effective tax rate is primarily due to a decrease in
permanent differences. Liquidity and Capital Resources As reflected in the Condensed Consolidated Statements of Cash Flow, net cash provided by the
Companys operating activities was $14,243 for the quarter ended March 31, 2005 primarily due to
(i) net income of $843, (ii) non-cash charges of $12,713 consisting of depreciation and
amortization due to increased capital investments principally in the Broadband segment, (iii) an
increase in accounts payable and accrued liabilities of approximately $2,432 primarily due to an
increase in outstanding capital obligations related to the broadband residential services network
build-out and (iv) an increase in income taxes payable of $538 due to the timing of the first
quarter estimated income taxes payment. These amounts were offset by an increase in accounts
receivable of $2,496 due primarily to subscriber growth in the Broadband segment and the timing of the receipt of a
payment from the CHCF. Net cash used in the Companys investing activities for the quarter ended March 31, 2005 was
$19,090 due to capital expenditures pertaining to ongoing plant construction projects. Net cash used in the Companys financing activities was $3,783 for the quarter ended March 31, 2005
due primarily to (i) dividend payments of $3,648 and (ii) payments related to capital lease
obligations. The Company had a working capital deficit of $20,385 at March 31, 2005, due primarily to a decrease
in cash and short-term investments to fund items as described above and an increase in short-term
borrowings, accrued income taxes, accrued pension benefits and other accrued liabilities. The
deficit was reduced in part by a decrease in estimated and contractual shareable earnings
obligations. As discussed below, the Company believes that its working capital position, operating
cash flows and borrowing capacity are sufficient to satisfy its liquidity requirements in 2005. The Companys most significant use of funds for the remainder of 2005 is expected to be for (i)
budgeted capital expenditures of approximately $60,000, (ii) scheduled payments of long-term debt
of $3,743, (iii) support of the operations of SureWest Broadband/Residential Services up to an
anticipated $6,241 and (iv) support of the operations of SureWest Wireless up to an anticipated
$1,546. In addition, during the remainder of 2005 the payment of dividends, which is at the
discretion of the Companys Board of Directors, could be as much as $11,000 based on the Companys
most recent dividend and payments. A substantial portion of the 2005 budgeted capital expenditures
is at the discretion of the Company and dependent upon the Companys working capital position,
operating cash flows and ability to borrow, as described below. The Company is required to comply
with its cable franchise agreements to continue its build-out in the franchise areas. The Company currently receives funding of $11,500 annually from the CHCF, a program designed by the
CPUC to establish a fair and equitable local rate structure and to reduce any disparity in the
rates charged by certain telephone companies serving high-cost areas.
The CHCF is due to expire January 1, 2009. 23




---



##### Table of Contents



The Company has a business loan agreement with a bank for a $50,000 line of credit. As of March
31, 2005 and December 31, 2004, there was $10,000 outstanding under this credit facility and the
interest rate was 3.65% and 3.14%, respectively, which is based on a LIBOR-based pricing formula.
In December 2004, the bank amended the credit facility, extending the expiration date until July 1,
2006 and revising certain covenants. In February 2000, the Board of Directors authorized the repurchase of up to one million shares of
the Companys common stock. In June 2002, the Board of Directors approved the repurchase of an
additional 500 thousand shares. The shares are purchased from time to time in the open market or
through privately negotiated transactions, subject to overall financial and market conditions.
Through March 31, 2005, approximately one million shares of common stock had been repurchased
through the programs. The Company has remaining authorization from the Board of Directors to
repurchase an additional 469 thousand outstanding shares. The Company had cash and cash equivalents at March 31, 2005, of $9,489. The Company believes that
its working capital position, operating cash flows and borrowing capacity are sufficient to satisfy
its liquidity requirements in 2005. The Companys forecast indicates it is likely that the Company
will continue to borrow funds during the remainder of 2005 to fund operations and planned capital
expenditures, while maintaining adequate cash and cash equivalents. Such borrowing might be
undertaken under the newly extended bank credit facility or by the incurrence of additional
long-term indebtedness, or a combination of short-and long-term borrowing. The Company believes,
given its financial position and debt-to-equity position, it has substantial additional short-and
long-term borrowing capacity. As indicated above, a substantial portion of the Companys 2005
budgeted capital expenditures and cash dividend payments is at the discretion of the Company.
Accordingly, the Company believes that it can modify its planned construction and commitments and
cash dividend payments if the results of operations or available capital so require. Dividends are declared at the discretion of the Companys Board of Directors. However, the Note
Purchase Agreement under which the Company issued its Series A and Series B Senior Notes, and other
unsecured credit arrangements contain financial and operating covenants that restrict, among other
things, the payment of cash dividends, the repurchase of the Companys capital stock, the making of
certain other restricted payments and the incurrence of additional indebtedness. The bank line of
credit agreement requires that the Company obtain written consent to exceed $100,000 in total debt
with maturities greater than five years. The Company does not believe this requirement will have a
material affect on its ability to obtain additional debt if it is deemed necessary. In addition,
the Company is required to maintain certain financial ratios and minimum levels of tangible net
worth. At March 31, 2005, retained earnings of approximately $34,885 were available for the payment
of cash dividends, the repurchase of the Companys capital stock or other restricted payments under
the terms of the Companys credit arrangements. Critical Accounting Policies and Estimates Below is a summary of the Companys critical accounting policies and estimates. Management has
discussed development and selection of critical accounting policies and estimates with the
Companys Audit Committee.  
    In accordance with Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill
and Other Intangible Assets,goodwill and wireless spectrum licenses are reviewed for
impairment annually, or more frequently if an event occurs or circumstances change that would
reduce the fair value below its carrying value. The impairment test for goodwill requires the
Company to estimate the fair value at the reporting unit level. To determine the fair value in
2004, the Company obtained an independent valuation of the Companys goodwill using a
discounted cash flow model. Assumptions used in this model include the following:  
    cash flow assumptions regarding investment in network facilities, distribution channels
and customer base (the assumptions underlying these inputs are based upon a combination of
historical results and trends, new industry developments and the Companys business plans);
    an 11% weighted average cost of capital based on industry weighted averaged cost of capital; and
    no terminal growth rate.   24




---



##### Table of Contents



The use of different estimates or assumptions within the discounted cash flow model when
determining fair value of the Companys goodwill could result in a different fair value. For
example, the Company used a discount rate of 11% and no terminal growth rate in its assessment
of fair value in 2004. If the discount rate were to increase two percent, the fair value of the
goodwill would decrease by $49,400, but would not result in an impairment of goodwill.The Companys wireless spectrum licenses include Personal Communications Services (PCS) and
Local Multipoint Distribution Service (LMDS) licenses. In assessing the recoverability of the
Companys PCS licenses, the Company obtained an independent valuation in 2004, which reviewed
transactions involving sales of comparable wireless spectrum licenses in the aftermarket, using
characteristics of the license and the related market, including geographic location, market
size, megahertz frequency and population density.In assessing the recoverability of the Companys LMDS licenses, in 2004 the Company obtained an
independent valuation, as comparable license sales data was not available. The independent
valuation estimates fair value of the Companys LMDS licenses using a discounted cash flow
model. Assumptions used in this model include the following:  
    cash flow assumptions regarding investment in network facilities, distribution channels
and customer base (the assumptions underlying these inputs are based upon a combination of
historical results and trends, new industry developments and the Companys business plans);
    a 20% weighted average cost of capital based on industry weighted averaged cost of
capital adjusted to reflect the inherent risks associated with the introduction of a new
service offering; and
    a 3% terminal value growth rate.  The use of different estimates or assumptions within the discounted cash flow model when
determining fair value of the Companys LMDS licenses could result in different values for these
licenses. For example, the Company used a discount rate of 20% and a terminal growth rate of 3%
in its assessment of fair value in 2004. If the discount rate were to increase one percent, the
fair value of the LMDS licenses would decrease by $600, which would result in an impairment
charge of approximately $140 based on the carrying value of the LMDS licenses as of December 31,
2004. In addition, the Companys LMDS licenses may be impaired in the near future if the
estimates and assumptions used in the 2004 LMDS license discounted cash flow model are not met.If the estimated fair value is less than the carrying value, then the carrying value is written
down to the fair value. As a result of the Companys annual test in 2004, no impairment of
either goodwill or PCS or LMDS licenses was indicated. Further, during the quarter ended March
31, 2005, the Company was unaware of any events or changes in circumstance that would require a
test of impairment that may potentially reduce the fair value below the carrying value.
    Total revenues from telephone services are affected by rates authorized by
various regulatory agencies. The FCC monitors SureWest Telephones interstate earnings through
the use of annual cost separation studies prepared by SureWest Telephone. The FCC establishes
rules that carriers must follow in the preparation of the annual studies. Based on these
rules, the Company is required to prospectively set its annual interstate rates based on the
aforementioned cost separation studies. These cost studies include estimates and assumptions
regarding various financial data including operating expenses, taxes and investment in
property, plant and equipment. Non-financial data estimates are also utilized in the
preparation of these cost studies, including projected demand usage and detailed network
information. The Company must also make estimates of the jurisdictional separation of this
data to assign current financial and operating data to the interstate or intrastate
jurisdiction. These estimates are finalized in future periods as actual data becomes available
to complete the separation studies. Additionally, certain FCC rules regarding interstate
shareable earnings obligations have not yet been clarified as to whether the Companys rate
filings are deemed lawful and, therefore, protected from over-earnings liability. Further, the
Companys separation studies include estimates and assumptions regarding issues before the FCC
involving intercarrier interconnection, Internet traffic, and traffic utilizing Internet
Protocol. The Company also participates in the NECA pool for certain interstate revenues. In
addition to the 25




---



##### Table of Contents



estimates noted above, the Companys earned rate-of-return from its participation in the NECA
pool can also be impacted by the earnings and data of other carriers who participate in the
pool.In accordance with the NRF, SureWest Telephone is subject to ongoing monitoring and reporting
requirements by the CPUC, and it was initially required to share earnings with customers based
on its earned annual rate-of-return. The Company utilizes models, which rely on estimates
regarding the jurisdictional separation of financial data and operational data into the
interstate jurisdictions as discussed previously for the purposes of calculating its earned
annual rate-of-return. However, as discussed more fully in Note 3, SureWest Telephone has
entered into a settlement agreement, which was approved by the CPUC in November 2004, to cease
intrastate sharing requirements beginning January 1, 2005 through at least December 31, 2010.
The settlement agreement also resolves existing sharing obligations and related earnings issues
for the monitoring periods 2000-2004.In addition, the Company must make estimates and assumptions regarding various issues before the
FCC and CPUC involving intercarrier interconnection, Internet traffic, traffic utilizing
Internet Protocol, methods used to allocate costs for services provided by SureWest
Communications and SureWest Telephone to its affiliates and the treatment of certain plant and
tax costs, including internal-use software costs.As a result of these estimates and assumptions, it is reasonably possible that managements
estimates of SureWest Telephones interstate shareable earnings obligations could change in the
near term, and the amounts involved could be material. For example, the CPUC approved a
settlement agreement on November 19, 2004 that resolved the Companys intrastate shareable
earnings for the years 2000 through 2004. In accordance with this settlement agreement, the
Company recorded $2,948 in local revenues due to a change in accounting estimate in the fourth
quarter of 2004 (for a more detailed discussion regarding the settlement agreement, see
Regulation and Contractual and Estimated Shareable Earnings Obligationswithin Note 3 to the
Companys condensed consolidated financial statements). This increase in revenue resulted in a
decrease of the Companys net loss by $2,046 ($0.14 per share). In addition, in 2002 the Company
made changes in its estimates for interstate shareable earnings obligations for approximately
$5,800, principally due to the D.C. Circuit Court of Appeals decision issued in May 2002, which
determined that a tariff filed properly under Section 204 streamlined procedures and allowed
to go into effect without suspension is deemed lawful. Therefore, the carrier is not
subsequently obligated to pay refunds for earnings higher than the permitted rate of return as
prescribed by the FCC for that monitoring period.
    The Company recognizes revenue when (i) persuasive
evidence of an arrangement between the Company and
the customer exists, (ii) delivery of the product to
the customer has occurred or service has been
provided to the customer, (iii) the price to the
customer is fixed or determinable and (iv)
collectibility of the sales price is reasonably
assured.
    The Company maintains allowances for doubtful
accounts for estimated losses resulting from the
potential inability of its customers to make required
payments. In evaluating the collectibility of its
accounts receivable, the Company assesses a number of
factors including a specific customers or carriers
ability to meet its financial obligations to the
Company, the length of time the receivable has been
past due and historical and future expectations of
conditions that may impact the Companys ability to
collect its accounts receivable. If circumstances
change or economic conditions worsen such that the
Companys past collection experience is no longer
relevant, the Companys estimate of the
recoverability of its accounts receivable could be
further reduced from the levels reflected in the
Companys condensed consolidated balance sheet. If
uncollectibility of the Companys billed revenue
changes by 1%, the Company would expect an increase
in uncollectible expense of approximately $2,200. As
of March 31, 2005, the Company had three customers
that accounted for 3% of consolidated accounts
receivable in the aggregate. Although management
believes that these customers are creditworthy, a
severe adverse impact on their business operations
could have a corresponding material effect on their
ability to pay timely and, therefore, on the
Companys results of operations, cash flows and
financial condition. In addition, certain revenues
are subject to refund if the customer terminates
services or returns equipment within a stipulated
time period, or if certain performance criteria are
not met. Accordingly, the Company maintains accounts
receivable allowances and recognizes certain customer
refund liabilities, through 26




---



##### Table of Contents



charges to revenues, based on the Companys best estimates of the resolution of
these contingencies, which are based on historical experience.
    The Company states its inventories held for sale at
lower of cost or market. In assessing the ultimate
recoverability of inventories, the Company is
required to make estimates regarding future customer
demand and technological advances of equipment.
    Property, plant and equipment are recorded at cost.
Retirements and other reductions of regulated
telephone plant and equipment are charged against
accumulated depreciation with no gain or loss
recognized in accordance with the composite group
remaining life methodology utilized for telephone
plant assets. When property applicable to
non-telephone operations is sold or retired, the
asset and related accumulated depreciation are
removed from the accounts and the associated gain or
loss is recognized. Property, plant and equipment is
depreciated or amortized using the straight-line
method over their estimated economic lives. The
economic lives are estimated at the time the assets
are acquired and are based on historical experience
with similar assets, as well as anticipated
technological or other changes. If technological
changes were to occur more rapidly than anticipated
or differently than anticipated, the economic lives
assigned to these assets may need to be shortened,
resulting in the recognition of increased
depreciation and amortization expense in future
periods. Likewise, if the anticipated technological
or other changes occur more slowly than anticipated,
the life of the asset group could be extended based
on the life assigned to new assets added to the
group. This could result in a reduction of
depreciation and amortization expense in future
periods. The Company reviews the estimated useful
lives of its property, plant and equipment once every
three years, or when events or circumstances indicate
that the carrying amount may not be recoverable over
the remaining lives of the assets. In assessing the
recoverability of the Companys property, plant and
equipment, the Company must make assumptions
regarding estimated future cash flows and other
factors to determine the fair value of the respective
assets.
    The Company accounts for asset retirement obligations
in accordance with SFAS No. 143, Accounting for Asset
Retirement Obligations, which requires the Company to
recognize a retirement obligation (future cost of
removal) when a legal obligation exists to remove
plant at some point in the future. The Company
believes it may have potential retirement obligations
relating to its wireless cell sites. Based on terms
outlined in its tower leases, the Company is
obligated to return the land or facilities to their
original condition at the end of the cell site lease
term, should the lease be terminated. The Company has
used a probability-weighted cash flow approach in
estimating its potential retirement obligation. The
Company calculates the net present value of the
retirement obligation assuming an inflation rate of
3%, a discount rate of 7% and a market risk premium
of 4%. The Company has also assumed the settlement
date is 25 years from the date the asset is placed
into service. The Company has also used a
probability-weighted assessment to address the
uncertainty regarding the timing of future cash flows
to settle the potential liability. The Company
believes that utilizing probabilities less than 100%
is appropriate because the Company believes the
likelihood of incurring material asset retirement
expenditures is remote. The Company monitors the
estimates and assumptions used in determining its
potential asset retirement obligations for its cell
sites. However, the Company believes it is remote
that any future adjustment to its asset retirement
liability for obligations existing as of March 31,
2005 will be material to the Companys condensed
consolidated financial statements.
    The Company accounts for income taxes using the liability method. Under this method,
deferred tax assets and liabilities are determined based on differences between the financial
reporting and tax bases of assets and liabilities and are measured using the enacted tax rates
and laws that are expected to be in effect when the differences are expected to reverse. The
Company does not have a valuation allowance on its deferred tax asset as of March 31, 2005 or
2004 because it believes it is more likely than not that such deferred tax asset will be
realized. Should the Company determine that it would not be able to realize all or part of its
deferred tax asset in the future, an adjustment to the deferred tax asset would be charged to
income in the period in which the determination was made.
    The Company has pension and post-retirement benefit costs and obligations. The Companys
pension and post-retirement benefit obligations are actuarially determined based on estimates
of discount rates, long-term rates 27




---



##### Table of Contents



of return on plan assets and increases in future compensation levels. Changes in these
estimates and other factors could significantly impact the Companys pension and
post-retirement benefit costs and obligations. Assumed health care cost trend rates have a
significant effect on the amounts reported for the health care plans. A one-percentage-point
change in assumed health care cost trend rates would have the following effects: 1-Percentage-
    
    
    1-Percentage-Point Increase
    
    
    Point DecreaseEffect on total 2004 service and interest cost
    
    $
    72
    
    
    $
    (61
    )Effect on post-retirement benefit obligation
as of December 31, 2004
    
    $
    526
    
    
    $
    (499
    )
  The discount rate is determined based on the current yields on high quality corporate
fixed-income investments with maturities corresponding to the expected duration of the benefit
obligations. During 2005, the Company expects the discount rate to remain at 5.75%, which is
consistent with the prior year.In 2004, the Company used an expected long-term rate of return of 8.50%. For 2005, the Company
does not believe the expected long-term rate will change significantly. The expected long-term
rate of return on plan assets is determined based on the current and projected investment
portfolio mix and estimated long-term investment returns for each asset class. The projected
portfolio mix of the plan assets is developed in consideration of the expected duration of
related plan obligations and private equity positions. The expected return on plan assets is
determined by applying the expected long-term rate of return to the market-value of plan assets.The future compensation levels are based on recent experience as well as future expectations.
During 2005 the Company expects its future compensation level to remain consistent at 5%, which
is consistent with the prior year.
    The Company is a party to a variety of litigation, regulatory proceedings and other
contingencies that arise in the ordinary course of business. The Company is required to assess
the likelihood of any adverse judgments or outcomes to these matters, as well as potential
ranges of probable losses for certain of these matters. The determination of the liabilities
required, if any, for loss contingencies is made after careful analysis of each individual
issue. In the opinion of management, the ultimate outcome of these matters will not materially
affect the Companys consolidated financial position and results of operations.
    The Company currently sponsors two Equity Incentive Plans (the Plans) for certain
employees, outside directors and consultants of the Company, which were approved by the
Companys shareholders. The Plans permit issuance by the Company of awards in the form of
restricted shares, stock units, performance shares, stock options and stock appreciation
rights. Effective January 1, 2003, the Company adopted the preferable fair value recognition
provisions of SFAS No. 123, Accounting for Stock-Based Compensation.Under the prospective
transition method selected by the Company, as described in SFAS No. 148, Accounting for
Stock-Based Compensation-Transition and Disclosure, compensation expense was recognized
beginning in 2003 for all employee awards granted, modified or settled after January 1, 2003.
This change in accounting for stock-based compensation resulted in increased compensation
expense of $5 and $9, which decreased net income by $3 (no effect on earnings per share) and
$5 (no effect on earnings per share) for the quarters ended March 31, 2005 and 2004,
respectively.The Company voluntarily made the choice to change to the preferable method of accounting for
employee stock options in accordance with SFAS No. 123. The Company concluded that stock
options are a form of employee compensation expense and, therefore, it is appropriate that
these expenses be recorded in the results of operations to more clearly reflect economic
reality.The Black-Scholes-Merton option pricing model includes assumptions regarding dividend yields,
expected volatility, expected lives and risk-free interest rates. These assumptions reflect
managements best estimates, 28




---



##### Table of Contents



but these items involve inherent uncertainties based on market
conditions generally outside of the control of the Company. As a result, if other assumptions
had been used in the current period, stock-based compensation expense could have been materially
different. If management uses different assumptions in future periods, stock-based compensation
expense could be materially impacted in future years. Recent Accounting Pronouncements In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123 (revised
2004), Share-Based Payment(SFAS No. 123(R)), which is a revision of SFAS No. 123.SFAS No.
123(R) supersedes Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to
Employees,and amends SFAS No. 95, Statement of Cash Flows.Generally, the approach in SFAS No.
123(R) is similar to the approach described in SFAS No. 123. However, SFAS No. 123(R) requires all
share-based payments to employees, including grants of employee stock options, to be recognized in
the statement of operations based on their fair values. Pro forma disclosure is no longer an
alternative. SFAS No. 123(R) as originally issued was to be effective for public companies for interim or annual
periods beginning after June 15, 2005. However, in April 2005 the Securities and Exchange
Commission (the SEC) announced that companies may implement SFAS No. 123(R) at the beginning of
their next fiscal year (instead of their next reporting period) beginning after June 15, 2005. The
effective date of the new standard for the Companys consolidated financial statements is January
1, 2006 (beginning with the reporting period ending March 31, 2006). Early adoption will be
permitted in periods in which financial statements have not yet been issued. The Company expects to
adopt SFAS No. 123(R) on January 1, 2006. SFAS No. 123(R) permits public companies to adopt its requirements using one of two methods:  1.
    A modified prospective method in which compensation cost is recognized
beginning with the effective date (a) based on the requirements of SFAS No. 123(R) for
all share-based payments granted after the effective date and (b) based on the
requirements of SFAS No. 123 for all awards granted to employees prior to the effective
date of SFAS No. 123(R) that remain unvested on the effective date.2.
    A modified retrospective method, which includes the requirements of the
modified prospective method described above, but also permits entities to restate their
financial statements based on the amounts previously recognized under SFAS No. 123 for
purposes of pro forma disclosures either for (a) all prior periods presented or (b)
prior interim periods of the year of adoption. The Company is in the process of evaluating which method of adoption it will use to adopt SFAS No.
123(R). The Company does not believe the adoption of this new guidance will have a material effect
on its condensed consolidated financial position, results of operations or cash flows. In March 2005, the FASB issued Interpretation (FIN) No. 47, Accounting for Conditional Asset
Retirement Obligations. FIN No. 47 clarifies that the term conditional asset retirement
obligation as used in SFAS No. 143, Accounting for Asset Retirement Obligations, refers to a legal
obligation to perform an asset retirement activity in which the timing and/or method of settlement
are conditional on a future event that may or may not be within the control of the entity. FIN No.
47 requires an entity to recognize a liability for the fair value of a conditional asset retirement
obligation if the fair value of the liability can be reasonably estimated. FIN No. 47 is effective
no later than the end of fiscal years ending after December 15, 2005. The Company is currently
evaluating the effect FIN No. 47 will have on its consolidated financial position, results of
operations or cash flows. 29




---



##### Table of Contents



Factors That Could Affect Future Results As a result of the following factors, as well as other variables affecting our operating results,
past financial performance may not be a reliable indicator of future performance, and historical
trends should not necessarily be used to anticipate results or trends in future periods. Representative examples of these factors include (without limitation) the following:  We expect to continue to face significant competition in all parts of our business and the level
of competition is expected to intensify.The telecommunications industry is highly competitive.
We face actual or potential competition from many existing and emerging companies, including
other incumbent and competitive local telephone companies, long-distance carriers and resellers,
wireless telephone companies, Internet service providers, satellite companies and cable
television companies. We may not be able to successfully anticipate and respond to various
competitive factors affecting the industry, including regulatory changes that may affect our
competitors and us differently, new technologies and services that may be introduced, changes in
consumer preferences, demographic trends and discount pricing strategies by competitors. As the
incumbent carrier in Sacramento, SBC Communications enjoys certain business advantages,
including its size, financial resources, favorable regulatory position, brand recognition and
connection to virtually all of our customers and potential customers there. As the largest
cable operator in Sacramento and Placer County, Comcast enjoys certain business advantages,
including its size, financial resources, ownership or superior access to programming and other
content, brand recognition, and first-in-the-field advantages with a customer base that
generates positive cash flow for its operations. We face intense competition in our markets for
long-distance, Internet access and other ancillary services that are important to our business
and to our growth strategy.We must adapt to rapid technological change. Technological developments could increase our
costs and cause a decline in demand for our services. In addition, technology changes can
reduce the costs of entry for others and give competitors significant new advantages. If we do
not replace or upgrade technology and equipment that becomes obsolete, we will be unable to
compete effectively because we will not be able to meet the needs or expectations of our
customers, and we may be placed at a cost disadvantage in offering our services. Additionally,
replacing or upgrading our infrastructure in the future could result in significant capital
expenditures.We are subject to a complex and uncertain regulatory environment.Some parts of our business
are extensively regulated, and the nature of regulation continues to undergo fundamental change
and reinterpretation. Many businesses that compete with the Company are comparatively less
regulated. Many significant regulatory decisions have had to be accommodated in recent years,
and there are pending decisions on issues affecting the Company that are of great importance.Our operations have undergone material changes, and our actual operating results can be expected
to differ from the results indicated in our historical financial statements. As a result of our
2002 acquisition of assets, which launched our residential broadband business, and the
subsequent expansion of our cable television business, our mix of operating assets differs from
those operations upon which our historical financial statements are based. Consequently, our
historical financial statements may not be reliable as an indicator of future results.Our success depends upon our ability to manage our growth and expansion. If our acquisitions
and growth initiatives are not successful, we could suffer an adverse effect on our business and
results of operations. Our growth strategy will continue to require us to invest significant
capital in facilities and services that may not achieve the desired returns. Our future success
depends, in part, upon our ability to manage our growth, including our ability to build network
and related facilities to serve new customers, integrate our operations to take advantage of new
capabilities and systems; attract and retain skilled personnel across the Company, effectively
manage the demands of day to day operations in new areas while attempting to execute our
business strategy, and realize the projected growth and revenue targets developed by Company
management.We are reliant on support funds provided under federal and state laws. We receive revenues from
various federal or state support funds: interstate common line support from the Universal
Service Program, CHCF-B 30




---



##### Table of Contents



and Universal Lifeline Service Fund. These governmental programs are reviewed and amended from
time to time, and are likely to change in the near future. As described in the Regulation
section above, the Company currently receives funding of $11,500 annually from the CHCF, a
program designed by the CPUC to establish a fair and equitable local rate structure and to
reduce any disparity in the rates charged by certain telephone companies serving high-cost
areas. The CHCF is scheduled to expire January 1, 2009. The outcome and impact on the Companys operations resulting
from future changes to these governmental programs cannot be determined at this time.We could be harmed by the recent adverse developments affecting other communications companies.
There have been numerous bankruptcies and other financial difficulties experienced by other
carriers and suppliers in the telecommunications and Internet sectors. Similar situations with
our suppliers, some of whom provide products and services for which there are few substitutes,
could cause us to experience delays, service interruptions or additional expenses. Situations
with carrier and other customers could affect our ability to collect services that have been
provided.We depend on third parties, over whom we have no control, to deliver our services. Because of
the interconnected nature of the telecommunications industry, we depend heavily on other local
telephone companies, long-distance carriers, and numerous other third parties to deliver our
services. In addition, we are dependent on easements, franchises and licenses from various
private parties such as established telephone companies and other utilities, railroads,
long-distance companies, and from state highway authorities, local governments and transit
authorities for access to aerial pole space, underground conduits and other rights-of-way in
order to construct and operate our networks. The failure to maintain in effect the necessary
third party arrangements on acceptable terms would have an adverse effect on our ability to
conduct our business.We are subject to new corporate governance and internal control reporting requirements, and our
failure to comply with existing and future requirements could adversely affect our business.
Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002 (Section 404) and related Securities
and Exchange Commission rules, we have previously issued a report of managements assessment of
the effectiveness of our internal controls at December 31, 2004. In addition, our Independent
Registered Public Accounting Firm audited and reported on, managements assessment. Management
concluded that the Companys internal control over financial reporting was not effective at
December 31, 2004 as a result of a material weakness identified at December 31, 2004, for which
remediation efforts are ongoing. If our deficiencies are not adequately addressed, we could
experience accounting errors that could result in misstatements of our financial position and
results of operations, potential restatements of our financial statements or otherwise adversely
affect our business, reputation and results of operations. Inferior internal controls could
also cause investors to lose confidence in our reported financial information, which could have
a negative effect on the trading price of our securities.If we are unable to effectively and efficiently implement the necessary initiatives to eliminate
the material weakness identified in our internal controls and procedures, there could be an
adverse affect on our operations or financial results.In connection with the Managements
Report on Internal Control over Financial Reporting at December 31, 2004, management identified
a material weakness in the Companys internal control over financial reporting relating to the
accounting for property, plant and equipment, which resulted from a control weakness that caused
the following conditions: The Company was unable to completely reconcile its plant in service
and plant under construction subsidiary ledgers to the corresponding general ledger balances for
periods throughout 2004 and as of December 31, 2004. Management believes these unreconciled
differences were attributable principally to deficiencies in the reliability of the Companys
information system interfaces between the general ledger and the property, plant and equipment
subsidiary ledgers. In addition, during 2004, several errors occurred in the Companys periodic
depreciation and capitalized interest calculations that were more than inconsequential.
Additionally, as of December 31, 2004, the Company did not have effective procedures with which
to determine the cost bases of property, plant and equipment that had been retired. Moreover,
certain manual internal controls pertaining to property, plant and equipment implemented by the
Company during the third quarter of 2004 were not operating effectively as of December 31, 2004.
These matters required the Company to record adjustments to both its annual and interim 2004
consolidated financial statements. The significant accounts affected by this material weakness
are property, plant and equipment and related accumulated depreciation included in the Companys
consolidated balance sheets, and depreciation expense and 31




---



##### Table of Contents



interest expense included in the Companys consolidated statements of operations. Due to this
material weakness, management believes that as of March 31, 2005, the Companys disclosure
controls and procedures were not effective.During the year ended December 31, 2004 and during the first quarter of 2005, we implemented
various initiatives, and will be implementing additional initiatives during the remainder of
2005, which are intended to improve our internal controls, and address the matters discussed in
Managements Report on Internal Control over Financial Reporting. The implementation of the
initiatives and the consideration of additional necessary improvements are among our highest
priorities. The Board of Directors, under the direction of the Audit Committee, will
continually assess the progress of the initiatives and the improvements, and take further
actions as deemed necessary. Until the identified material weakness is eliminated, there is a
risk of an adverse affect on our operations or financial results. 32




---



##### Table of Contents



Regulatory and Legal Matters SureWest Telephone is subject to regulation by the FCC and CPUC. In the past, there have been
various proceedings before these agencies to which SureWest Telephone has been a party. In 1996,
Congress passed the Telecommunications Act of 1996 (the Act), which significantly changed the
regulatory environment for telecommunications companies. Beginning in 1996, the FCC conducted
proceedings and adopted orders implementing the Acts provisions to open local exchange service
markets, such as the market of SureWest Telephone, to competition. These proceedings and orders
address interconnection, intercarrier compensation, access charges, universal service and
IP-enabled service. With respect to local competition, the FCC rules outline pricing methodologies
for the states to follow when setting rates for incumbent carriers (such as SureWest Telephone) to
charge competitors for resale, interconnection and unbundled network elements. Due to the ongoing actions taken by the FCC to promulgate rules and regulations on interconnection
access charges and universal service reform, and the various on-going legal challenges considering
the validity of these FCC orders, it is not yet possible to determine fully the impact of the Act
and related FCC regulations on SureWest Telephones operations. The Companys financial condition and results of operations have been and will be affected by
recent and future proceedings before the CPUC and FCC. Pending before the FCC and CPUC are
proceedings, which are considering:  
    Additional rules governing the opening of markets to competition;
    The goals and definition of universal telephone service in a changing
environment, including examination of subsidy support mechanisms for subscribers
of different carriers (including incumbent carriers) and in various geographic
areas;
    Rules that will provide non-discriminatory access by competing service
providers to the network capabilities of local exchange carriers; and
    The regulated rates and earnings of SureWest Telephone. The Company has been involved in a proceeding at the CPUC that has considered the continued need
for certain sharing requirements in the intrastate jurisdiction, and in connection with that
review, has also considered the issues of whether the Company overearned in the intrastate
jurisdiction in recent monitoring periods, and if so, the amount of such overearnings that should
be shared with customers. In July 2004, the Company entered into a settlement agreement with the
other parties in the proceeding, the ORA and TURN, to resolve all issues in the proceeding. In
November 2004, the CPUC approved the settlement agreement. Among other things, the settlement
agreement resolves all earnings issues for the monitoring periods 2000-2004, put into place a
surcredit mechanism for the amount of the settlement, and suspends the requirement for any
intrastate sharing for later monitoring periods from January 1, 2005 through at least December 31,
2010. There are a number of pending and anticipated other regulatory proceedings occurring at the federal
and state levels that may have a material impact on SureWest Telephone. These regulatory
proceedings include, but are not limited to, consideration of changes to the interstate universal
service fund, intercarrier compensation, reform and the regulation of local exchange carriers, and
regulation of IPenabled services. The outcomes and impact on SureWest Telephones operations of
these proceedings and related court matters cannot be determined at this time. The eventual impact on the Company of the effect of all the proceedings described above cannot
presently be determined. 33




---



##### Table of Contents



ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Companys 2004 Annual Report on Form 10-K contains certain disclosures about the Companys
limited exposure to market risk for changes in interest rates. There have been no material changes
to the information provided which would require additional disclosures as of the date of this
filing. 34




---



##### Table of Contents



ITEM 4. CONTROLS AND PROCEDURES As of the end of the period covered by this report, we carried out an evaluation, under the
supervision and with the participation of our management, including our Chief Executive Officer and
Chief Financial Officer, of the effectiveness of the design and operation of our disclosure
controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as
amended). Based upon, and as of the date of this evaluation, and due to the material weakness in
the Companys internal control over accounting for property, plant and equipment (as described
below), the Chief Executive Officer and Chief Financial Officer have concluded that, the Companys
disclosure controls and procedures were not effective, at the reasonable assurance level, to ensure
that information required to be disclosed by the Company in reports that it files or submits under
the Securities Exchange Act is authorized, recorded, processed, summarized and reported within the
time periods specified in SEC rules and forms. Management of the Company is responsible for establishing and maintaining adequate internal control
over financial reporting. The Companys internal control system was designed to provide reasonable
assurance to the Companys management, Board of Directors and Audit Committee regarding the
reliability of financial reporting and the preparation of published financial statements in
accordance with generally accepted accounting principles. A material weakness is a significant deficiency, or combination of significant deficiencies, that
results in more than a remote likelihood that a material misstatement of the annual or interim
financial statements will not be prevented or detected. A significant deficiency is a control
deficiency, or combination of control deficiencies, that adversely affects the companys ability to
initiate, authorize, record, process, or report external financial data reliably in accordance with
generally accepted accounting principles such that there is more than a remote likelihood that a
misstatement of the companys annual or interim financial statements that is more than
inconsequential will not be prevented or detected. The Company has identified a material weakness in the Companys internal control over financial
reporting relating to the accounting for property, plant and equipment, which resulted from control
weaknesses that caused the following conditions: The Company was unable to completely reconcile
its plant in service and plant under construction subsidiary ledgers to the corresponding general
ledger balances for periods throughout 2004 and as of December 31, 2004. Management believes these
unreconciled differences are attributable principally to deficiencies in the reliability of the
Companys information system interfaces between the general ledger and the property, plant and
equipment subsidiary ledgers. In addition, during 2004, several errors occurred in the Companys
periodic depreciation and capitalized interest calculations that were more than inconsequential.
Additionally, as of December 31, 2004, the Company did not have effective procedures with which to
determine the cost bases of property, plant and equipment that had been retired. Moreover, certain
manual internal controls pertaining to property, plant and equipment implemented by the Company
during the third quarter of 2004 were not operating effectively as of December 31, 2004. These
matters required the Company to record adjustments to both its annual and interim 2004 consolidated
financial statements. The significant accounts affected by this material weakness are property,
plant and equipment and related accumulated depreciation included in the Companys consolidated
balance sheets, and depreciation expense and interest expense included in the Companys
consolidated statements of operations. Remediation Steps Related to Material Weakness The Company has or intends to implement the following remediation steps to address the material
weakness discussed above:  
    Enhancements to the Companys enterprise resource planning and accounting software, for
which implementation commenced in the second quarter of 2004, and which is ongoing.
    The performance of additional detailed reviews, on a monthly basis, of all open
construction projects by the appropriate project manager to validate the results generated
by the Companys systems. 35




---



##### Table of Contents




    The review of systematic routines, which generate and transfer data between modules
within the enterprise resource planning system, as necessary to determine if the routines
are generating accurate reports.
    Timely detailed reviews by management will occur to provide reasonable assurance that
manual controls are operating effectively. The Company believes that it is reasonably likely the material weakness related to property, plant
and equipment will be remediated and tested in 2005. Other Internal Control Matters Management of the Company, during its assessment of the effectiveness of the Companys internal
control over financial reporting as of December 31, 2004, identified the following other internal
control deficiencies: Information Technology  
    The Company has identified certain deficiencies related to its Information Technology
general and application controls. In response to these deficiencies, during the third
quarter of 2004, the Company engaged an outside consulting firm to design and implement
changes to the controls in an effort to remediate the identified deficiencies. Although the
Company has made progress in its remediation efforts, these efforts were not completed by
December 31, 2004. The Company believes that it is reasonably likely that this control
deficiency will be remediated and tested in 2005. The Company has commenced its
remediation testing relating to specific Information Technology controls discussed above,
and based on the preliminary results, it appears that the remediation efforts are improving
the overall controls over the Information Technology area. However, the Company is not able
to make conclusions relative to the overall effectiveness of the improvements. Accounting
Personnel, Policies and Procedures  
    During managements assessment of internal controls, it was noted that the quality of
evidence was not consistent across the Companys controls. Management put into place
various remediation steps during the third and fourth quarters of 2004 which it believed
would improve the overall quality of the control documentation. During managements
testing of internal controls in 2005, we will determine if such remediation was effective
in improving the Companys overall quality of control documentation. In April 2005, the
Company commenced its 2005 testing of selected internal controls for the quarter ended
March 31, 2005, and anticipates completing its testing for the selected controls during the
second quarter of 2005. The Company will test the balance of its internal controls during
the remainder of 2005 and ending in the first quarter of 2006 with respect to the necessary
testing of year-end controls.  Change in Internal Control over Financial ReportingDuring the quarter ended March 31, 2005, the Company implemented various improvements to
internal controls, which included: (i) a continuation of the effort to review and validate the
integrity of the data contained in the Companys property, plant and equipment sub-modules and
(ii) the creation of a formal committee comprised of employees from the Companys Corporate
Finance, Information Technology and Human Resources departments to assess the timing of the
Companys monthly financial statement close process.In February 2005, the Company completed its REWARD program, which resulted in the early
retirement of approximately 7% of the workforce. In addition, during the quarter ended March
31, 2005 and effective April 1, 2005, the Company completed a reorganization to better align its
business into functional support groups.In February 2005, the Company announced that it had begun a search for a President and CEO/Elect
as a result of the indication by Brian H. Strom of his desire to ultimately retire from those
positions. The Company intends to conduct and complete the search for a successor that will
allow the President and CEO/Elect to serve with Mr. Strom prior to his formal retirement to
assure an effective and smooth transition. 36




---



##### Table of Contents



The effects on internal controls of the REWARD program, the reorganization and the officer
transition have not yet been fully assessed by the Company.Except for the items discussed above, there has been no change in the Companys internal control
over financial reporting during the quarter ended March 31, 2005 that has materially affected,
or is reasonably likely to materially affect, the Companys control over financial reporting. 37




---



##### Table of Contents



PART II 
 ITEM 1. LEGAL PROCEEDINGS(Dollars in thousands) Except for the proceedings described below, the Company is not aware of any material pending legal
proceedings, other than ordinary routine litigation incidental to its business, to which it is a
party or to which any of its property is subject. In 1996, the California Public Utilities Commission (CPUC) issued a decision in connection with
SureWest Telephones general rate proceeding, which authorized SureWest Telephone to implement a
New Regulatory Framework (NRF) for services furnished within SureWest Telephones service area in
order to accommodate market and regulatory movement toward competition and greater pricing
flexibility. Under the NRF, SureWest Telephone is subject to ongoing monitoring and reporting
requirements, and it was initially required to share earnings with customers through a reduction of
revenues if its earned annual rate-of-return exceeds that authorized by the CPUC. In accordance with the requirements of its general rate case order, SureWest Telephone filed an
application for review of its NRF in 1999. In connection with this proceeding, the CPUCs Office of
Ratepayer Advocates (ORA) undertook a verification audit of SureWest Telephones non-regulated
and affiliated transactions pursuant to the general rate case and other CPUC orders. In June 2001,
the CPUC adopted its decision in this matter (the Decision). The Decision did not suspend the
sharing mechanism as SureWest Telephone had requested, and further provided that SureWest Telephone
must change the method used to allocate costs for services provided by SureWest Telephone to its
affiliates, the treatment of certain directory revenues and the treatment of internal-use software
costs. Additionally, in accordance with the provisions of the Decision, the Company recorded
certain liabilities and reductions of revenues relating to estimated intrastate shareable earnings
obligations. The Company has been involved in a proceeding at the CPUC that has considered the continued need
for certain sharing requirements in the intrastate jurisdiction, and in connection with that
review, has also considered the issues of whether the Company overearned in the intrastate
jurisdiction in recent monitoring periods, and if so, the amount of such overearnings that should
be shared with customers. In July 2004, the Company entered into a settlement agreement with the
other parties in the proceeding, the ORA and The Utility Reform Network (TURN), to resolve all
issues in the proceeding. In November 2004, the CPUC approved the settlement agreement. The
settlement agreement resolves all earnings issues for the monitoring periods 2000 through 2004, put
into place a surcredit mechanism for the amount of the settlement, and suspends the requirement for
any intrastate sharing for later monitoring periods from January 1, 2005 through at least December
31, 2010. Prior to January 1, 2002, SureWest Telephone billed SBC Communications (SBC) various charges for
certain local service and network access service revenues in accordance with certain agreements as
described below. In 1999, SBC expressed interest in withdrawing from the designated carrier plan
(DCP) for SureWest Telephones toll traffic. The DCP was a compensation arrangement between
SureWest Telephone and SBC for certain intrastate toll services. SureWest Telephone and SBC agreed
to allow the DCP arrangement to expire in December 2001. The termination of the DCP did not have a
material impact on the Companys consolidated financial position as of December 31, 2002 or results
of operations for the year then ended. In 1999, SBC also expressed interest in entering into a new, permanent compensation arrangement for
extended area service (EAS). At that time, SBC had been paying SureWest Telephone approximately
$11,500 per year for EAS pursuant to a Settlement Transition Agreement. In November 2000, the CPUC
authorized SBC to terminate its annual EAS payments to SureWest Telephone effective November 30,
2000. The CPUC authorized replacement funding to SureWest Telephone on an interim basis using funds
from the California High Cost Fund (CHCF). The CHCF is a program designed by the CPUC to
establish a fair and equitable local rate structure and to reduce any disparity in the rates
charged by telephone companies serving high-cost areas. The CHCF 38




---



##### Table of Contents



is scheduled to expire January 1, 2009. In
addition, the CPUC opened an Order Instituting Investigation (OII) for the purpose of determining
whether future recovery of all, none, or a portion of the approximate $11,500 annual payments
previously received from SBC should come from SureWest Telephones ratepayers or other regulatory
recovery mechanisms. This proceeding began in 2001, evidentiary hearings were held during 2002, and
briefing was completed in February 2003. In this proceeding, the ORA recommended that the CPUC
discontinue SureWest Telephones present interim EAS funding from the CHCF without replacement
revenues from ratepayers. The CPUC has made no indication as to what, if any, changes will be
forthcoming relating to EAS revenues. The results of these proceedings and their potential effects
on SureWest Telephone cannot yet be determined. SureWest Telephones operations may also be impacted by the Telecommunications Act of 1996 (the
Act). The Act significantly changed the regulatory environment for telecommunications companies.
Beginning in 1996, the Federal Communications Commission (FCC) conducted proceedings and adopted
orders implementing the Acts provisions to open local exchange service markets, such as the market
of SureWest Telephone, to competition. These proceedings and orders address interconnection, access
charges and universal service. Given the ongoing activities of the FCC to promulgate rules and regulations on interconnection,
access charges, and universal service reform, and the various on-going legal challenges considering
the validity of these FCC orders, it is not yet possible to determine fully the impact of the Act
and related FCC regulations on SureWest Telephones operations. There are a number of other regulatory proceedings occurring at the federal and state levels that
may have a material impact on SureWest Telephone. These regulatory proceedings include, but are not
limited to, consideration of changes to the jurisdictional separations process, the interstate
universal service fund, intercarrier compensation access charge reform and the regulation of local
exchange carriers and IP-enabled services. The outcomes and impact on SureWest Telephones
operations of these proceedings and related court matters cannot be determined at this time. The regulatory proceedings occurring at the state and federal levels described above may also
broaden the scope of competition in the provision of regulated services and change the rates and
rate structure for regulated services furnished by SureWest Telephone, the effects of which on
SureWest Telephone cannot yet be determined. 
 ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS Not applicable. 
 ITEM 3. DEFAULTS UPON SENIOR SECURITIES Not applicable. 
 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. 
 ITEM 5. OTHER INFORMATION Not applicable. 39




---



##### Table of Contents



ITEM 6. EXHIBITS (a) Index to Exhibits. MethodExhibit No.
    
    Description
    
    of Filing3.1
    
    Articles of Incorporation
of Registrant, together
with Certificate of
Amendment of Articles of
Incorporation dated January
25, 1996 and Certificate of
Amendment of Articles of
Incorporation dated June
21, 1996 (Filed as Exhibit
3(a) to Form 10-Q Quarterly
Report for the quarter
ended September 30, 1996)
    
    Incorporated by reference3.2
    
    Certificate of Amendment of
Articles of Incorporation
dated May 18, 2001 (Filed
as Exhibit 3(b) to Form
10-Q Quarterly Report for
the quarter ended June 30,
2001)
    
    Incorporated by reference3.3
    
    Bylaws of Registrant (Filed
as Exhibit 3(b) to Form
10-K Annual Report of the
Registrant for the year
ended December 31, 2000)
    
    Incorporated by reference4.1
    
    Shareholder Rights Plan
(Filed as Exhibit 2.1 to
Form 8-A Registration
Statement under the
Securities Act of 1934)
    
    Incorporated by reference10.1
    
    Note Purchase Agreement for
Series A Senior Notes in
the aggregate amount of
$40,000,000 dated December
9, 1998 (Filed as Exhibit
10(b) to Form 10-K Annual
Report of Registrant for
the year ended December 31,
1998)
    
    Incorporated by reference10.2
    
    Supplement to Note Purchase
Agreement for Series B
Senior Notes in the
aggregate amount of
$60,000,000 dated March 13,
2003 (Filed as Exhibit 99.1
to the Form 8-K filed March
13, 2003)
    
    Incorporated by reference10.3
    
    Business Loan Agreement of
Registrant with Bank of
America, dated March 15,
2000, as amended by
Amendment No. 1 dated as of
April 10, 2000 (Filed as
Exhibit 10(f) to Form 10-Q
Quarterly Report of
Registrant for the quarter
ended March 31, 2000), as
amended by Amendment No. 2
dated as of September 15,
2000, Amendment No. 3 dated
as of July 17, 2001, and
Amendment No. 4 dated as of
June 26, 2000 (Filed as
Exhibit 10(l) to Form 10-Q
Quarterly Report of
Registrant for the Quarter
ended June 30, 2002)
    
    Incorporated by reference10.4
    
    Amendment No. 5 to Business
Loan Agreement dated February
26, 2003 (filed as Exhibit
10(e) to Form 10-K Annual
Report of Registrant for the
year ended December 31, 2002)
    
    Incorporated by reference
 40




---



##### Table of Contents



MethodExhibit No.
    
    Description
    
    of Filing10.5
    
    Amendment No. 6 to Business
Loan Agreement dated as of
January 13, 2004 (Filed as
Exhibit 10.7 to Form 10-K/A
Annual Report of Registrant for
the year ended December 31,
2003)
    
    Incorporated by reference10.6
    
    Amendment No. 7 to Business Loan
Agreement dated as of March 25, 2004
(Filed as Exhibit 10.7 to Form 10-K/A
Annual Report of Registrant for the year
ended December 31, 2003)
    
    Incorporated by
reference10.7
    
    Amendment No. 8 to Business Loan
Agreement dated as of December 31, 2004
    
    Incorporated by
reference10.8
    
    1999 Restricted Stock Bonus Plan (Filed
as Exhibit 10(d) to Form 10-K Annual
Report of Registrant for the year ended
December 31, 1998)
    
    Incorporated by
reference10.9
    
    2000 Equity Incentive Plan, as amended
(filed as Exhibit 10.7 to Form 10-K/A
Annual Report of Registrant for year
ended December 31, 2003)
    
    Incorporated by
reference10.10
    
    SureWest KSOP (filed as Exhibit 4.1 to
Registration Statement on Form S-8 [No.
333-87222])
    
    Incorporated by
reference10.11
    
    Letter agreement dated January 16, 2001
between Registrant and Brian H. Strom
(Filed as Exhibit 10 (g) to Form 10-K
Annual Report of Registrant for the year
ended December 31, 2000)
    
    Incorporated by
reference10.12
    
    Letter agreement dated January 16, 2001
between Registrant and Jay B. Kinder
(Filed as Exhibit 10 (i) to Form 10-K
Annual Report of Registrant for the year
ended December 31, 2000)
    
    Incorporated by
reference10.13
    
    Letter agreement dated January 16, 2001
between Registrant and Bill M. DeMuth
(Filed as Exhibit 10.14 to Form 10-K/A
Annual Report of Registrant for the year
ended December 31, 2003)
    
    Incorporated by
reference10.14
    
    Letter agreement dated January 16, 2001
between Registrant and Fred A. Arcuri
(Filed as Exhibit 10.15 to Form 10-K/A
Annual Report of Registrant for the year
ended December 31, 2003)
    
    Incorporated by
reference10.15
    
    Letter agreement dated January
16, 2001 between Registrant
and Robert M. Burger (Filed as
Exhibit 10(k) to Form 10-K
Annual Report of Registrant
for the year ended December
31, 2000)
    
    Incorporated by reference10.16
    
    Restricted Stock Unit Award,
dated December 21, 2004,
between Registrant and Roger
J. Valine (Filed as Exhibit
10.15 to Form 10-K Annual
Report of Registrant for the
year ended December 31, 2004)
    
    Incorporated by reference
 41




---



##### Table of Contents



MethodExhibit No.
    
    Description
    
    of Filing10.17
    
    Form of Restricted Stock Unit
Award, dated December 21,
2004, between Registrant and
each of Guy R. Gibson, Steven
C. Oldham, John R. Roberts III
and Timothy D. Taron (Filed as
Exhibit 10.16 to Form 10-K
Annual Report of Registrant
for the year ended December
31, 2004)
    
    Incorporated by reference10.18
    
    Form of Restricted Stock Unit
Award, dated February 23,
2005, between Registrant and
Brian H. Strom (Filed as
Exhibit 10.17 to Form 10-K
Annual Report of Registrant
for the year ended December
31, 2004)
    
    Incorporated by reference10.19
    
    Form of Restricted Stock Unit
Award, dated February 23,
2005, between Registrant and
each of Fred A. Arcuri, Bill
M. DeMuth and Jay B. Kinder
(Filed as Exhibit 10.18 to
Form 10-K Annual Report of
Registrant for the year ended
December 31, 2004)
    
    Incorporated by reference10.20
    
    Form of Restricted Stock Unit
Award for Registrants 2000
Equity Incentive Plan (Filed
as Exhibit 10.19 to Form 10-K
Annual Report of Registrant
for the year ended December
31, 2004)
    
    Incorporated by reference10.21
    
    Form of Stock Option Agreement
for Registrants 2000 Equity
Incentive Plan (Filed as
Exhibit 10.20 to Form 10-K
Annual Report of Registrant
for the year ended December
31, 2004)
    
    Incorporated by reference10.22
    
    Form of Restricted Stock
Agreement for Registrants
2000 Equity Incentive Plan
(Filed as Exhibit 10.21 to
Form 10-K Annual Report of
Registrant for the year ended
December 31, 2004)
    
    Incorporated by reference31.1
    
    Certification of Brian H.
Strom, President and Chief
Executive Officer, as adopted
pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002
    
    Filed herewith31.2
    
    Certification of Philip A.
Grybas, Senior Vice President
and Chief Financial Officer,
as adopted pursuant to Section
302 of the Sarbanes-Oxley Act
of 2002
    
    Filed herewith32.1
    
    Certification of Brian H.
Strom, President and Chief
Executive Officer, pursuant to
18 U.S.C. Section 1350, as
adopted pursuant to Section
906 of the Sarbanes-Oxley Act
of 2002
    
    Filed herewith32.2
    
    Certification of Philip A.
Grybas, Senior Vice President
and Chief Financial Officer,
pursuant to 18 U.S.C. Section
1350, as adopted pursuant to
Section 906 of the
Sarbanes-Oxley Act of 2002
    
    Filed herewith
 42




---



##### Table of Contents



SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused
this report to be signed on its behalf by the undersigned, thereunto duly authorized. SUREWEST COMMUNICATIONS(Registrant)By:
    
    /s/ BRIAN H. STROMBrian H. Strom,President and Chief
Executive OfficerBy:
    
    /s/ PHILIP A. GRYBASPhilip A. Grybas,Senior Vice President and
Chief Financial Officer
 Date: May 4, 2005 43