QWEST CORP - Quarter Report: 2008 September (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended September 30, 2008

or

For the transition period from             to            

Commission File No. 001-03040

QWEST CORPORATION

(Exact name of registrant as specified in its charter)

(303) 992-1400

(Registrant’s telephone number, including area code)

N/A

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

THE REGISTRANT, A WHOLLY OWNED SUBSIDIARY OF QWEST COMMUNICATIONS INTERNATIONAL INC., MEETS THE CONDITIONS SET FORTH IN GENERAL INSTRUCTIONS H(1) (a) AND (b) OF FORM 10-Q AND IS THEREFORE FILING THIS FORM WITH REDUCED DISCLOSURE FORMAT.

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  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 definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

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

On October 29, 2008, one share of Qwest Corporation common stock was outstanding.

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QWEST CORPORATION

FORM 10-Q

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GLOSSARY OF TERMS

Our industry uses many terms and acronyms that may not be familiar to you. To assist you in reading this document and other documents we file with the Securities and Exchange Commission, we have provided below definitions of some of these terms.

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PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

QWEST CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(UNAUDITED)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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QWEST CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(UNAUDITED)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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QWEST CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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QWEST CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

For the Three and Nine Months Ended September 30, 2008

(Unaudited)

Unless the context requires otherwise, references in this report to “QC” refer to Qwest Corporation, references to “Qwest,” “we,” “us,” the “Company” and “our” refer to Qwest Corporation and its consolidated subsidiaries, references to “QSC” refer to our direct parent company, Qwest Services Corporation, and its consolidated subsidiaries, and references to “QCII” refer to our ultimate parent company, Qwest Communications International Inc., and its consolidated subsidiaries.

Note 1: Basis of Presentation

The condensed consolidated balance sheet as of December 31, 2007, which was derived from audited financial statements, and the unaudited interim condensed consolidated financial statements as of and for the three and nine months ended September 30, 2008 have been prepared in accordance with the instructions for Form 10-Q. In compliance with those instructions, certain information and footnote disclosures normally included in consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) have been condensed or omitted. We believe that the disclosures made are adequate to make the information not misleading.

In the opinion of management, these statements include all normal recurring adjustments necessary to fairly present our condensed consolidated results of operations, financial position and cash flows as of September 30, 2008 and for all periods presented. These condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2007, as updated by our Current Report on Form 8-K dated April 4, 2008 (our “April 4, 2008 Form 8-K”).

The condensed consolidated results of operations for the three and nine months ended September 30, 2008 and the condensed consolidated statement of cash flows for the nine months ended September 30, 2008 are not necessarily indicative of the results or cash flows expected for the full year or of the results we would have incurred had we operated as a stand-alone entity during the periods presented.

Business Combinations

In light of regulatory changes in 2007 and consistent with QCII’s continuing strategy to simplify its and our corporate structure and gain operational efficiencies, in the first quarter of 2008 QCII moved to us most of the administrative and other functions of QSC and merged into us two of QSC’s other wholly owned subsidiaries that previously charged the majority of their costs to us:

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QWEST CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

For the Three and Nine Months Ended September 30, 2008

(Unaudited)

These reorganization activities combined businesses that were already controlled by QCII, therefore we accounted for these activities in a manner similar to a pooling of interests. These activities had the following effect on our condensed consolidated financial statements for the three and nine months ended September 30, 2007 and as of December 31, 2007:

In addition, to aid the understanding of these and future financial statements, we recast prior year financial information in our April 4, 2008 Form 8-K.

QCII continues to evaluate other ways to better organize the legal structure and operations of its subsidiaries and may make additional changes to the legal structure and operations of its subsidiaries, including us, in the future. In connection with these past or future reorganization activities, we do not believe we have consummated, and we do not expect to consummate in the future, any business combinations or other transactions that will adversely affect our consolidated financial condition or results of operations.

Reclassifications

During the first quarter of 2008, we changed the definitions we use to classify expenses as cost of sales, selling expenses or general, administrative and other operating expenses. Operating expenses are now reported as follows:

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QWEST CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

For the Three and Nine Months Ended September 30, 2008

(Unaudited)

We believe these changes allow users of our financial statements to better understand our cost structure and the way we manage our business. These expense classifications may not be comparable to those of other companies. These changes had no impact on total operating expenses or net income for any period. To reflect the impact these changes would have had if they had been implemented in prior periods, we have reclassified certain financial information for the three and nine months ended September 30, 2007 that is presented in these condensed consolidated financial statements. In addition, to aid the understanding of these and future financial statements, we reclassified certain prior year financial information in our April 4, 2008 Form 8-K.

We have also reclassified certain other prior period amounts to conform to the current period presentations.

Derivative Financial Instruments

We sometimes use derivative financial instruments, specifically interest rate swap contracts, to manage interest rate risks. We execute these instruments with creditworthy banks and monitor our counterparty exposure. An interest rate hedge is generally designated as either a cash flow hedge or a fair value hedge. In a cash flow hedge, a borrower of variable interest debt agrees with another party to make fixed payments equivalent to paying fixed rate interest on debt in exchange for receiving payments from the other party equivalent to receiving variable rate interest on debt, the effect of which is to eliminate some portion of the variability in the borrower’s overall cash flows. In a fair value hedge, a borrower of fixed rate debt agrees with another party to make variable payments equivalent to paying variable rate interest on the debt in exchange for receiving fixed payments from the other party equivalent to receiving fixed rate interest on debt, the effect of which is to eliminate some portion of the variability in the fair value of the borrower’s overall debt portfolio.

We recognize all derivatives on our condensed consolidated balance sheets at fair value. We generally designate the derivative as either a cash flow hedge or a fair value hedge on the date on which we enter into the derivative instrument.

For a derivative that is designated as and meets all of the required criteria for a cash flow hedge, we record in accumulated other comprehensive income, which is included in accumulated deficit on our condensed consolidated balance sheets, any changes in the fair value of the derivative. We then reclassify these amounts into earnings as the underlying hedged item affects earnings. In addition, if there are any changes in the fair value of the derivative arising from ineffectiveness of the cash flow hedging relationship, we record those amounts immediately in other expense (income)—net in our condensed consolidated statements of operations. For a derivative that is designated as and meets all of the required criteria for a fair value hedge, we record in other expense (income)—net in our condensed consolidated statements of operations the changes in fair value of the derivative and the underlying hedged item.

We assess quarterly whether each derivative is highly effective in offsetting changes in fair values or cash flows of the hedged item. If we determine that a derivative is not highly effective as a hedge, or if a derivative

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QWEST CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

For the Three and Nine Months Ended September 30, 2008

(Unaudited)

ceases to be a highly effective hedge, we discontinue hedge accounting with respect to that derivative prospectively. We record immediately in earnings changes in the fair value of derivatives that are not designated as hedges.

Use of Estimates

Our condensed consolidated financial statements are prepared in accordance with GAAP. These accounting principles require us to make certain estimates, judgments and assumptions. We believe that the estimates, judgments and assumptions made when accounting for items and matters such as, but not limited to, investments, long-term contracts, customer retention patterns, allowance for doubtful accounts, depreciation, amortization, asset valuations, internal labor capitalization rates, affiliate transactions, recoverability of assets (including deferred tax assets), impairment assessments, employee benefits, taxes, reserves and other provisions and contingencies are reasonable, based on information available at the time they are made. These estimates, judgments and assumptions can affect the reported amounts of assets, liabilities and components of equity as of the dates of the condensed consolidated balance sheets, as well as the reported amounts of revenue, expenses and components of cash flows during the periods presented in our condensed consolidated statements of operations and our condensed consolidated statements of cash flows. We also make estimates in our assessments of potential losses in relation to threatened or pending tax and legal matters. See Note 5—Tax Matters and Note 7—Commitments and Contingencies for additional information.

For all of these and other matters, actual results could differ from our estimates.

USF, Gross Receipts Taxes and Other Surcharges

Our revenue and general, administrative and other operating expenses include taxes and surcharges that we recognize on a gross basis of $51 million and $151 million for the three and nine months ended September 30, 2008, respectively, and $53 million and $157 million for the three and nine months ended September 30, 2007, respectively.

Depreciation and Amortization

Property, plant and equipment is shown net of accumulated depreciation on our condensed consolidated balance sheets. Accumulated depreciation was $32.726 billion and $31.976 billion as of September 30, 2008 and December 31, 2007, respectively.

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QWEST CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

For the Three and Nine Months Ended September 30, 2008

(Unaudited)

Capitalized software is shown net of accumulated amortization on our condensed consolidated balance sheets. Accumulated amortization was $1.403 billion and $1.311 billion as of September 30, 2008 and December 31, 2007, respectively.

Recently Adopted Accounting Pronouncements

Effective January 1, 2008, we adopted Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements” (“SFAS No. 157”), for all financial instruments and non-financial instruments accounted for at fair value on a recurring basis. SFAS No. 157 provides a definition of fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements for future transactions. We carry on our condensed consolidated balance sheets financial instruments whose value cannot be determined by reference to an observable market—including those described in more detail in Note 2—Investments. We continue to estimate the value of these instruments using judgmentally determined inputs, some of which are observable and some of which are not observable. We have not changed the methods used to value these financial instruments as a result of our adoption of this standard. Our condensed consolidated balance sheets also indirectly reflect the value of financial instruments held by certain QCII employee benefit plans in which our employees and retirees participate. However, we only adjust our balance sheet annually at December 31 to reflect market changes in the value of QCII employee benefit plan assets. QCII continues to assess whether the methods previously used to determine the fair value of employee benefit plan assets are appropriate within the SFAS No. 157 framework for measuring fair value, but we do not anticipate that any changes in valuation methods will have a material impact on our financial position or results of operations.

Effective January 1, 2008, we also adopted SFAS No. 159, “Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS No. 159”). Under SFAS No. 159, entities may choose to measure at fair value many financial instruments and certain other items that are not currently required to be measured at fair value. SFAS No. 159 also establishes recognition, presentation, and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. SFAS No. 159 does not affect any existing accounting literature that requires certain assets and liabilities to be carried at fair value. Although we have adopted this standard, we have not yet elected the fair value option for any assets or liabilities that currently are not required to be recorded at fair value. Therefore, the adoption of this standard has not had any impact on our financial position or results of operations.

Note 2: Investments

QSC manages all cash and investments for us and our affiliates. Our proportionate ownership of any investments, including illiquid investments, can change because we record our portion of the entire portfolio of cash and investments managed by QSC. These changes are reflected on a net basis in cash flows from investing activities on our consolidated statements of cash flows.

As of September 30, 2008 and December 31, 2007, our investments included auction rate securities of $56 million and $31 million, respectively, which are classified as non-current, available-for-sale investments and are included in other non-current assets at estimated fair value on our condensed consolidated balance sheets. Auction rate securities are generally long-term debt instruments that provide liquidity through a Dutch auction process that resets the applicable interest rate at pre-determined calendar intervals, generally every 28 days. This mechanism generally allows existing investors to rollover their holdings and continue to own their respective securities or liquidate their holdings by selling their securities at par value. Prior to August 2007, QSC invested in these securities for short periods of time as part of its cash management program. However, the uncertainties

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QWEST CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

For the Three and Nine Months Ended September 30, 2008

(Unaudited)

in the credit markets have prevented QSC and other investors from liquidating their holdings of these securities in auctions since the third quarter of 2007. These securities are insured against loss of principal and interest by bond insurers with AA and BB credit ratings at September 30, 2008 and AAA credit ratings at December 31, 2007 and they are collateralized by the issuer. These securities were valued using a discounted cash flow model that takes into consideration the following factors among others:

We recorded unrealized losses, net of deferred income taxes, on these auction rate securities of $3 million and $6 million, respectively, for the three and nine months ended September 30, 2008. The cumulative unrealized losses related to these securities as of September 30, 2008 were $6 million, net of deferred income taxes. These unrealized losses were recorded in accumulated other comprehensive income, which is included in accumulated deficit in our condensed consolidated balance sheets. We consider the decline in fair value to be a temporary impairment because the securities are rated investment grade and the issuer continues to make interest payments in accordance with the terms of the offering document and because we have the ability and intent to hold the securities until they recover or mature. However, if the credit ratings of the securities or the bond insurers deteriorate or the value of the collateral deteriorates, we may further adjust the carrying value of these investments. We may also determine that the decline in fair value is other than temporary if our intent or ability to hold these securities until they recover changes or the creditworthiness of the issuer deteriorates, we would then recognize the decline in fair value in other expense (income)—net in our condensed consolidated statements of operations. An increase of one percentage point in the discount rate used in our valuation model would result in an immaterial decrease in the estimated fair value of these investments. Because we are uncertain as to when the liquidity issues relating to these investments will improve, we continue to classify these securities as non-current as of September 30, 2008.

During the fourth quarter of 2007, an investment fund we historically treated as a cash equivalent began liquidating its holdings and restricting distributions. As a result, we reclassified our holdings in the fund from cash and cash equivalents to investments, which are included in other current assets on our condensed consolidated balance sheets. We valued this investment considering the asset values of the securities underlying the fund. As of December 31, 2007, $21 million of our remaining investment in the fund was included in other current assets and $3 million was included in other non-current assets on our condensed consolidated balance sheet because we did not expect to be able to liquidate this portion of our investment in 2008. As of September 30, 2008, $12 million of our remaining investment in the fund was included in other current assets and $6 million was included in other non-current assets on our condensed consolidated balance sheet because we continued to expect that we would not be able to liquidate this portion of our investment in the subsequent twelve months. During the three and nine months ended September 30, 2008, we recorded immaterial realized and unrealized losses for the change in the fair value of the fund, which were recorded in other expense (income)—net in our condensed consolidated statements of operations.

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QWEST CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

For the Three and Nine Months Ended September 30, 2008

(Unaudited)

Note 3: Borrowings

We were in compliance with all provisions and covenants of our borrowings as of September 30, 2008. The fair value of our long-term borrowings was approximately $7.0 billion and $8.0 billion at September 30, 2008 and December 31, 2007, respectively. The book value of our long-term borrowings was approximately $7.9 billion at September 30, 2008 and December 31, 2007.

During the first quarter of 2008, we entered into the interest rate hedges described below as part of our long- and short-term debt strategies. One objective of our short-term debt strategy is to take advantage of favorable interest rates by swapping floating rate debt to fixed rate debt using cash flow hedges. One objective of our long-term debt strategy is to achieve a more balanced ratio of fixed rate to floating rate debt by swapping a portion of our fixed interest rate debt to floating rate debt through fair value hedges. This decreases our exposure to changes in the fair value of our fixed interest rate debt due to changes in interest rates.

We evaluate counterparty credit risk before entering into any hedge transaction. During the third quarter of 2008, one of our counterparties was in the process of merging into a large bank. While the merger was not completed by September 30, 2008, we evaluated the new counterparty risk and found it to be acceptable. We will continue to closely monitor the financial market and the risk that our counterparties will default on their obligations to us. We have the ability and are prepared to unwind these hedge transactions if our counterparties’ credit risk becomes unacceptable to us.

In March 2008, we entered into interest rate hedges on $500 million of the outstanding $750 million aggregate principal amount of our Floating Rate Notes due 2013. The notes bear interest at a rate per year equal to the London Interbank Offered Rate (“LIBOR”) plus 3.25%. These hedges had the economic effect of converting our floating interest rate to fixed interest rates of approximately 6.0% for a term of approximately two years. We designated these swaps as cash flow hedges. The value of our cash flow hedges of approximately $3 million is recorded in other non-current assets on our condensed consolidated balance sheet as of September 30, 2008, with a related increase, net of deferred taxes, in accumulated other comprehensive income, which is included in accumulated deficit. We did not recognize any gain or loss in earnings for hedge ineffectiveness during the three and nine months ended September 30, 2008.

In March 2008, we also entered into interest rate hedges on the outstanding $500 million aggregate principal amount of our 6.5% Notes due 2017. These hedges had the economic effect of converting our fixed interest rate to a floating interest rate until these notes mature in 2017. We designated these swaps as fair value hedges. The fair value of these hedges is approximately $11 million and is recorded in other non-current liabilities on our condensed consolidated balance sheet as of September 30, 2008, with a related reduction in the carrying value of long-term debt of $14 million. A net immaterial gain for hedge ineffectiveness is recorded in other expense (income)—net in our condensed consolidated statements of operations.

The cash flow and fair value hedges are valued using projected future cash flows, discounted at mid-market implied forward LIBOR rates. The debt underlying the fair value hedges is valued using projected future cash flows, discounted at mid-market implied forward LIBOR rates, plus a constant spread above LIBOR determined at the inception of the hedging relationship. These valuations are determined excluding accrued interest.

Note 4: Severance

For the three months ended September 30, 2008 and 2007, we accrued severance costs of $62 million and $6 million, respectively, reversed severance costs of $1 million and $0 million, respectively, and paid severance

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QWEST CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

For the Three and Nine Months Ended September 30, 2008

(Unaudited)

costs of $9 million and $12 million, respectively. For the nine months ended September 30, 2008 and 2007, we accrued severance costs of $121 million and $15 million, respectively, reversed severance costs of $11 million and $7 million, respectively, and paid severance costs of $60 million and $38 million, respectively. A portion of our severance charges is included in each of cost of sales, selling expenses and general, administrative and other operating expenses in our condensed consolidated statements of operations. As of September 30, 2008 and December 31, 2007, our severance liability was $73 million and $23 million, respectively.

Note 5: Tax Matters

During the third quarter of 2008, we collected a state property tax refund of $40 million, which was recognized in the second quarter of 2008, as the result of a property tax settlement on assessments we challenged for tax years 2002-2007.

We are included in consolidated federal income tax returns of QCII. QCII treats our consolidated results as if we were a separate taxpayer. QCII’s policy requires us to pay our tax liabilities in cash based upon separate return taxable income. As a result, QCII’s federal tax audits may affect us.

During the third quarter of 2008, QCII executed a settlement with the IRS relating to its audit of the 1998-2001 tax years. We have not yet funded our share of the settlement determined in accordance with our tax allocation policies. We expect to pay $71 million in the fourth quarter of 2008 as our share of the settlement. We recognized an immaterial interest benefit as a result of the settlement. Our unrecognized tax benefits have decreased by $34 million since December 31, 2007 primarily due to the 1998-2001 settlement.

On April 15, 2008, QCII received from the Internal Revenue Service (“IRS”) the Revenue Agent’s Report for tax years 2004 and 2005. The report contains proposed adjustments on several issues, including issues that may affect us. Based on QCII’s and our evaluation of the IRS’s positions reflected in the proposed adjustments, we have not recorded a material adjustment to our unrecognized tax benefits or our uncertain tax position liability. However, there can be no assurance that QCII and the IRS will reach settlements on any of these issues or that, if QCII does reach settlements, the terms will be favorable to us.

Note 6: Product Revenue

We generate the majority of our revenue by providing services using our telecommunications network. We also generate revenue from services we provide to our affiliates. These services are further described below.

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QWEST CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

For the Three and Nine Months Ended September 30, 2008

(Unaudited)

We also generate other revenue from USF surcharges and the subleasing of space in our office buildings, warehouses and other properties.

Revenue from our products and services for the three and nine months ended September 30, 2008 and 2007 is summarized in the following table:

In April 2008, we signed a five-year agreement with a nationwide wireless service provider to market its wireless products and services under its brand name beginning in 2008. Revenue from services provided under this new arrangement will be recorded on a net basis in our consolidated financial statements as voice services. One of our affiliates currently offers wireless services under a service arrangement with a different nationwide wireless service provider. Under this arrangement, which will end in 2009, our affiliate sells wireless products and services under the Qwest brand name and reports revenues on a gross basis.

In the fourth quarter of 2007, we changed the way we determine sales and marketing and advertising support services billed to our affiliates. For the three and nine months ended September 30, 2008, our revenue from affiliate services would have been higher by $33 million and $97 million, respectively, had we billed our affiliates for these services based upon the policy in effect in 2007.

Note 7: Commitments and Contingencies

QCII is involved in several legal proceedings to which we are not a party that, if resolved against QCII, could have a material adverse effect on our business and financial condition. We have included below a discussion of these matters, together with a discussion of those matters to which we are a party. Only those matters to which we are a party (primarily the third matter described under the heading “Other Matters” relating to litigation brought by several owners of payphones) represent contingencies for which we have recorded, or could reasonably anticipate recording, an accrual if appropriate to do so.

Throughout this note, when we refer to a class action as “putative” it is because a class has been alleged, but not certified in that matter. Until and unless a class has been certified by the court, it has not been established that the named plaintiffs represent the class of plaintiffs they purport to represent. Settlement classes have been certified in connection with the settlements of certain of the putative class actions described below where the courts held that the named plaintiffs represented the settlement class they purported to represent.

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QWEST CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

For the Three and Nine Months Ended September 30, 2008

(Unaudited)

The terms and conditions of applicable bylaws, certificates or articles of incorporation, agreements or applicable law may obligate QCII to indemnify its former directors, officers and employees with respect to certain of the matters described below, and QCII has been advancing legal fees and costs to many former directors, officers and employees in connection with certain matters described below.

Settlement of Consolidated Securities Action

Twelve putative class actions purportedly brought on behalf of purchasers of QCII’s publicly traded securities between May 24, 1999 and February 14, 2002 were consolidated into a consolidated securities action pending in federal district court in Colorado against QCII and various other defendants. The first of these actions was filed on July 27, 2001. Plaintiffs alleged, among other things, that defendants issued false and misleading financial results and made false statements about QCII’s business and investments, including materially false statements in certain of QCII’s registration statements. The most recent complaint in this matter sought unspecified compensatory damages and other relief. However, counsel for plaintiffs indicated that the putative class would seek damages in the tens of billions of dollars.

In November 2005, QCII, certain other defendants, and the putative class representatives entered into, and filed with the federal district court in Colorado, a Stipulation of Partial Settlement that, if implemented, will settle the consolidated securities action against QCII and certain other defendants (the “QCII settlement”). No parties admit any wrongdoing as part of the QCII settlement. Pursuant to the QCII settlement, QCII deposited approximately $400 million in cash into a settlement fund. In connection with the QCII settlement, QCII received $10 million from Arthur Andersen LLP. As part of the QCII settlement, the class representatives and the settlement class they represent are also releasing Arthur Andersen. If the QCII settlement is not implemented, QCII will be repaid the $400 million plus interest, less certain expenses, and QCII will repay the $10 million to Arthur Andersen.

If implemented, the QCII settlement will resolve and release the individual claims of the class representatives and the claims of the settlement class they represent against QCII and all defendants except Joseph Nacchio, our former chief executive officer, and Robert Woodruff, our former chief financial officer. In September 2006, the federal district court in Colorado issued an order approving the proposed QCII settlement on behalf of purchasers of QCII’s publicly traded securities between May 24, 1999 and July 28, 2002, over the objections of Messrs. Nacchio and Woodruff. Messrs. Nacchio and Woodruff then appealed that order to the United States Court of Appeals for the Tenth Circuit. In addressing that appeal, the Tenth Circuit held that the federal district court order overruling Nacchio and Woodruff’s objections to the QCII settlement was not sufficiently specific, and it remanded the case to the district court with instructions to consider certain issues and to provide a more detailed explanation for its earlier decision overruling those objections. Subsequent to the remand, a proposed settlement was reached involving the claims of the putative class against Messrs. Nacchio and Woodruff as described below that, if implemented, will also result in the implementation of the QCII settlement.

On August 4, 2008, QCII, Messrs. Nacchio and Woodruff, and the putative class representatives entered into a Stipulation of Settlement (the “Nacchio/Woodruff settlement”) that, if implemented, will, among other things, (i) settle the individual claims of the putative class representatives and the class they purport to represent against Messrs. Nacchio and Woodruff, and (ii) result in the withdrawal by Messrs. Nacchio and Woodruff of their objections to the QCII settlement and the resolution of their indemnification dispute with QCII arising from the QCII settlement. Under the proposed Nacchio/Woodruff settlement, QCII would contribute $40 million, and

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QWEST CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

For the Three and Nine Months Ended September 30, 2008

(Unaudited)

Messrs. Nacchio and Woodruff would contribute a total of $5 million of insurance proceeds. The Nacchio/Woodruff settlement is subject to a number of conditions and future contingencies, including that it (i) requires both preliminary and final court approval, and (ii) provides QCII with the right to terminate the settlement if class members representing more than a specified amount of alleged securities losses elect to opt out of the settlement. No parties admit any wrongdoing as a part of the Nacchio/Woodruff settlement.

KPNQwest Litigation/Investigation

On June 25, 2004, the trustees in the Dutch bankruptcy proceeding for KPNQwest, N.V. (of which QCII was a major shareholder) filed a lawsuit in the federal district court for the District of New Jersey alleging violations of the Racketeer Influenced and Corrupt Organizations Act, and breach of fiduciary duty and mismanagement under Dutch law. QCII is a defendant in this lawsuit along with Joseph Nacchio, Robert S. Woodruff and John McMaster, the former president and chief executive officer of KPNQwest. Plaintiffs allege, among other things, that defendants’ actions were a cause of the bankruptcy of KPNQwest and they seek damages for the bankruptcy deficit of KPNQwest of approximately $2.4 billion. Plaintiffs also seek treble damages as well as an award of plaintiffs’ attorneys’ fees and costs. On October 17, 2006, the court issued an order granting defendants’ motion to dismiss the lawsuit, concluding that the dispute should be adjudicated in the Netherlands rather than New Jersey. Plaintiffs appealed this decision to the United States Court of Appeals for the Third Circuit, which affirmed the dismissal. Plaintiffs have petitioned the United States Supreme Court to review the Third Circuit’s decision.

On September 13, 2006, Cargill Financial Markets, Plc and Citibank, N.A. filed a lawsuit in the District Court of Amsterdam, located in the Netherlands, against QCII, KPN Telecom B.V., Koninklijke KPN N.V.(“KPN”), Joseph Nacchio, John McMaster, and other former employees or supervisory board members of QCII, KPNQwest, or KPN. The lawsuit alleges that defendants misrepresented KPNQwest’s financial and business condition in connection with the origination of a credit facility and wrongfully allowed KPNQwest to borrow funds under that facility. Plaintiffs allege damages of approximately €219 million (or approximately $316 million based on the exchange rate on September 30, 2008).

On October 31, 2002, Richard and Marcia Grand, co-trustees of the R.M. Grand Revocable Living Trust, dated January 25, 1991, filed a lawsuit in Arizona Superior Court. As amended and following the appeal of a partial summary judgment against plaintiffs which was affirmed in part and reversed in part, plaintiffs allege, among other things, that defendants violated state securities laws in connection with plaintiffs’ investments in KPNQwest securities. QCII is a defendant in this lawsuit along with Qwest B.V. (one of QCII’s subsidiaries), Joseph Nacchio and John McMaster. Plaintiffs claim to have lost approximately $10 million in their investments in KPNQwest, and are also seeking interest and attorneys’ fees.

On August 23, 2005, the Dutch Shareholders Association (Vereniging van Effectenbezitters, or VEB) filed a petition for inquiry with the Enterprise Chamber of the Amsterdam Court of Appeals, located in the Netherlands, with regard to KPNQwest. VEB sought an inquiry into the policies and course of business at KPNQwest that are alleged to have caused the bankruptcy of KPNQwest in May 2002, and an investigation into alleged mismanagement of KPNQwest by its executive management, supervisory board members, joint venture entities (QCII and KPN), and KPNQwest’s outside auditors and accountants. On December 28, 2006, the Enterprise Chamber ordered an inquiry into the management and conduct of affairs of KPNQwest for the period January 1 through May 23, 2002. QCII and others have appealed that order to the Netherlands Supreme Court.

QCII will continue to defend against the pending KPNQwest litigation matters vigorously.

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QWEST CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

For the Three and Nine Months Ended September 30, 2008

(Unaudited)

Other Matters

Several putative class actions relating to the installation of fiber optic cable in certain rights-of-way were filed against QCII on behalf of landowners on various dates and in various courts in California, Colorado, Georgia, Illinois, Indiana, Kansas, Massachusetts, Mississippi, Missouri, Oregon, South Carolina, Tennessee and Texas. For the most part, the complaints challenge QCII’s right to install its fiber optic cable in railroad rights-of-way. Complaints in Colorado, Illinois and Texas, also challenge QCII’s right to install fiber optic cable in utility and pipeline rights-of-way. The complaints allege that the railroads, utilities and pipeline companies own the right-of-way as an easement that did not include the right to permit QCII to install its fiber optic cable in the right-of-way without the plaintiffs’ consent. Most actions (California, Colorado, Georgia, Kansas, Mississippi, Missouri, Oregon, South Carolina, Tennessee and Texas) purport to be brought on behalf of state-wide classes in the named plaintiffs’ respective states. The Massachusetts action purports to be on behalf of state-wide classes in all states in which QCII has fiber optic cable in railroad rights-of-way (other than Louisiana and Tennessee), and also on behalf of two classes of landowners whose properties adjoin railroad rights-of-way originally derived from federal land grants. Several actions purport to be brought on behalf of multi-state classes. The Illinois state court action purports to be on behalf of landowners in Illinois, Iowa, Kentucky, Michigan, Minnesota, Nebraska, Ohio and Wisconsin. The Illinois federal court action purports to be on behalf of landowners in Arkansas, California, Florida, Illinois, Indiana, Missouri, Nevada, New Mexico, Montana and Oregon. The Indiana action purports to be on behalf of a national class of landowners adjacent to railroad rights-of-way over which QCII’s network passes. The complaints seek damages on theories of trespass and unjust enrichment, as well as punitive damages. On July 18, 2008, the Massachusetts court entered an order preliminarily approving a settlement of all of the actions described above, except the action pending in Tennessee. The court also set a hearing for November 17, 2008 to consider final approval of the proposed settlement.

Qwest Communications Corporation (“QCC”), one of QCII’s other subsidiaries, is a defendant in litigation filed by several billing agents for the owners of payphones seeking compensation for coinless calls made from payphones. The matter is pending in the United States District Court for the District of Columbia. Generally, the payphone owners claim that QCC underpaid the amount of compensation due to them under Federal Communications Commission (“FCC”) regulations for coinless calls placed from their phones onto QCC’s network. The claim seeks compensation for calls, as well as interest and attorneys’ fees. QCC will vigorously defend against this action.

We have been a defendant in litigation brought by several owners of payphones relating to the rates we charged them for the lines to their payphones between 1997 and 2003. Generally, the payphone owners have claimed that we charged more for payphone access lines than we were permitted to charge under the applicable FCC rules. The largest of these lawsuits, filed in the United States District Court for the Western District of Washington, has been amicably settled for an immaterial amount and dismissed. One lawsuit is still pending in the United States District Court for the District of Utah, which is currently stayed pending resolution of related proceedings before the FCC. Another proceeding against us is also pending before the Oregon Public Utility Commission. Several related proceedings are underway at the FCC involving us, other telecommunications companies, and payphone owners. In all of these proceedings, the payphone owners seek damages for amounts paid allegedly exceeding the amounts that were permitted under the applicable FCC rules. We will vigorously defend against these actions.

A putative class action filed on behalf of certain of QCII’s retirees was brought against QCII, the Qwest Life Insurance Plan and other related entities in federal district court in Colorado in connection with QCII’s decision

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QWEST CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

For the Three and Nine Months Ended September 30, 2008

(Unaudited)

to reduce the life insurance benefit for these retirees to a $10,000 benefit. The action was filed on March 30, 2007. The plaintiffs allege, among other things, that QCII and other defendants were obligated to continue their life insurance benefit at the levels in place before QCII decided to reduce them. Plaintiffs seek restoration of the life insurance benefit to previous levels and certain equitable relief. The district court ruled in QCII’s favor on the central issue of whether QCII properly reserved its right to reduce the life insurance benefit under applicable law and plan documents. The retirees have amended their complaint to assert additional claims. QCII believes the remaining claims are without merit, and QCII will continue to vigorously defend against this matter.

Flood Damage

During June 2008, floods in the Midwest, particularly Iowa, caused damage to our network and other assets. Based on our current assessment, we estimate that cumulative expenditures required for the restoration of our network and physical plant will be approximately $30 million, including repairs and equipment replacement. For the three and nine months ended September 30, 2008, we incurred repair expenditures of $6 million and $8 million, respectively, which are included in the $30 million estimate. Although we carry commercial property insurance that covers certain property damage and business interruption, we do not expect that a substantial portion of the $30 million estimate will be covered because we are subject to a $5 million deductible for buildings and contents and a $25 million deductible for buried outside plant. We are working with our insurance carriers to determine the extent to which insurance proceeds will offset these expenditures.

Note 8: Labor Union Contracts

In August 2008, we reached tentative agreements with our labor unions, the Communications Workers of America (“CWA”) and the International Brotherhood of Electrical Workers (“IBEW”), on new three-year collective bargaining agreements. Each of these agreements needed to be ratified by union members, and in September 2008 CWA members failed to ratify the CWA agreement. In October 2008, we again reached tentative agreements with the CWA and IBEW, this time on new four-year collective bargaining agreements. Each of these agreements must be ratified by union members, and if ratified, will expire on October 6, 2012. As of September 30, 2008, employees covered by these agreements totaled 18,135, or 57% of all our employees.

Note 9: Dividends

We declared dividends to QSC of $600 million and $2.2 billion and paid dividends of $800 million and $1.8 billion during the three and nine months ended September 30, 2008, respectively.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Unless the context requires otherwise, references in this report to “QC” refer to Qwest Corporation, references to “Qwest,” “we,” “us,” the “Company” and “our” refer to Qwest Corporation and its consolidated subsidiaries, references to “QSC” refer to our direct parent company, Qwest Services Corporation, and its consolidated subsidiaries, and references to “QCII” refer to our ultimate parent company, Qwest Communications International Inc., and its consolidated subsidiaries.

Certain statements set forth below under this caption constitute forward-looking statements. See “Special Note Regarding Forward-Looking Statements” at the end of this Item 2 for additional factors relating to such statements, and see “Risk Factors” in Item 1A of Part II of this report for a discussion of certain risk factors applicable to our business, financial condition and results of operations.

Business Overview and Presentation

We provide voice, data, Internet and satellite video services. We generate revenue from services provided in the 14-state region of Arizona, Colorado, Idaho, Iowa, Minnesota, Montana, Nebraska, New Mexico, North Dakota, Oregon, South Dakota, Utah, Washington and Wyoming. We refer to this region as our local service area.

Our operations are included in the consolidated operations of our ultimate parent, QCII, and generally account for the majority of QCII’s consolidated revenue. In addition to our operations, QCII maintains a national telecommunications network. Through its fiber optic network, QCII provides the following products and services that we do not provide:

For certain products and services we provide, and for a variety of internal communications functions, we use parts of QCII’s telecommunications network to transport voice and data traffic. Through its network, QCII also provides nationally and globally some data and Internet access services that are similar to services we provide within our local service area. These services include private line, ATM and frame relay.

Our analysis presented below is organized to provide the information we believe will be useful for understanding the relevant trends going forward. However, this discussion should be read in conjunction with our condensed consolidated financial statements and the notes thereto in Item 1 of Part I of this report.

In light of regulatory changes in 2007 and consistent with QCII’s continuing strategy to simplify its and our corporate structure and gain operational efficiencies, in the first quarter of 2008 QCII moved to us most of the administrative and other functions of QSC and merged into us two of QSC’s other wholly owned subsidiaries that previously charged the majority of their costs to us:

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These reorganization activities combined businesses that were already controlled by QCII, therefore we accounted for these activities in a manner similar to a pooling of interests. These activities had the following effect on our condensed consolidated financial statements for the three and nine months ended September 30, 2007 and as of December 31, 2007:

In addition, to aid the understanding of these and future financial statements, we recast prior year financial information in our Current Report on Form 8-K dated April 4, 2008 (our “April 4, 2008 Form 8-K”).

QCII continues to evaluate other ways to better organize the legal structure and operations of its subsidiaries and may make additional changes to the legal structure and operations of its subsidiaries, including us, in the future. In connection with these past or future reorganization activities, we do not believe we have consummated, and we do not expect to consummate in the future, any business combinations or other transactions that will adversely affect our consolidated financial condition or results of operations.

During the first quarter of 2008, we also changed the definitions we use to classify expenses as cost of sales, selling expenses or general, administrative and other operating expenses. Operating expenses are now reported as follows:

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We believe these reclassification changes allow users of our financial statements to better understand our cost structure and the way we manage our business. These expense classifications may not be comparable to those of other companies. These changes had no impact on total operating expenses or net income for any period.

To reflect the impact that the reorganization activities and expense reclassifications described above would have had if they had been implemented in prior periods, we have recast and reclassified certain financial information for the three and nine months ended September 30, 2007 that is presented in this Item 2 and in our condensed consolidated financial statements in Item 1 of Part I of this report. In addition, to aid the understanding of this filing and future filings, we recast and reclassified certain prior year financial information in our April 4, 2008 Form 8-K.

We have also reclassified certain other prior year revenue, expenses and access line amounts to conform to the current year presentation.

Business Trends

Our financial results continue to be impacted by several significant trends, which are described below:

We also continue to focus on improving penetration of broadband services, and broadband subscribers continue to grow as customers migrate to higher speed Internet connections. We reached 2.7 million broadband subscribers as of September 30, 2008 compared to 2.4 million as of the same date in 2007. We believe the ability to continually increase connection speeds is competitively important. As a result, we continue to invest in increasing our available connection speeds to meet customer demand. We expect broadband subscriber growth to continue, but at a lesser rate than in prior periods, as we continue to compete in a maturing market where a significant portion of consumers already have a broadband connection.

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While these trends are important to understanding and evaluating our financial results, the other transactions, events and trends discussed in “Risk Factors” in Item 1A of Part II of this report may also materially impact our business operations and financial results.

Results of Operations

Overview

We generate the majority of our revenue by providing services using our telecommunications network. We also generate revenue from services we provide to our affiliates. Depending on the products or services purchased, a customer may pay a service activation fee, a monthly service fee, a usage charge or a combination of these. Our services are further described below.

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We also generate other revenue from USF surcharges and the subleasing of space in our office buildings, warehouses and other properties.

The following table summarizes our results of operations for the three and nine months ended September 30, 2008 and 2007 and the number of employees as of September 30, 2008 and 2007:

Operating Revenue

The following table compares our total operating revenue by products and services for the three and nine months ended September 30, 2008 and 2007:

In addition to the specific items discussed below, we believe declining economic conditions negatively impacted our revenue for the three and nine months ended September 30, 2008.

Voice Services Revenue

Voice services revenue decreased primarily due to lower local voice services revenue as a result of access line losses of 9% as of September 30, 2008 compared to September 30, 2007. We had 11.869 million and 13.032 million access lines as of September 30, 2008 and 2007, respectively. We continue to experience access line losses as a result of competitive pressures and declining economic conditions, as described in “Business Trends.”

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Data, Internet and Video Services Revenue

Data, Internet and video services revenue increased primarily due to an 11% increase in broadband subscribers and, to a lesser extent, a 30% increase in satellite video subscribers as of September 30, 2008 compared to September 30, 2007. The growth in broadband services revenue resulted from continuing increases in penetration and, to a lesser extent, increased rates as customers upgraded to higher speed services. Private line services revenue also increased as a result of higher volumes. These revenue increases were partially offset by a decline in frame relay and ATM services revenue due to lower volumes.

Affiliate Services Revenue

Affiliate services revenue decreased primarily due to a change in the way we determine sales and marketing and advertising support services billed to our affiliates. We implemented this change in the fourth quarter of 2007. These revenue decreases were partially offset by an increase in services we provided to support an affiliate’s data and Internet product offerings.

We estimate that the profit from these affiliate services was approximately $90 million and $100 million, before income taxes, for the three months ended September 30, 2008 and 2007, respectively, and $290 million, before income taxes, for each of the nine month periods ended September 30, 2008 and 2007.

Operating Expenses

The following table provides further detail regarding our total operating expenses for the three and nine months ended September 30, 2008 and 2007:

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Cost of Sales (exclusive of depreciation and amortization)

Cost of sales are costs incurred in providing products and services to our customers. These include: employee-related costs directly attributable to operating and maintaining our network (such as salaries, wages and certain benefits); and other cost of sales directly related to our network operations (such as professional fees, materials and supplies, equipment sales costs and outsourced services).

Employee-related costs increased for the three months ended September 30, 2008 primarily due to a severance charge of approximately $40 million related to network operations, partially offset by lower costs associated with the first quarter of 2008 employee reductions in our network operations. Employee-related costs remained essentially flat for the nine months ended September 30, 2008 primarily due to severance charges of approximately $40 million in each of the first and third quarters of 2008 related to employee reductions in our network operations, which were partially offset by lower costs as a result of the first quarter of 2008 employee reductions. As a result of these employee reductions, we expect total employee-related costs to decrease by approximately 4% to 5% in future periods.

Other cost of sales increased primarily due to higher equipment sales costs and higher professional fees and other costs for operating and maintaining our network.

As discussed in Note 7—Commitments and Contingencies to our condensed consolidated financial statements in Item 1 of Part I of this report, during June 2008 floods in the Midwest, particularly Iowa, caused damage to our network. Based on our current assessment, we estimate that cumulative expenditures required for the restoration of our network and physical plant will be approximately $30 million, including repairs and equipment replacement. For the three and nine months ended September 30, 2008, we incurred repair expenditures of $6 million and $7 million, respectively, which are included in the $30 million estimate.

Selling Expenses

Selling expenses are costs incurred in selling products and services to our customers. These include: employee-related costs directly attributable to selling products or services (such as salaries, wages, internal commissions and certain benefits); marketing, advertising and external commissions; and other selling costs (such as bad debt expense, professional fees and outsourced services).

Employee-related costs increased primarily due to a severance charge of $8 million in the third quarter of 2008 and higher costs associated with our sales force. These increases were partially offset by a decline in the amortization of customer acquisition costs associated with the activation of access lines. Certain customer acquisition costs are deferred and amortized over the expected life of the customer relationship and have been declining in amount as a result of access line losses and promotional waivers of activation fees.

Marketing, advertising and external commissions decreased primarily due to lower costs for media advertising in 2008.

Other selling costs increased due to higher professional fees related to systems and process improvements to support selling and billing functions and higher costs for postage and shipping, bad debt expense and other costs, including expenses associated with sponsoring the Democratic and Republican National Conventions, which took place in our 14-state region in the third quarter of 2008.

General, Administrative and Other Operating Expenses

General, administrative and other operating expenses are corporate overhead and other operating costs. These include: employee-related costs for administrative functions (such as salaries, wages and certain benefits);

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taxes and fees (such as property and other taxes and USF charges); real estate and occupancy costs (such as rents, utilities and fleet costs); and other general, administrative and other operating costs (such as professional fees, outsourced services, litigation related charges and general computer systems support services). These expenses also include our pension and post-retirement benefits costs for all employees and retirees.

Employee-related costs decreased for the three months ended September 30, 2008 primarily due to lower pension and post-retirement benefit costs, partially offset by increases in certain health care costs and a severance charge of $15 million. Employee-related costs decreased for the nine months ended September 30, 2008 primarily due to lower pension costs, payroll taxes and certain health care costs, partially offset by severance charges of $24 million and an increase in post-retirement benefit costs.

Taxes and fees for the nine months ended September 30, 2008 decreased primarily due to a $40 million favorable property tax settlement recognized in the second quarter of 2008 and other favorable adjustments in 2008.

Other expenses for the three months ended September 30, 2008 decreased primarily due to a $13 million legal reserve accrual recorded in the third quarter of 2007 related to patent infringement claims. For the nine months ended September 30, 2008, other expenses decreased due to the legal reserve recorded in the third quarter of 2007 and lower marketing research expense partially offset by increased professional fees.

Affiliate Expenses

Affiliate expenses include charges for our use of long-distance services, wholesale Internet access, insurance, occupancy charges and certain retiree benefits.

Affiliate expenses increased primarily due to Internet access and voicemail services, occupancy charges and a general liability insurance credit adjustment in 2007.

Depreciation and Amortization

The following table provides detail regarding depreciation and amortization expense:

Depreciation expense decreased due to lower capital expenditures and the changing mix of our investment in property, plant and equipment since 2002. If our capital investment program remains approximately the same and we do not significantly shorten our estimates of the useful lives of our assets, we expect that our depreciation expense will continue to decrease.

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Other Consolidated Results

The following table provides detail regarding other expense (income)—net and income tax expense: