Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
     EXCHANGE ACT OF 1934

 

     For the quarterly period ended June 30, 2008

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
     EXCHANGE ACT OF 1934

 

     For the transition period from              to             

Commission file number 001-32732

 

 

Embarq Corporation

(Exact name of registrant as specified in its charter)

 

 

 

Delaware    20-2923630

(State or other jurisdiction of

incorporation or organization)

  

(IRS Employer

Identification No.)

5454 W. 110th Street

Overland Park, Kansas

   66211
(Address of principal executive offices)    (Zip Code)

Registrant’s telephone number, including area code (913) 323-4637

(Former name, former address and former fiscal year, if changed since last report)

 

 

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 these reports), and (2) has been subject to these filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act (check one):

Large accelerated filer  x        Accelerated filer  ¨        Non-accelerated filer  ¨        Smaller reporting company  ¨

Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act). Yes ¨ No x

COMMON SHARES OUTSTANDING AT JULY 25, 2008:

COMMON STOCK: 142,506,790

 

 

 


Table of Contents

EMBARQ CORPORATION

TABLE OF CONTENTS

 

     Page
Reference

Part I – Financial Information

  

Item 1.

Financial Statements

   1

Consolidated Balance Sheets

   1

Consolidated Statements of Operations and Comprehensive Income (Unaudited)

   2

Consolidated Statements of Cash Flows (Unaudited)

   3

Consolidated Statement of Stockholders’ Equity (Unaudited)

   4

Condensed Notes to Consolidated Financial Statements (Unaudited)

   5

Report of Independent Registered Public Accounting Firm

   11

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   12

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

   22

Item 4.

Controls and Procedures

   22

Part II – Other Information

  

Item 1.

Legal Proceedings

   23

Item 1A.

Risk Factors

   23

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

   23

Item 3.

Defaults Upon Senior Securities

   23

Item 4.

Submission of Matters to a Vote of Security Holders

   24

Item 5.

Other Information

   24

Item 6.

Exhibits

   25

Signatures

   27


Table of Contents

PART I – FINANCIAL INFORMATION

Item  1. Financial Statements

EMBARQ CORPORATION

CONSOLIDATED BALANCE SHEETS

(millions, except per share data)

 

     As of June 30,
2008
    As of December 31,
2007
 
     (Unaudited)        

Assets

    

Current assets

    

Cash and equivalents

   $ 50     $ 69  

Accounts receivable, net of allowance for doubtful accounts of $57 and $60

     581       616  

Inventories, net

     119       138  

Deferred tax assets

     78       76  

Prepaid expenses and other current assets

     87       87  
                

Total current assets

     915       986  

Gross property, plant and equipment

     20,949       20,802  

Accumulated depreciation

     (13,360 )     (13,054 )
                

Net property, plant and equipment

     7,589       7,748  

Goodwill

     27       27  

Prepaid pension asset

     130       108  

Other assets

     45       32  
                

Total

   $ 8,706     $ 8,901  
                

Liabilities and Stockholders’ Equity

    

Current liabilities

    

Current maturities of long-term debt

   $ 82     $ 99  

Accounts payable

     337       387  

Payroll and employee benefits

     146       208  

Accrued income taxes

     68       27  

Accrued operating taxes

     105       97  

Deferred revenue

     189       202  

Accrued interest

     59       56  

Other current liabilities

     94       122  
                

Total current liabilities

     1,080       1,198  

Noncurrent liabilities

    

Long-term debt

     5,888       5,779  

Deferred income taxes

     1,114       1,130  

Benefit plan obligations

     318       320  

Other noncurrent liabilities

     217       210  
                

Total noncurrent liabilities

     7,537       7,439  

Stockholders’ equity

    

Preferred stock, $.01 par value; 200 shares authorized; no shares issued

     —         —    

Common stock, $.01 par value; 1,250 shares authorized; 153.8 and 153.1 shares issued; 144.2 and 153.1 shares outstanding

     2       2  

Paid-in capital

     (214 )     (231 )

Retained earnings

     832       623  

Accumulated other comprehensive income (loss)

     (130 )     (130 )

Treasury stock, 9.6 and no shares held in treasury

     (401 )     —    
                

Total stockholders’ equity

     89       264  
                

Total

   $ 8,706     $ 8,901  
                

See accompanying Condensed Notes to Consolidated Financial Statements (Unaudited)

 

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EMBARQ CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (UNAUDITED)

(millions, except per share data)

 

     Quarters Ended June 30,     Year to Date June 30,  
     2008     2007     2008     2007  

Net Operating Revenues

        

Service revenues

   $ 1,407     $ 1,454     $ 2,840     $ 2,912  

Product revenues

     142       151       280       282  
                                

Total net operating revenues

     1,549       1,605       3,120       3,194  
                                

Operating Expenses

        

Cost of services

     381       404       771       821  

Cost of products

     132       142       270       269  

Selling, general and administrative

     361       395       719       799  

Depreciation

     247       264       498       534  
                                

Total operating expenses

     1,121       1,205       2,258       2,423  
                                

Operating Income

     428       400       862       771  

Interest expense

     100       111       204       220  

Other (income) expense, net

     (1 )     —         (2 )     —    
                                

Income Before Income Taxes

     329       289       660       551  

Income tax expense

     123       113       242       215  
                                

Net Income

   $ 206     $ 176     $ 418     $ 336  
                                

Amendments to and remeasurement of employee benefit plans, net of tax

     —         (196 )     —         (196 )

Amortization of employee benefit plans prior service cost and actuarial losses, net of tax

     —         (4 )     (1 )     (6 )

Amortization of cash flow derivatives, net of tax

     —         1       1       2  
                                

Comprehensive Income, Net of Tax

   $ 206     $ 375     $ 418     $ 536  
                                

Earnings per Common Share

        

Basic

   $ 1.40     $ 1.16     $ 2.79     $ 2.23  
                                

Diluted

   $ 1.38     $ 1.15     $ 2.76     $ 2.20  
                                

Weighted Average Common Shares Outstanding

        

Basic

     146.8       151.8       149.7       151.0  

Potentially dilutive shares under equity incentive plans

     2.0       1.8       1.7       2.0  
                                

Diluted

     148.8       153.6       151.4       153.0  
                                

See accompanying Condensed Notes to Consolidated Financial Statements (Unaudited)

 

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EMBARQ CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

(millions)

 

     Year to Date
June 30,
 
     2008     2007  

Operating Activities

    

Net income

   $ 418     $ 336  

Adjustments to reconcile net income to net cash provided by operating activities:

    

Depreciation

     498       534  

Provision for losses on accounts receivable

     49       37  

Deferred and noncurrent income taxes

     (21 )     (52 )

Stock-based compensation expense

     22       30  

Net losses (gains) on sales of assets

     (9 )     (7 )

Other, net

     26       22  

Changes in assets and liabilities:

    

Accounts receivable

     (14 )     (26 )

Inventories and other current assets

     (4 )     (30 )

Accounts payable and other current liabilities

     (98 )     (146 )

Noncurrent assets and liabilities, net

     (24 )     7  
                

Net cash provided by operating activities

     843       705  
                

Investing Activities

    

Capital expenditures

     (360 )     (371 )

Proceeds from construction reimbursements

     4       5  

Proceeds from sales of assets

     2       18  
                

Net cash used by investing activities

     (354 )     (348 )
                

Financing Activities

    

Principal payments on long-term debt

     (19 )     (462 )

Borrowings under revolving credit agreement

     790       585  

Repayments under revolving credit agreement

     (680 )     (455 )

Proceeds from common stock issued

     10       98  

Repurchase of common stock

     (390 )     (2 )

Dividends paid to stockholders

     (208 )     (174 )

Tax effects of stock-based compensation

     —         21  

Other, net

     (11 )     (7 )
                

Net cash used by financing activities

     (508 )     (396 )
                

Decrease in Cash and Equivalents

     (19 )     (39 )

Cash and Equivalents at Beginning of Period

     69       53  
                

Cash and Equivalents at End of Period

   $ 50     $ 14  
                

See accompanying Condensed Notes to Consolidated Financial Statements (Unaudited)

 

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EMBARQ CORPORATION

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (UNAUDITED)

(millions, except per share data)

 

     Preferred
Stock
   Common
Stock
   Paid-in
Capital
    Retained
Earnings
    Accumulated
Other
Comprehensive
Income (Loss)
    Treasury
Stock
    Total
Stockholders’
Equity
 

January 1, 2008 Balance

   $ —      $ 2    $ (231 )   $ 623     $ (130 )   $ —       $ 264  

Net income

     —        —        —         418       —         —         418  

Dividends to shareholders ($1.375 per share)

     —        —        —         (209 )     —         —         (209 )

Common stock issued

     —        —        10       —         —         —         10  

Stock-based compensation expense

     —        —        22       —         —         —         22  

Restricted stock units surrendered for tax withholding

     —        —        (15 )     —         —         —         (15 )

Amortization of (net of tax):

                

Employee benefit plans prior service cost and actuarial losses

     —        —        —         —         1       —         1  

Cash flow derivative

     —        —        —         —         (1 )     —         (1 )

Repurchase of common stock

     —        —        —         —         —         (401 )     (401 )
                                                      

June 30, 2008 Balance

   $ —      $ 2    $ (214 )   $ 832     $ (130 )   $ (401 )   $ 89  
                                                      

See accompanying Condensed Notes to Consolidated Financial Statements (Unaudited)

 

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EMBARQ CORPORATION

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

The information in this Form 10-Q has been prepared according to Securities and Exchange Commission (SEC) rules and regulations. The consolidated interim financial statements of Embarq Corporation (Embarq) reflect all adjustments, consisting only of normal recurring accruals needed to fairly present Embarq’s consolidated financial position, results of operations and cash flows.

Certain information and footnote disclosures normally included in consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States were condensed or omitted. As a result, these consolidated financial statements should be read along with Embarq’s Annual Report on Form 10-K for the year ended December 31, 2007. Operating results for the 2008 year to date period do not necessarily represent the results that may be expected for the year ending December 31, 2008.

Note 1. Background and Basis of Presentation

Background

Embarq was incorporated in 2005 under the laws of Delaware and was formerly a wholly owned subsidiary of Sprint Nextel Corporation (Sprint Nextel). On May 17, 2006, Sprint Nextel spun-off its local communications business and product distribution operations, thereby establishing Embarq as a separate, stand-alone company.

Embarq provides a suite of integrated communications services including local and long distance voice, data, high-speed Internet, satellite video, professional services and communications equipment to consumer and business customers primarily in local service territories in 18 states. Embarq also provides access to its local network and other wholesale communications services primarily to other carriers, wireless providers and correctional institutions. Through its Logistics segment, Embarq engages in wholesale product distribution, logistics and configuration services.

As of June 30, 2008, Embarq had approximately 18 thousand active employees. Approximately 34% of these employees were represented by unions subject to collective bargaining agreements. Of the union-represented employees, approximately 48% have collective bargaining agreements that will expire within one year. There were no material changes related to employee collective bargaining agreements during the year to date period ended June 30, 2008.

Basis of Presentation

The accompanying consolidated financial statements reflect all the accounts of Embarq and its wholly owned subsidiaries. All intercompany transactions have been eliminated.

The consolidated financial statements were prepared using accounting principles generally accepted in the United States. These principles require management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities and the reported amounts of revenues and expenses. Actual results could differ from those estimates.

Certain prior year amounts have been reclassified to conform to the current year presentation. These reclassifications had no effect on the results of operations or stockholders’ equity as previously reported.

Universal Service Fund

Embarq records federal and state Universal Service Fund (USF) surcharges on a gross basis. The total amount of surcharges recorded in net operating revenue for the quarter and year to date periods ended June 30, 2008 and 2007, were as follows:

 

     Quarter Ended June 30,    Year to Date June 30,
     2008    2007    2008    2007
     (millions)

Federal and state USF surcharges

   $ 21    $ 24    $ 42    $ 46

 

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Workforce Actions

In order to better align organizational resources with Embarq’s business needs as well as to improve its overall cost structure, Embarq has taken various steps, including both voluntary and involuntary reductions in its workforce. Related to these reductions, Embarq recognized the following severance charges (credits):

 

     Quarter Ended
June 30,
   Year to Date
June 30,
     2008     2007    2008     2007
     (millions)

Cost of services

         

Telecommunications segment

   $ (2 )   $ 1    $ (1 )   $ 3

Selling, general and administrative

         

Telecommunications segment

     4       1      6       12

Logistics segment

     —         —        —         1
                             

Subtotal

     4       1      6       13
                             

Total severance charges

   $ 2     $ 2    $ 5     $ 16
                             

Depreciation Rate Adjustments

On an annual basis, Embarq performs an analysis of the remaining life depreciation rates. Depreciation rates for various digital switching equipment, digital loop carrier equipment and high-speed Internet equipment were adjusted during 2008 and 2007, which resulted in depreciation expense being reduced by the following:

 

     Quarters Ended
June 30,
   Year to Date
June 30,
     2008    2007    2008    2007

Depreciation expense reduction (millions)

   $ 12    $ 11    $ 24    $ 23

Basic and diluted earning per share

   $ 0.05    $ 0.04    $ 0.10    $ 0.09

Treasury Stock

Shares of common stock repurchased by Embarq are reflected as treasury stock on the trade date and are carried at cost, including any direct third-party fees. Embarq uses the weighted average cost method for the issue of common stock from treasury. In the event shares are not retired and subsequently issued from treasury, paid-in capital will increase for any gains and paid-in capital, or retained earnings in the event of a deficit in paid-in capital, will decrease for any losses.

Spin-Off Related Expenses

Embarq replicated or otherwise arranged for replacement of certain facilities, systems, infrastructure and personnel related to functions historically performed by Sprint Nextel and successfully completed the exit of all remaining transitional agreements in May 2008.

No significant spin-off expenditures were incurred during the year to date period ended June 30, 2008. Embarq incurred the following spin spin-off related charges and capital expenditures for the quarter and year to date period ended June 30, 2007:

 

     Quarter    Year to Date
     (millions)

Spin-off related charges

   $ 8    $ 17

Capital expenditures

     2      6

Adoption of SFAS 157

On January 1, 2008, Embarq adopted Statement of Financial Accounting Standards (SFAS) No. 157, Fair Value Measurements, for its financial assets and liabilities. Embarq’s adoption of SFAS No. 157 did not impact its financial position, results of operations, liquidity or disclosures as there are no financial assets or liabilities that are measured at fair value on a recurring basis. In accordance with FASB Staff Position (FSP) No. 157-2, Effective Date of FASB Statement No. 157, Embarq elected to defer until January 1, 2009, the adoption of SFAS No. 157 for all nonfinancial assets and liabilities that are not recognized or disclosed at fair value in the financial statements on a recurring basis. This includes goodwill and nonfinancial long-lived assets that are measured at fair value in impairment testing and asset retirement obligations initially measured at fair value. The adoption of SFAS No. 157 for those nonfinancial assets and liabilities within the scope of FSP 157-2 is not expected to have a material impact on Embarq’s financial position, results of operations or liquidity.

 

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Recently Issued Accounting Pronouncements

Emerging Issues Task Force (EITF), 03-6-1, Determining Whether Instruments Granted in Share-based Payment Transactions are Participating Securities. This standard concluded that unvested share-based payment awards that contain a nonforfeitable right to receive dividends, whether paid or unpaid, are participating securities and should be included in the computation of earnings per share pursuant to the two-class method prescribed under SFAS No. 128, Earnings per Share. This standard is effective for fiscal years beginning after December 15, 2008 with early adoption prohibited. Embarq is evaluating the impact of this standard but does not believe it will have a material impact on basic or diluted earnings per share.

Note 2. Commitments and Contingencies

Litigation, Claims and Assessments

Seven former manufactured gas plant sites have been identified that may have been owned or operated by entities acquired by Embarq’s subsidiary, Centel Corporation (Centel), before that company was acquired by Sprint Nextel. These sites are not currently owned or operated by either Sprint Nextel or Embarq. On three sites, Embarq and the current landowners are working with the EPA pursuant to administrative consent orders. Expenditures pursuant to the orders are not expected to be material. On five sites, including the three sites where the EPA is involved, Centel has entered into agreements with other potentially responsible parties to share costs. Further, Sprint Nextel has agreed to indemnify Embarq for most of any eventual liability arising from all seven of these sites.

In December 2007, a group of retirees filed a putative class action lawsuit in the United States District Court for the District of Kansas, challenging the decision to make certain modifications to Embarq’s retiree benefits programs generally effective January 1, 2008. See Note 5, Employee Benefit Plans. Defendants include Embarq Corporation, certain of its benefits plans, its Employee Benefits Committee and its plan administrator. Additional defendants include Sprint Nextel and certain of its benefits plans. In addition, a complaint in arbitration has been filed by 15 former Centel executives, similarly challenging the benefits changes. Embarq and other defendants intend to vigorously contest these claims and charges.

In addition, Embarq is subject to various other lawsuits, regulatory proceedings against Embarq and other claims typical for a business enterprise. While it is not possible to determine the ultimate disposition of each of these proceedings and whether they will be resolved consistent with Embarq’s expectations, Embarq expects that the outcome of these proceedings, individually or in the aggregate, will not have a material adverse effect on its financial condition, results of operations or liquidity.

Purchase Commitments: Network Operations Center

During the second quarter 2008, Embarq entered into a seven year outsourcing agreement for traffic monitoring services and technical support for its voice network operations. Certain Embarq employees are expected to become employees of the vendor during the third quarter when the arrangement is expected to become effective. Embarq’s contractual obligation, based on expected call traffic volume, is estimated to be approximately $27 million annually, which will also be reflected as cost of services in the Consolidated Statements of Operations and Comprehensive Income (Unaudited).

Note 3. Debt and Financial Instruments

During 2008, Embarq increased outstanding borrowings under its credit agreement by $110 million, entirely through net advances on the revolving credit facility. Additionally, Embarq made $19 million in scheduled principal payments.

As of June 30, 2008, Embarq’s long-term debt had a carrying value of approximately $6.0 billion and a fair value of approximately $5.7 billion. This fair value was computed based on observable market transactions and through discounted cash flow analysis using market-based credit spreads.

Note 4. Income Taxes

Embarq records deferred income taxes based on temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and their tax basis.

 

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The differences that caused Embarq’s effective income tax rates to vary from the 35% federal statutory rate for income taxes related to continuing operations were as follows:

 

     Year to Date
June 30,
 
     2008     2007  
     (millions)  

Income tax expense at the federal statutory rate

   $ 231     $ 193  

Effect of:

    

State income taxes, net of federal income tax effect

     9       22  

Other, net

     2       —    
                

Income tax expense

   $ 242     $ 215  
                

Effective income tax rate

     36.7 %     39.0 %
                

In the fourth quarter of 2007, Embarq modified its legal entity structure, which resulted in a reduction of state income tax expense. Also, a favorable negotiated state income tax settlement in the first quarter of 2008 reduced state income tax expense for 2008 by $5 million.

Note 5. Employee Benefit Plans

The components of net periodic benefit cost were as follows:

 

     Quarter Ended June 30,
2008
    Quarter Ended June 30,
2007
 
     Pension
Benefits
    Other Post-
retirement
Benefits
    Pension
Benefits
    Other Post-
retirement
Benefits
 
     (millions)  

Service cost

   $ 14     $ 2     $ 14     $ 2  

Interest cost

     50       4       49       9  

Expected return on plan assets

     (68 )     (1 )     (66 )     (1 )

Amortization of prior service cost (benefit)

     3       (13 )     4       (15 )

Amortization of actuarial losses

     8       3       10       4  
                                

Net cost (benefit)

   $ 7     $ (5 )   $ 11     $ (1 )
                                

 

     Year to Date June 30,
2008
    Year to Date June 30,
2007
 
     Pension
Benefits
    Other Post-
retirement
Benefits
    Pension
Benefits
    Other Post-
retirement
Benefits
 
     (millions)  

Service cost

   $ 28     $ 4     $ 28     $ 4  

Interest cost

     101       8       97       18  

Expected return on plan assets

     (137 )     (2 )     (131 )     (2 )

Amortization of prior service cost (benefit)

     6       (26 )     8       (29 )

Amortization of actuarial losses

     17       6       20       8  
                                

Net cost (benefit)

   $ 15     $ (10 )   $ 22     $ (1 )
                                

During the second quarter of 2007, Embarq amended its other postretirement medical and life insurance plans to eliminate medical coverage and Medicare premium subsidies for Medicare-eligible retirees and Medicare-eligible beneficiaries and cap the maximum amount of life insurance benefits through the company-sponsored plan for qualified retirees at $10 thousand, effective January 1, 2008. In addition, effective September 1, 2007, Embarq eliminated company-provided life insurance coverage for retirees who also have benefits through a separate subsidiary company-sponsored plan.

In March 2008, Embarq became aware of transactions that involved the inadvertent receipt of funds by the plan sponsors from the assets of the defined benefit pension plans in which Embarq’s employees and retirees currently participate, and in which they participated before the spin-off. These transactions, which began in 2002 and continued through March 2008, require payments to the plans’ trusts. With respect to the period following the spin-off, Embarq paid all amounts owed to its plan’s trust. For the period before the spin-off, the Embarq plan’s trust may receive additional funds from the pre-spin-off plan or pre-spin-off plan sponsor related to these transactions. While it is not possible for Embarq to determine the ultimate disposition of the pre-spin-off amount and whether it will be resolved consistent with current expectations, the eventual outcome is not expected to have a material adverse effect on Embarq’s financial condition, results of operations or liquidity.

 

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Note 6. Stock-based Compensation

Second Quarter 2008

On May 1, 2008, approximately 20 thousand restricted stock units were granted to non-employee members of the board of directors as part of their annual compensation program. These awards had a fair value of $43.08 per restricted stock unit resulting in approximately $1 million in compensation expense that will be recognized over the one year vesting term.

First Quarter 2008

On February 27, 2008, approximately 0.4 million restricted stock units were granted to certain non-executive employees as part of Embarq’s 2007 short-term incentive program. The total award was based on the achievement of performance objectives under the 2007 short-term incentive program. These awards had a fair value of $42.91 per restricted stock unit and will vest in full on December 1, 2008.

On March 2, 2008, approximately 0.9 million stock options and 0.4 million restricted stock units were granted to executive officers and other executive level employees as part of Embarq’s 2008 long-term incentive program. The stock options will vest 34% on March 2, 2009, and 33% will vest on each of March 2, 2010 and 2011. The restricted stock units contain market and performance provisions and will vest on March 2, 2011. The restricted stock units ultimately issued could increase up to 200% of the initial number of awards granted or be reduced to zero depending on Embarq’s performance. The fair value was $6.24 per stock option and $41.94 per restricted stock unit.

The significant assumptions used to calculate the fair value for the 2008 annual stock option grant were as follows:

 

     2008 Annual Grant  

Underlying stock price

   $ 41.94  

Exercise price

   $ 41.94  

Expected volatility

     30.8 %

Risk-free interest rate

     2.9 %

Expected dividend yield

     6.6 %

Expected term (years)

     6.0  

Total compensation expense related to all of the awards noted above was $40.8 million, which is expected to be recognized over a weighted average vesting period of 2.0 years.

Note 7. Business Segment Information

Embarq has two segments, Telecommunications and Logistics. The Telecommunications segment provides a suite of integrated communication services including local and long distance voice, data, high-speed Internet, satellite video, professional services and communications equipment to consumer and business customers primarily within Embarq’s local service territories in 18 states. The Telecommunications segment also provides access to Embarq’s local network and other wholesale communications services primarily to other carriers, wireless providers and correctional institutions. The Logistics segment engages in wholesale product distribution, logistics and configuration services.

Embarq manages its segments to the operating income level. Items, such as interest, other income and expense and income taxes are managed at the consolidated level. The reconciliation of operating income to net income is shown in the accompanying Consolidated Statements of Operations and Comprehensive Income (Unaudited).

The financial information by operating segment was as follows:

 

     Quarter Ended June 30, 2008    Quarter Ended June 30, 2007
     Telecommunications    Logistics    Consolidated    Telecommunications    Logistics    Consolidated
     (millions)

Voice

   $ 994    $ —      $ 994    $ 1,071    $ —      $ 1,071

Data

     199      —        199      188      —        188

High-speed Internet

     137      —        137      121      —        121

Other

     77      —        77      74      —        74
                                         

Service revenues

     1,407      —        1,407      1,454      —        1,454

Product revenues

     32      110      142      28      123      151
                                         

Total net operating revenues

   $ 1,439    $ 110    $ 1,549    $ 1,482    $ 123    $ 1,605
                                         

Operating income

   $ 424    $ 4    $ 428    $ 396    $ 4    $ 400
                                         

 

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     Year to Date June 30, 2008    Year to Date June 30, 2007
     Telecommunications    Logistics    Consolidated    Telecommunications    Logistics    Consolidated
     (millions)

Voice

   $ 2,018    $ —      $ 2,018    $ 2,155    $ —      $ 2,155

Data

     397      —        397      377      —        377

High-speed Internet

     270      —        270      237      —        237

Other

     155      —        155      143      —        143
                                         

Service revenues

     2,840      —        2,840      2,912      —        2,912

Product revenues

     55      225      280      50      232      282
                                         

Total net operating revenues

   $ 2,895    $ 225    $ 3,120    $ 2,962    $ 232    $ 3,194
                                         

Operating income

   $ 860    $ 2    $ 862    $ 770    $ 1    $ 771
                                         

Note 8. Supplemental Cash Flow Information and Non-Cash Activities

Embarq’s supplemental cash flow information and non-cash activities were as follows:

 

     Year to Date
June 30,
     2008     2007
     (millions)

Supplemental Cash Flow Information

    

Cash paid for interest, net of amounts capitalized

   $ 201     $ 221

Cash paid for income taxes

     209       290

Non-Cash Activities

    

Capital expenditure accrual

   $ (16 )   $ 15

Cash held in escrow from the sale of assets

     10       5

Pending settlement of repurchases of common stock

     11       —  

Dividends accrued

     1       —  

Extinguishment of debt

     —         3

Issuance of treasury stock to the Employee Stock Purchase Plan

     —         2

Note 9. Subsequent Events

From July 1 through July 25, 2008, Embarq repurchased 1.7 million shares of common stock for a total of $78 million, representing an average price of $44.65 per share.

 

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Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders

Embarq Corporation:

We have reviewed the accompanying consolidated balance sheet of Embarq Corporation and subsidiaries (the “Company”) as of June 30, 2008, the related consolidated statements of operations and comprehensive income for the three-month and six-month periods ended June 30, 2008 and 2007, the related consolidated statements of cash flows for the six-month periods ended June 30, 2008 and 2007, and the related consolidated statement of stockholders’ equity for the six-month period ended June 30, 2008. These consolidated financial statements are the responsibility of the Company’s management.

We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

Based on our reviews, we are not aware of any material modifications that should be made to the consolidated financial statements referred to above for them to be in conformity with U.S. generally accepted accounting principles.

We have previously audited, in accordance with standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Embarq Corporation and subsidiaries (the “Company”) as of December 31, 2007, and the related consolidated statements of operations and comprehensive income, cash flows and stockholders’ equity for the year then ended (not presented herein); and in our report dated February 28, 2008, we expressed an unqualified opinion on those consolidated financial statements. Our report on the consolidated financial statements and the related financial statement schedule refers to the adoption of the provisions of FASB Interpretation No. 47, Accounting for Conditional Asset Retirement Obligations, as of December 31, 2005. Also, as discussed in Note 6 to the consolidated financial statements, the Company adopted the provisions of Statement of Financial Accounting Standards No. 158, Employers Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106 and 132(R), as of December 31, 2006. Lastly, as discussed in Note 5 to the consolidated financial statements, the Company adopted the provisions of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes- an Interpretation of FASB Statement No. 109, as of January 1, 2007. In our opinion, the information set forth in the accompanying consolidated balance sheet as of December 31, 2007, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.

/s/ KPMG LLP

Kansas City, Missouri

July 30, 2008

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

We make forward-looking statements in this document. These forward-looking statements relate to our outlook or expectations for earnings, revenues, expenses, asset quality or other future financial or business performance, strategies or expectations, or the impact of legal, regulatory or supervisory matters on our business, results of operations or financial condition. Specifically, forward-looking statements may include:

 

   

statements relating to our plans, intentions, expectations, objectives or goals;

 

   

statements relating to our future economic performance, business prospects, revenue, income and financial condition, and any underlying assumptions relating to those statements; and

 

   

statements preceded by, followed by or that include the words “estimate,” “plan,” “project,” “forecast,” “intend,” “expect,” “anticipate,” “believe,” “seek,” “target” or similar expressions.

These statements reflect our management’s judgment based on currently available information and involve a number of risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. With respect to these forward-looking statements, our management has made assumptions regarding, among other things, customer growth and retention, pricing, operating costs, network usage, technology and the economic and regulatory environment.

Future performance cannot be ensured. Actual results may differ materially from those in the forward-looking statements. Some factors that could cause our actual results to differ include, but are not limited to:

 

   

the effects of vigorous competition in the markets in which we operate, including access line loss to cable operators and wireless providers;

 

   

the impact of new, emerging and competing technologies on our business;

 

   

the effect of changes in the legal and regulatory environment and the impact of compliance with regulatory mandates;

 

   

potential fluctuations in our financial performance, including revenues, capital expenditures and operating expenses;

 

   

the impact of any adverse change in the ratings assigned to our debt by ratings agencies on the cost of financing or the ability to raise additional financing if needed;

 

   

the effects of mergers, consolidations or other unexpected developments in the industries relevant to our operations;

 

   

the failure to realize expected improvement in operating efficiencies;

 

   

the costs and business risks associated with the development of new products and services;

 

   

the uncertainties related to our investments in networks, systems and other businesses;

 

   

the uncertainties related to the implementation of our business strategies;

 

   

the inability of third parties to perform to our requirements under agreements related to our business operations;

 

   

our ownership of or ability to license technology that may be necessary to expand our business offerings;

 

   

restrictions in our patent agreement with Sprint Nextel;

 

   

unexpected adverse results of legal proceedings involving our company;

 

   

the impact of equipment failure or other breaches of network or information technology security;

 

   

potential work stoppages;

 

   

a determination by the IRS that the spin-off from Sprint Nextel should be treated as a taxable transaction;

 

   

the volatility in the equity market;

 

   

the effects of changes in both general and local economic conditions on the markets we serve, which can impact demand for our products and services; customer purchasing decisions; collectability of revenue; and required levels of capital expenditures related to new construction of residences and businesses;

 

   

the possible impact of adverse changes in political or other external factors over which we have no control, including hurricanes and other severe weather; and

 

   

other risks referenced in our Annual Report on Form 10-K, including in Part I, Item 1A, “Risk Factors”, and from time to time in other filings of ours with the SEC.

 

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You are cautioned not to place undue reliance on any forward-looking statements, which speak only as of the date of this document. Except as required by law, we undertake no obligation to publicly update or release any revisions to these forward-looking statements to reflect any events or circumstances after the date of this document or to reflect the occurrence of unanticipated events.

OVERVIEW

Operations

We provide a suite of integrated communications services to consumer and business customers primarily in our local service territories in 18 states. Our service and product offerings include local and long distance voice, data, high-speed Internet, satellite video, professional services and communications equipment. In addition, we continue to serve existing wireless customers acquired under our mobile virtual network operator arrangement with Sprint Nextel; however, as part of our orderly transition away from providing these services, we have curtailed most sales activities.

We also provide wholesale services primarily to other carriers, wireless providers and correctional institutions. Services offered include switched access, special access, intelligent network database, collocation, resale switched access lines, pay telephone, unbundled network elements, high speed data services and billing and collection services.

Through our Logistics segment, we engage in wholesale product distribution, logistics and configuration services.

Our mission is to profitably serve targeted customers through simple solutions and a customer experience that satisfies their personal and business needs. Our strategy for success in the marketplace has five key elements: 1) innovate in everything we do, 2) drive productivity and cost efficiency, 3) win and retain targeted customers, 4) drive value though the delivery of broadband services and 5) explore and pursue growth opportunities complementary to our core business.

Consistent with the past several years, we have continued to experience overall declines in telecommunications net operating revenue during 2008. Historically, these overall declines have resulted from voice revenue reductions driven by switched access line losses, somewhat offset by growth in data and high-speed Internet revenue. In recent quarters, voice revenue declines and line loss trends have been comparatively worse. We believe these recent trends are partially the result of general and local economic conditions in the markets we serve. The partial offset of voice revenue declines from growth in data services and high-speed Internet revenue is expected to continue based on recent results and trends; however, the amount of offset may decline in the future due to expected reduced rates of growth for these products and services.

The following table reflects information about our switched access lines:

 

     Lines Served    Quarterly Line Loss     Annual Line Loss  
     June 30, 2008    June 30, 2008     June 30, 2007     June 30, 2008     June 30, 2007  
     (thousands)  

Primary

   3,755    (128 )   (3.3 )%   (109 )   (2.6 )%   (370 )   (9.0 )%   (300 )   (6.8 )%

Additional

   274    (15 )   (5.2 )%   (18 )   (5.1 )%   (62 )   (18.5 )%   (74 )   (18.0 )%
                                                     

Total Consumer

   4,029    (143 )   (3.4 )%   (127 )   (2.8 )%   (432 )   (9.7 )%   (374 )   (7.7 )%

Business

   1,841    (20 )   (1.1 )%   (13 )   (0.7 )%   (55 )   (2.9 )%   (28 )   (1.5 )%

Wholesale

   152    (7 )   (4.4 )%   (8 )   (4.3 )%   (24 )   (13.6 )%   (32 )   (15.4 )%
                                                     

Total

   6,022    (170 )   (2.7 )%   (148 )   (2.2 )%   (511 )   (7.8 )%   (434 )   (6.2 )%
                                                     

Beginning in 2008, we no longer include in our business switched access line counts those lines that support our internal administrative and operational activities. Accordingly, the business access line counts at June 30, 2007, were adjusted by 158 thousand access lines to reflect this change.

Consumer switched access line losses represent the most significant portion of our losses. These losses were primarily attributed to an increasing overlap of cable operators within our local service territories offering VoIP, as well as an increasing number of customers choosing to discontinue traditional wireline phone service to rely solely on wireless services.

Product substitution among our offerings also contributes to our access line losses. Certain of our business access line losses result from the conversion to our data services. These substitutions result in a reduction in the number of switched access lines we serve, but do not represent a loss of the customer relationship.

For the year to date period ended June 30, 2008, our high-speed Internet subscribers increased to approximately 1.4 million subscribers, which is an increase of 18% as compared to the same period in 2007, while associated revenue increased 14%.

Demand during the quarter for data services continued to be strong. Our data services consist mainly of dedicated circuits connecting other carriers’ networks to their customers’ locations, wireless carriers’ cell towers to mobile switching centers or business customers to our network. Revenue associated with these services increased 5% for the year to date period ended June 30, 2008, compared to the same period in 2007.

 

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Satellite video service is also a growing element of our bundled service offers that we currently offer through sales agency relationships with various satellite video service providers. As of June 30, 2008, we had 239 thousand satellite video service subscribers, compared to 178 thousand as of June 30, 2007.

To measure our success in our consumer bundling initiatives as well as attracting and retaining high value customers, average monthly revenue per household (ARPH) is a measure that we closely monitor. This measure is calculated by dividing one sixth of year to date consumer revenue by average primary consumer access lines.

 

     Year to Date June 30,    Difference  
     2008    2007    Amount     %  

Consumer revenue (millions)

   $ 1,297    $ 1,345    $ (48 )   (3.6 )%

Average primary consumer access lines (thousands)

     3,862      4,207      (345 )   (8.2 )%
                            

ARPH

   $ 55.97    $ 53.28    $ 2.69     5.0 %
                            

Spin-Off Related Expenditures

We replicated or otherwise arranged for replacement of certain facilities, systems, infrastructure and personnel related to functions historically performed by Sprint Nextel and successfully completed the exit of all remaining transitional agreements in May 2008.

No significant spin-off expenditures were incurred during the year to date period ended June 30, 2008. We incurred the following spin spin-off related charges and capital expenditures for the quarter and year to date periods ended June 30, 2007:

 

     Quarter    Year to Date
     (millions)

Spin-off related charges

   $ 8    $ 17

Capital expenditures

     2      6

Industry Environment

We operate in an industry that has been and continues to be subject to intense competition in conjunction with regulatory and legislative change. Given these factors, as well as the trend toward consolidation in the industry, we routinely assess the implications of these industry factors on our operations. These assessments, along with regulatory and legislative developments, may impact the future valuation of our long-lived assets and could have a material effect on our business, results of operations, financial condition and liquidity.

Adoption of SFAS 157

On January 1, 2008, we adopted Statement of Financial Accounting Standards (SFAS) No. 157, Fair Value Measurements, for our financial assets and liabilities. Our adoption of SFAS No. 157 did not impact our financial position, results of operations, liquidity or disclosures as there are no financial assets or liabilities that are measured at fair value on a recurring basis. In accordance with FASB Staff Position (FSP) No. 157-2, Effective Date of FASB Statement No. 157, we elected to defer until January 1, 2009, the adoption of SFAS No. 157 for all nonfinancial assets and liabilities that are not recognized or disclosed at fair value in the financial statements on a recurring basis. This includes goodwill and nonfinancial long-lived assets that are measured at fair value in impairment testing and asset retirement obligations initially measured at fair value. The adoption of SFAS No. 157 for those nonfinancial assets and liabilities within the scope of FSP 157-2 is not expected to have a material impact on our financial position, results of operations or liquidity.

Recently Issued Accounting Pronouncements

EITF 03-6-1, Determining Whether Instruments Granted in Share-based Payment Transactions are Participating Securities. This standard concluded that unvested share-based payment awards that contain a nonforfeitable right to receive dividends, whether paid or unpaid, are participating securities and should be included in the computation of earnings per share pursuant to the two-class method prescribed under SFAS No. 128. This standard is effective for fiscal years beginning after December 15, 2008 with early adoption prohibited. We are evaluating the impact of this standard but do not believe it will have a material impact on basic or diluted earnings per share.

 

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RESULTS OF OPERATIONS

 

     Quarters Ended June 30,    Year to Date June 30,
     2008    2007    2008    2007
     (millions)

Net Operating Revenues

           

Telecommunications segment

   $ 1,439    $ 1,482    $ 2,895    $ 2,962

Logistics segment

     110      123      225      232
                           

Total net operating revenues

   $ 1,549    $ 1,605    $ 3,120    $ 3,194
                           

Operating Income

           

Telecommunications segment

   $ 424    $ 396    $ 860    $ 770

Logistics segment

     4      4      2      1
                           

Total operating income

   $ 428    $ 400    $ 862    $ 771
                           

Net Income

   $ 206    $ 176    $ 418    $ 336
                           

Segmental Results of Operations – Telecommunications

Our Telecommunications segment consists of regulated local phone companies serving approximately 6 million access lines primarily in 18 states as of June 30, 2008. We provide a suite of integrated communication services including local and long distance voice, data, high-speed Internet, satellite video, professional services and communications equipment to consumer and business customers primarily in our local service territories. We also provide access to our local network and other wholesale communications services primarily to other carriers, wireless providers and correctional institutions.

 

     Quarters Ended June 30,     Difference  

(millions)

   2008    % of
Revenues
    2007    % of
Revenues
    $ / Percent  

Net operating revenues

              

Voice

   $ 994    69 %   $ 1,071    72 %   $ (77 )   (7 )%

Data

     199    14 %     188    13 %     11     6 %

High-speed Internet

     137    10 %     121    8 %     16     13 %

Other

     77    5 %     74    5 %     3     4 %
                                        

Service revenues

     1,407    98 %     1,454    98 %     (47 )   (3 )%

Product revenues

     32    2 %     28    2 %     4     14 %
                                        

Total net operating revenues

     1,439    100 %     1,482    100 %   $ (43 )   (3 )%

Operating expenses

              

Costs of services

     381    27 %     404    27 %     (23 )   (6 )%

Costs of products

     33    2 %     33    2 %     —       —   %

Selling, general and administrative

     355    25 %     387    26 %     (32 )   (8 )%

Depreciation

     246    17 %     262    18 %     (16 )   (6 )%
                                        

Total operating expenses

     1,015    71 %     1,086    73 %     (71 )   (7 )%
                                        

Operating income

   $ 424    29 %   $ 396    27 %   $ 28     7 %
                                        

Capital expenditures

   $ 181      $ 188      $ (7 )   (4 )%
                                

Switched access lines (thousands)

     6,022        6,533        (511 )   (7.8 )%
                                

Switched access minutes of use (millions)

     6,370        7,066        (696 )   (10 )%
                                

High-speed Internet subscribers (thousands)

     1,364        1,156        208     18 %
                                

 

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     Year to Date June 30,     Difference  

(millions)

   2008    % of
Revenues
    2007    % of
Revenues
    $ / Percent  

Net operating revenues

              

Voice

   $ 2,018    70 %   $ 2,155    73 %   $ (137 )   (6 )%

Data

     397    14 %     377    13 %     20     5 %

High-speed Internet

     270    9 %     237    8 %     33     14 %

Other

     155    5 %     143    4 %     12     8 %
                                        

Service revenues

     2,840    98 %     2,912    98 %     (72 )   (2 )%

Product revenues

     55    2 %     50    2 %     5     10 %
                                        

Total net operating revenues

     2,895    100 %     2,962    100 %     (67 )   (2 )%

Operating expenses

              

Costs of services

     770    27 %     821    28 %     (51 )   (6 )%

Costs of products

     66    2 %     63    2 %     3     5 %

Selling, general and administrative

     703    24 %     779    26 %     (76 )   (10 )%

Depreciation

     496    17 %     529    18 %     (33 )   (6 )%
                                        

Total operating expenses

     2,035    70 %     2,192    74 %     (157 )   (7 )%
                                        

Operating income

   $ 860    30 %   $ 770    26 %   $ 90     12 %
                                        

Capital expenditures

   $ 360      $ 370      $ (10 )   (3 )%
                                

Switched access minutes of use (millions)

     13,253        14,642        (1,389 )   (9 )%
                                

Net Operating Revenues

Net operating revenues decreased $43 million for the quarter and decreased $67 million for the year to date period ended June 30, 2008, compared to the same periods in 2007. Variances in individual categories of revenue are discussed below.

Voice

Voice revenues include monthly recurring fees for local service, enhanced calling features and long distance. Additionally, voice revenues include access and other wholesale services to other carriers to enable connectivity to our network as well as USF receipts and customer surcharges. Voice revenues declined $77 million for the quarter and decreased $137 million for the year to date period ended June 30, 2008, compared to the same periods in 2007.

The following table lists the major drivers of these changes:

 

     Increase (Decrease)  
     Quarter     Year to Date  
     (millions)  

Decline in local voice revenues primarily due to access line losses

   $ (54 )   $ (102 )

Decline in long-distance voice revenues primarily due to access line losses and yield declines

     (6 )     (13 )

Decline in access revenues primarily associated with lower access minutes of use

     (9 )     (14 )

Other

     (8 )     (8 )
                

Total decrease

   $ (77 )   $ (137 )
                

 

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Data

Data revenues represent data network services sold to business customers and special access services sold to other carriers. Data revenues increased $11 million for the quarter and increased $20 million for the year to date period ended June 30, 2008, compared to the same periods in 2007. The following table lists the major drivers of these changes:

 

     Increase (Decrease)
     Quarter    Year to Date
     (millions)

Special access revenue

   $ 7    $ 15

Other

     4      5
             

Total increase

   $ 11    $ 20
             

High-speed Internet

High-speed Internet revenues increased $16 million for the quarter and increased $33 million for the year to date period ended June 30, 2008, compared to the same periods in 2007. These increases are due to an 18% increase in subscribers at June 30, 2008, compared to June 30, 2007.

Other Service

Other service revenues mainly includes professional services, intelligent network database services, billing and collection services, wireless and sales of services through various sales agency relationships, including our satellite video service offering. Other service revenues increased $3 million for the quarter and increased $12 million for the year to date period ended June 30, 2008, compared to the same periods in 2007. These increases were primarily related to wireless and professional services revenue.

Product Revenues

Product revenues are derived mainly from sales of customer premises equipment, or CPE, which is communications equipment that resides at a business customer’s location for the management of voice and data networks and applications. Sales of high-speed Internet equipment to our customers also are reflected in product revenues. Product revenues increased $4 million for the quarter and increased $5 million for the year to date period ended June 30, 2008, compared to the same periods in 2007.

Costs of Services

Costs of services include costs to operate and maintain the local network including employee-related costs directly supporting our network, costs directly associated with various service offerings, intercarrier compensation (such as access payments and reciprocal compensation), federal and state USF assessments and various operating taxes. Cost of services decreased $23 million for the quarter and decreased $51 million for the year to date period ended June 30, 2008, compared to the same periods in 2007. The following table lists the major drivers of these changes:

 

     Increase (Decrease)  
     Quarter     Year to Date  
     (millions)  

Network labor, benefits and severance charges

   $ (5 )   $ (24 )

High-speed Internet service costs, primarily due to web hosting

     (3 )     (9 )

Long-distance costs primarily related to purchased minutes of use

     (7 )     (8 )

Intercarrier compensation

     (4 )     (7 )

Other costs

     (4 )     (3 )
                

Total decrease

   $ (23 )   $ (51 )
                

Costs of Products

Costs of products was comparable for the quarter and increased $3 million for the year to date period ended June 30, 2008, compared to the same periods in 2007. The 2008 cost increase is primarily related to the product revenue increases noted above as well as adjustments to the carrying value of wireless handsets in 2008.

 

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Selling, General and Administrative

Selling, general and administrative (SGA) costs, includes costs associated with selling and marketing, customer service, information technology, bad debt expense, general corporate costs and all other employee-related costs. These costs decreased $32 million for the quarter and decreased $76 million for the year to date period ended June 30, 2008, compared to the same periods in 2007. The following table lists the major drivers of these changes:

 

     Increase (Decrease)  
     Quarter     Year to Date  
     (millions)  

Labor and benefits costs

   $ (16 )   $ (41 )

Severance charges

     3       (6 )

Spin-off related charges

     (8 )     (17 )

Systems and process improvement initiatives

     (10 )     (19 )

Other

     (1 )     7  
                

Total decrease

   $ (32 )   $ (76 )
                

SGA costs include charges for estimated bad debt expense. The reserve for bad debt requires management’s judgment and is based on many factors. Bad debt expense increased to approximately 1.7% of net operating revenues in the year to date period ended June 30, 2008, compared to 1.2% for the same period in 2007. The increase is partially due to additional expense associated with our wireless offering and current economic factors.

Depreciation

Depreciation expense decreased $16 million for the quarter and decreased $33 million for the year to date period ended June 30, 2008, compared to the same periods in 2007. The following table lists the major drivers of these changes:

 

     Increase (Decrease)  
     Quarter     Year to Date  
     (millions)  

2008 depreciation rate reductions

   $ (12 )   $ (24 )

2007 depreciation adjustments resulting from prior year sales and use tax assessments

     (2 )     (8 )

Lower net additions to property, plant and equipment

     —         (4 )

Other

     (2 )     3  
                

Total decrease

   $ (16 )   $ (33 )
                

Segmental Results of Operations – Logistics

Through our Logistics segment, we procure, configure, service and distribute equipment, materials and supplies to the communications industry. The products that we offer include outside plant, business communication systems, telephones and accessories and network access equipment from leading manufacturers.

 

     Quarters Ended June 30,     Difference  

(millions)

   2008    % of
Revenues
    2007    % of
Revenues
    $ / Percent  

Net operating revenues

   $ 110    100 %   $ 123    100 %     (13 )   (11 )%

Operating expenses

              

Costs of products and services

     99    90 %     109    89 %     (10 )   (9 )%

Selling, general and administrative

     6    5 %     8    6 %     (2 )   (25 )%

Depreciation and amortization

     1    1 %     2    2 %     (1 )   (50 )%
                                        

Total operating expenses

     106    96 %     119    97 %     (13 )   (11 )%
                                        

Operating income

   $ 4    4 %   $ 4    3 %   $ —       —   %
                                        

 

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     Year to Date June 30,     Difference  

(millions)

   2008    % of
Revenues
    2007    % of
Revenues
    $ / Percent  

Net operating revenues

   $ 225    100 %   $ 232    100 %     (7 )   (3 )%

Operating expenses

              

Costs of products and services

     205    91 %     206    89 %     (1 )   —   %

Selling, general and administrative

     16    7 %     20    9 %     (4 )   (20 )%

Depreciation and amortization

     2    1 %     5    2 %     (3 )   (60 )%
                                        

Total operating expenses

     223    99 %     231    100 %     (8 )   (3 )%
                                        

Operating income

   $ 2    1 %   $ 1    —   %   $ 1     100 %
                                        

Capital expenditures

   $ —        $ 1      $ (1 )   (100 )%
                                

Net Operating Revenues

Revenues from the Logistics segment decreased $13 million for the quarter and decreased $7 million for the year to date period ended June 30, 2008, compared to the same periods in 2007. These declines were primarily related to reductions in customer spending resulting from general economic factors partially offset by revenue related to a supply contract that originated in the third quarter of 2007.

Cost of Products and Services

Cost of products and services includes costs of equipment sold and other operating taxes. These costs decreased $10 million for the quarter and decreased $1 million for the year to date period ended June 30, 2008, compared to the same periods in 2007. The drivers of these changes are directly associated with the revenue factors noted above.

Selling, General and Administrative

Selling, general and administrative expense decreased $2 million for the quarter and decreased $4 million for the year to date period ended June 30, 2008, compared to the same periods in 2007. This decrease was primarily related to a decrease in severance charges and ongoing labor and benefits costs, as well as a gain related to the sale of a distribution facility.

Consolidated Non-operating Items

 

     Quarters Ended June 30,    Year to Date June 30,
     2008     2007    2008     2007
     (millions)

Interest expense

   $ 100     $ 111    $ 204     $ 220

Other (income) expense, net

     (1 )     —        (2 )     —  

Income tax expense

     123       113      242       215

Interest Expense

Interest expense decreased $11 million for the quarter and decreased $16 million for the year to date period ended June 30, 2008, compared to the same periods in 2007. This decrease is primarily due to the reduction of debt outstanding under our credit agreement as well as declines of interest rates related to these borrowings. Our effective interest rate on long-term debt decreased to 7.0% for the year to date period ended June 30, 2008 as compared to 7.2% for the same period in 2007. See “Liquidity and Capital Resources” below for more information about our financing activities.

 

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Income Tax Expense

Income tax expense increased $10 million for the quarter and increased $27 million for the year to date period ended June 30, 2008, compared to the same periods in 2007. This increase was primarily the result of income before income taxes increasing $40 million for the quarter and $109 million for the year to date period ended June 30, 2008, compared to the same periods in 2007. This increase was a result of the various factors discussed in the sections above, partially offset by reduced state income taxes resulting from a favorable negotiated settlement in 2008 and the modification of our legal entity structure in the fourth quarter of 2007.

LIQUIDITY AND CAPITAL RESOURCES

We manage our liquidity and capital resource needs primarily through managing the capital allocation of internally generated funds.

Cash Flows

The following table summarizes our decrease in cash and equivalents for the year to date periods ended June 30, 2008 and 2007:

 

     Year to Date June 30,  
     2008     2007  
     (millions)  

Operating activities

   $ 843     $ 705  

Investing activities

     (354 )     (348 )

Financing activities

     (508 )     (396 )
                

Decrease in cash and equivalents

   $ (19 )   $ (39 )
                

Operating Activities

Net cash provided by operating activities increased $138 million in the year to date period ended June 30, 2008, compared to the same period in 2007, based on the following:

 

     Increase (Decrease)  
     (millions)  

Collections from customers

   $ (62 )

Payments to employees and suppliers

     99  

Interest payments

     20  

Income tax payments, net

     81  
        

Total increase in cash provided by operating activities

   $ 138  
        

The changes in cash from operations as detailed in the table above were impacted by the drivers discussed in “Results of Operations,” as well as the timing of certain working capital and income tax requirements.

Investing Activities

Net cash used by investing activities increased $6 million in the year to date period ended June 30, 2008, compared to the same period in 2007.

Capital expenditures account for the majority of our investing activities. Our capital expenditures primarily fund new service addresses, increased network capacity and regulatory mandates; internal infrastructure; new capabilities; and sales success based expenditures primarily related to growth in high-speed Internet and data services. Capital expenditures of $360 million in the year to date period ended June 30, 2008, decreased $11 million from the same period in 2007. The following table shows the major drivers of these changes:

 

     Increase (Decrease)  
     (millions)  

Network expansion and mandates

   $ (46 )

Internal infrastructure

     7  

New capabilities

     11  

Sales success based

     17  
        

Total decrease in capital expenditures

   $ (11 )
        

 

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Proceeds from sales of assets decreased $16 million in the year to date period ended June 30, 2008, compared to the same period in 2007. This decrease was primarily related to proceeds received in the first quarter of 2007 related to the sales of rural telephone exchanges in the fourth quarter of 2006.

Financing Activities

Net cash used by financing activities increased $112 million in the year to date period ended June 30, 2008, compared to the same period in 2007. The following table shows the major drivers of this change:

 

     Increase (Decrease)  
     (millions)  

Net changes in long-term debt

   $ (423 )

Dividends paid to stockholders

     34  

Repurchase of common shares

     388  

Common stock issued

     88  

Other

     25  
        

Total increase in cash used by financing activities

   $ 112  
        

Capital Requirements

We currently expect capital expenditures, net of proceeds from construction reimbursements, for 2008 to be approximately $740 million. We continue to review capital expenditure requirements and will adjust spending and capital investment in response to operational needs, customer demand and changes in the levels of new construction activity in the markets we serve.

Liquidity

Since our spin-off in 2006, cash provided by operating activities has been more than sufficient to fund our ongoing capital investment requirements, repay scheduled maturities on outstanding debt and pay regular quarterly dividends to stockholders. As a result, we have been able to increase our dividend payouts, make discretionary payments on outstanding debt and initiate the stock repurchase program approved by our board of directors in early 2008. For 2008 and the next few years, despite the impact of continuing access line losses and increased competition, we believe cash provided by operating activities will be sufficient to fund our capital investment requirements, dividend payouts at current levels, the approved stock repurchase program and scheduled maturities on debt for the remainder of 2008 and subsequent years (which are $80 million in 2008 and $2 million in both 2009 and 2010).

Our total indebtedness at June 30, 2008, was approximately $6.0 billion, consisting of $4.5 billion in senior notes, $880 million in direct borrowings under our credit agreement and $605 million of other debt. As of June 30, 2008, we had approximately $0.9 billion of availability under our $1.5 billion revolving credit facility, which reflects direct borrowings of $520 million and issued letters of credit of $32 million. The credit agreement expires in 2011, and the initial tranches of our notes mature in 2013. We are in compliance with all applicable financial covenants associated with our borrowings.

We may also incur additional indebtedness from time to time for general corporate purposes, including working capital requirements and capital expenditures. Regulatory restrictions and the terms of our indebtedness, however, limit our ability to incur additional indebtedness, raise capital through our subsidiaries, pledge the stock of our subsidiaries, encumber our assets or the assets of our subsidiaries, or cause our subsidiaries to guarantee our indebtedness.

We expect to pay regular quarterly dividends. Thus far, in 2008 we have paid two quarterly dividends of $0.6875 per common share each. Our ability to fund a regular quarterly dividend will be impacted by our ability to generate cash from operations. The declaration, amount and timing of future dividends will be at the discretion of our board of directors, and will depend upon many factors, including our financial condition, results of operations, growth prospects, funding requirements, applicable law and other factors our board of directors deems relevant.

On January 9, 2008, our board of directors authorized a program for the repurchase of our common stock for an aggregate purchase price of up to $500 million until June 30, 2009. We anticipate purchasing shares either in the open market or through private transactions, depending on market conditions and other factors, in accordance with applicable securities laws. As of July 25, 2008, we have repurchased 11.3 million shares of common stock (representing approximately 7% of our outstanding shares) for a total of $479 million, representing an average price of $42.31 per share.

 

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In connection with the spin-off, we established our own pension and other postretirement benefit plans. Our pension plans are funded in excess of current federal minimum requirements. Contributions during 2008 are currently expected to be approximately $75 million; however, the final determination of contribution levels will be made during the third quarter, based on projected plan assets, liabilities and other relevant information. See Note 5, Employee Benefit Plans, of the Condensed Notes to the Consolidated Financial Statements (Unaudited), for additional information. Contributions to our other postretirement benefit plans, including medical and life insurance benefits, are expected to be approximately $30 million in 2008.

In December 2007, a group of retirees filed a putative class action lawsuit in the United States District Court for the District of Kansas, challenging certain modifications to our retiree benefit programs. See Note 2, Commitments and Contingencies, of the Condensed Notes to the Consolidated Financial Statements (Unaudited), for additional information.

Purchase Commitments

Our total purchase obligations and other items as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2007, has increased by approximately $195 million as of June 30, 2008. This increase is primarily related to a seven year outsourcing agreement for traffic monitoring services and technical support for our voice network operations; beginning in the third quarter 2008, we expect to incur expenses totaling approximately $27 million annually during the term of this arrangement, which will be reflected as cost of services in the Consolidated Statements of Operations and Comprehensive Income (Unaudited).

Item 3. Quantitative and Qualitative Disclosures About Market Risk

We are susceptible to market risks related to changes in interest rates and do not purchase or hold any market risk sensitive financial instruments for trading purposes.

We are subject to interest rate risk primarily associated with our borrowings under our credit agreement. From time to time, we may consider entering into swap and other agreements to manage our exposure to interest rate changes on our debt.

Approximately 85% of our outstanding debt at June 30, 2008, is fixed-rate debt. While changes in interest rates impact the fair value of this debt, there is no impact on earnings and cash flows.

We perform interest rate sensitivity analyses on our variable-rate debt. These analyses indicate that a 1% change in interest rates would have an annual pre-tax impact of $9 million on the Consolidated Statements of Operations and Comprehensive Income (Unaudited) and Consolidated Statements of Cash Flows (Unaudited) at June 30, 2008. While earnings and cash flows are impacted as interest rates change, our variable-rate debt is not subject to changes in fair values.

We also perform a sensitivity analysis on the fair market value of our outstanding debt. A 10% decrease in market interest rates would cause an increase of approximately $55 million in fair market value of our outstanding debt at June 30, 2008.

Item 4. Controls and Procedures

(a) Evaluation of Disclosure Controls and Procedures

As required by Rule 13a-15(b) under the Securities Exchange Act, and in connection with the preparation of this quarterly report on Form 10-Q, our management, including the Chief Executive Officer and Chief Financial Officer, carried out an evaluation of the design and operation of our disclosure controls and procedures. Based on this evaluation, the Chief Executive Officer and Chief Financial Officer each concluded that the design and operation of the disclosure controls and procedures were effective as of June 30, 2008, in providing assurance that information required to be disclosed in reports we file or submit is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure and in providing reasonable assurance that the information is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

During the second quarter of 2008, there have been no changes that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

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Table of Contents

PART II. – OTHER INFORMATION

Item 1. Legal Proceedings

In December 2007, a group of retirees filed a putative class action lawsuit in the United States District Court for the District of Kansas, challenging the decision to make certain modifications to Embarq’s retiree benefits programs generally effective January 1, 2008. See Note 5, Employee Benefit Plans of the Condensed Notes to Consolidated Financial Statements (Unaudited). Defendants include Embarq Corporation, certain of its benefits plans, its Employee Benefits Committee and its plan administrator. Additional defendants include Sprint Nextel and certain of its benefits plans. In addition, a complaint in arbitration has been filed by 15 former Centel Corporation executives, similarly challenging the benefits changes. Embarq and other defendants intend to vigorously contest these claims and charges.

In addition, Embarq is subject to various other lawsuits, regulatory proceedings against Embarq and other claims typical for a business enterprise. While it is not possible to determine the ultimate disposition of each of these proceedings and whether they will be resolved consistent with Embarq’s expectations, Embarq expects that the outcome of these proceedings, individually or in the aggregate, will not have a material adverse effect on its financial condition, results of operations or liquidity.

Item 1A. Risk Factors

There have been no material changes to the risk factors, disclosed in Item 1A to Part I in our Annual Report on Form 10-K for the year ended December 31, 2007.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

Issuer Purchases of Equity Securities

 

Quarter Ended June 30, 2008

   Total Number of
Shares Purchased (1)
   Average Price
Paid per Share (2)
   Total Number of Shares
Purchased as Part of
Publicly Announced
Plans or Programs (3)
   Maximum Number (or
Approximate Dollar
Value)
of Shares that May

Yet Be Purchased
Under

the Plan or Program

April 1 through April 30

   2,982,942    $ 39.55    2,982,942    $ 246,662,136

May 1 through May 31

   1,639,768      45.12    1,639,768      172,679,789

June 1 through June 30

   1,600,655      45.89    1,600,655      99,233,210
                       

Total

   6,223,365    $ 42.64    6,223,365    $ 99,233,210
                       

 

(1) Repurchases were made pursuant to an automatic trading plan executed pursuant to Rule 10b5-1 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) and were executed in accordance with the provisions of Rule 10b-18 of the Exchange Act.

 

(2) Average Price Paid per Share does not include transaction costs.

 

(3) On January 9, 2008, the Company announced a program to repurchase shares of its common stock in an aggregate amount of up to $500 million. This share repurchase program will terminate on June 30, 2009, unless extended by Embarq’s Board of Directors.

Item 3. Defaults Upon Senior Securities

There were no reportable events during the quarter ended June 30, 2008.

 

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Item 4. Submission of Matters to a Vote of Security Holders

Our annual meeting of shareholders was held on May 1, 2008 in Overland Park, Kansas. Shareholders of record as of March 4, 2008 were entitled to vote at the annual meeting. At the close of business on the record date, there were 153,116,035 shares of our common stock outstanding and entitled to vote at the meeting. There were 138,626,085 shares represented at the annual meeting of shareholders.

At the annual meeting, nine directors were elected to serve a term of one year, the appointment of KPMG LLP as our independent registered public accounting firm for 2008 was ratified and the Embarq Corporation 2008 Equity Incentive Plan, the Embarq Corporation 2008 Employee Stock Purchase Plan and the material terms of performance goals for qualified performance-based compensation were approved. A shareholder proposal to require an advisory vote on compensation did not receive a majority vote and was not approved.

The following votes were cast for the election of each director to serve on our board for a term of one year until the 2009 annual meeting or until a successor has been elected and qualified:

 

     For    Withheld

Peter C. Brown

   131,736,584    6,889,501

Steven A. Davis

   137,409,712    1,216,373

Richard A. Gephardt

   134,385,480    4,240,605

Thomas A. Gerke

   137,392,496    1,233,589

John P. Mullen

   137,421,602    1,204,483

William A. Owens

   135,187,668    3,438,417

Dinesh C. Paliwal

   136,617,202    2,008,883

Stephanie M. Shern

   136,636,267    1,989,818

Laurie A. Siegel

   136,627,515    1,998,570

The following votes were cast with respect to the proposal to ratify the appointment of KPMG LLP as our independent registered public accounting firm for the 2008 fiscal year:

 

For

   Against    Abstain

136,728,668

       867,048    1,030,367

The following votes were cast with respect to the approval of the Embarq Corporation 2008 Equity Incentive Plan:

 

For

   Against    Abstain

97,273,806

   27,554,735    1,027,924

The following votes were cast with respect to the approval of the Embarq Corporation 2008 Employee Stock Purchase Plan:

 

For

   Against    Abstain

124,435,070

       402,325    1,009,069

The following votes were cast with respect to the approval of the material terms of performance goals for qualified performance-based compensation:

 

For

   Against    Abstain

122,226,479

     2,581,015    1,038,970

The following votes were cast with respect to the consideration of a shareholder proposal to require an advisory vote on compensation:

 

For

   Against    Abstain

48,978,654

   72,568,505    4,299,305

Item 5. Other Information

There were no reportable events during the quarter ended June 30, 2008.

 

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Item 6. Exhibits

 

Exhibit

  

Description

  2.1*    Separation and Distribution Agreement (Incorporated by reference to Exhibit 2.1 to Amendment No. 4 to the Registration Statement on Form 10 (File No. 001-32732), filed with the Securities and Exchange Commission on May 2, 2006).
  2.2*    Transition Services Agreement between Embarq Corporation (receiver) and Sprint Nextel Corporation (provider) dated as of January 20, 2006 (Incorporated by reference to Exhibit 2.2 to Amendment No. 3 to the Registration Statement on Form 10 (File No. 001-32732), filed with the Securities and Exchange Commission on April 28, 2006).
  2.3*    Transition Services Agreement between Embarq Corporation (provider) and Sprint Nextel Corporation (receiver) dated as of January 20, 2006 (Incorporated by reference to Exhibit 2.3 to Amendment No. 3 to the Registration Statement on Form 10 (File No. 0001-32732), filed with the Securities and Exchange Commission on April 28, 2006.
  2.4*   

Tax Sharing Agreement dated as of May 17, 2006 by and among Sprint Nextel Corporation, Embarq Corporation and certain Embarq subsidiaries (Incorporated by reference to Exhibit 2.1 to the Current Report on Form 8-K (File No.

001-32732), filed with the Securities and Exchange Commission on May 18, 2006).

  2.5*    Employee Matters Agreement dated as of May 17, 2006 between Sprint Nextel Corporation and Embarq Corporation (Incorporated by reference to Exhibit 2.2 to the Current Report on Form 8-K (File No. 001-32732), filed with the Securities and Exchange Commission on May 18, 2006).
  2.6*    Patent Agreement dated as of May 17, 2006 by and between Sprint Nextel Corporation and Embarq Corporation (Incorporated by reference to Exhibit 2.5 to the Current Report on Form 8-K (File No. 001-32732), filed with the Securities and Exchange Commission on May 18, 2006).
  2.7*    Trademark Assignment and License Agreement dated as of May 17, 2006, by and among Sprint Nextel Corporation, Embarq Corporation and certain Embarq subsidiaries (Incorporated by reference to Exhibit 2.3 to the Current Report on Form 8-K (File No. 001-32732), filed with the Securities and Exchange Commission on May 18, 2006).
  2.8*   

Software and Proprietary Information Agreement dated as of May 17, 2006 by and between Embarq Corporation and Sprint Nextel Corporation (Incorporated by reference to Exhibit 2.4 to the Current Report on Form 8-K (File No.

001-32732), filed with the Securities and Exchange Commission on May 18, 2006).

  3.1    Amended and Restated Certificate of Incorporation (Incorporated by reference to Exhibit 3.1 to Amendment No. 4 to the Registration Statement on Form 10 (File No. 001-32732), filed with the Securities and Exchange Commission on May 2, 2006).
  3.2   

Amended and Restated Bylaws, as amended (Incorporated by reference to Exhibit 3.1 to the Current Report on Form

8-K (File No. 001-32732), filed with the Securities and Exchange Commission on July 25, 2006).

  4.1    Indenture, dated as of May 17, 2006, by and between Embarq Corporation and J.P. Morgan Trust Company, National Association, a national banking association, as trustee (Incorporated by reference to Exhibit 4.1 to the Current Report on Form 8-K (File No. 001-32732), filed with the Securities and Exchange Commission on May 18, 2006).
  4.2   

6.738% Global Note due 2013 (Incorporated by reference to Exhibit 4.2 to the Registrant’s Annual Report on Form

10-K (File No. 001-32372), filed with the Securities and Exchange Commission on March 9, 2007).

  4.3   

7.082% Global Note due 2016 (Incorporated by reference to Exhibit 4.3 to the Registrant’s Annual Report on Form

10-K (File No. 001-32372), filed with the Securities and Exchange Commission on March 9, 2007).

  4.4   

7.995% Global Note due 2036 (Incorporated by reference to Exhibit 4.4 to the Registrant’s Annual Report on Form

10-K (File No. 001-32372), filed with the Securities and Exchange Commission on March 9, 2007).

  4.5   

Credit Agreement, dated May 10, 2006, by and among Embarq Corporation (borrower), the banks, financial institutions and other institutional lenders (initial lenders) and issuers of letters of credit (initial issuing banks) and Citibank, N.A., as administrative agent (Incorporated by reference to Exhibit 4.1 to the Current Report on Form 8-K (File No.

001-32732), filed with the Securities and Exchange Commission on May 11, 2006).

10.1    Embarq Corporation 2008 Equity Incentive Plan (Incorporated by reference to Exhibit 10.1 to the registrant’s Current Report on Form 8-K (File No. 001-32732), filed with the Securities and Exchange Commission on May 2, 2008).
15.1    Letter Re Unaudited Interim Financial Information
31.1    Certification of Chief Executive Officer Pursuant to Securities Exchange Act of 1934 Rule 13a-14(a).
31.2    Certification of Chief Financial Officer Pursuant to Securities Exchange Act of 1934 Rule 13a-14(a).

 

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Exhibit

  

Description

32.1    Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2    Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

Our company will furnish to the SEC, upon request, a copy of the instruments defining the rights of holders of long-term debt that does not exceed 10% of the total assets of our company.

 

* Schedules and/or exhibits not filed will be furnished supplementally to the SEC upon request.

 

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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.

 

EMBARQ CORPORATION

                    (Registrant)

/s/ Gene M. Betts
Gene M. Betts
Chief Financial Officer
(Principal Financial Officer)
/s/ Richard B. Green
Richard B. Green
Vice President and Controller
(Chief Accounting Officer)

Dated: July 30, 2008

 

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