Paetec Holding Corp. Q3 2008 Earnings Call Transcript

Paetec Holding Corp. (PAET)

Q3 2008 Earnings Call

November 13, 2008 8:30 am ET

Executives

Arunis Chesonis – Chairman, CEO

Keith Wilson – Chief Financial Officer

Analysts

Frank Louthan – Raymond James

Tim Horan – Oppenheimer

Simon Flannery – Morgan Stanley

David Dixon – FBR Capital

Rai Archibold – Kaufman Bros.

Michael Rollins – Citigroup

Donna Jaegers – D.A. Davidson

Presentation

Operator

Welcome to the third quarter 2008 Paetec Holding Corp. earnings conference call. (Operator Instructions) I would now like to turn the presentation over to Mr. Tom Morabito, Vice President of Investor Relations.

Tom Morabito

Welcome to Paetec's third quarter 2008 conference call. With me on today's call are Chairman and CEO, Arunas Chesonis, and Chief Financial Officer Keith Wilson. Following our prepared remarks, we will then conduct the Q&A session. Our Chief Operating Officer, E. J. Butler is under the weather and unable to make the call. However, he will be joining us next quarter.

Before we get started I need to remind everyone that in our remarks today we'll be making some forward-looking statements about our expected operating results and financial position, our business strategy, our integration of acquired companies and other matters relating to our business. These statements involve known and unknown risks, uncertainties and other factors that may cause our actual operating results, financial position or performance to be materially different from those we express or imply in our forward-looking statements.

We have highlighted some of the more important risks and uncertainties in our earnings release. For a more detailed discussion, please refer to Paetec's 2007 10-K, and our other filings with the SEC. We disclaim any obligation to update publicly any of our forward-looking statements.

Finally, please note that on today's call we will be referring to certain non-GAAP financial metrics. These metrics are reconciled to the most comparable GAAP measures in our press release which has been posted on the investor relations portion of our web site at paetec.com.

With that, I would now like to turn the call over to Arunas.

Arunas Chesonis

For the third quarter we are reporting revenues of $406.1 million, adjusted EBITDA of $57.8 million and free cash flow which we define as adjusted EBITDA minus CapEx of $26.4 million. While management expects stronger operating results in the future, the third quarter performance was generally in line with our expectations.

General trending of our business has not changed since we reported second quarter earnings but importantly, new sales and up sales continue to be solid and are helping to offset pressures associated with minutes of use, contract renewal write downs and customer dislocation. The Paetec value proposition continues to be well received in the market and the company's position as an excellent alternative to the incumbent operators.

In my remarks today, I would like to focus on three main things. First, our new sales remain strong as customers continue to respond to Paetec's overall value proposition in these tough economic times. Second, we continue to take the necessary steps to deal with the current macro environment and third, I would like to reiterate that once again, we are in strong financial shape and very well positioned in the long term.

First, let's talk about new sales. Paetec continues to benefit in the market place as customers are drawn to Paetec's nationwide availability, our comprehensive product offerings and industry leading customer service. During the past 60 days, Paetec has been recognized by many organizations for the quality and creativity of our services.

On October 2, we received the Most Innovative Product Award from Telephony Magazine for the company's application of SiP Trunking service. The judges decided this customizable VOIP solution combined with our national presence as a key differentiator among our competitors for capacities ranging from T1 to gigabit Ethernet.

On October 21, the Association of Financial Professionals honored Paetec with its Pinnacle Award for Treasury as a strategic partner. We were singled our for our equipment rental program which helps business customers reduce or even eliminate the capital investment as part of the network services contract. Over the next few years, we see our family of financing options for clients as a strategic weapon to drive new sales. And, in late September we received the Telecom Business Excellence Award from the Research Firm, Atlantic ACM.

Our target market rated us highest compared to all carriers for large business and enterprise voice value, and during the third quarter, Paetec signed on 1,700 new customers with the average contract length being three years, which provides a great deal of stability. And just as a reminder, no single customer accounts for more than 1% of total revenues and we believe that this diversity in our revenue base differentiates us from a number of our competitive telecom peers.

Second, Paetec continues to aggressively cut costs to prepare for the difficult economic environment ahead, while at the same time, managing the operations in a way that we believe will keep the company well positioned for the economic turn around when it comes. While we are confident in the long term prospects of the business, it is important to ensure the company's cost structure is appropriately outlined for future market realities.

We anticipate taking another $30 million in expenses out of the business during 2009, including additional work force reductions and expense management initiatives. While these actions are important to pursue out of prudence and not necessity, we plan to continue to invest in sales and service personnel. Paetec's hallmark continues to be high levels of personal service and we expect that will continue regardless of the economic climate.

Additionally, Paetec plans to continue to appropriately invest in the network to ensure operational integration of previously acquired markets and back office systems.

Third, I would like to spend a few minutes reiterating that our financial position remains strong. We have now been free cash flow positive for 23 uninterrupted quarters and we ended the third quarter with $72 million in cash on hand. Giving effect to our October 15 draw down of our $50 million revolving credit facility, we currently have over $130 million in cash on the balance sheet.

Maintaining a solid liquidity position allows our company the flexibility to make investments when others may not have that ability. For example, we can repurchase some of our stock at a time where we believe it to be a great investment, and we can continue to make capital investments for the future.

As for our debt, we are enjoying the benefits a refinancing of debt last summer when the credit markets were significantly more favorable for issuers. We generally are not required to repay any of the principal outstanding on our term loans, other than $1.5 million per quarter until February 2013. Borrowings under the facility generally bear interest at an annual rate of LIBOR plus 2.5%.

Likewise, we generally are not required to repay any of the principal outstanding under the senior notes until July 2015, having only semi-annual interest payments to make before that date. The notes accrue interest at a rate of 9.5% per year.

In terms of covenants, the July 2007 amendment to our credit facility eliminated a financial covenant that had required us to maintain compliance with specified ratios of consolidated adjusted EBITDA to fixed charges and left us only one financial covenant under our credit facility. That remaining financial covenant requires our ratio of consolidated net debt to consolidated EBITDA for any measuring period not to exceed five to one.

We continue to remain well within the requirements of this covenant and the senior notes do not impose any financial maintenance covenants on our business.

Lastly, I also wanted to mention some positive news relating to our interest rate hedging activity. Paetec currently has $400 million in active swaps with $175 million maturing April 30, 2009 and $225 million maturing June 30, 2009. The blended all in rate on these swaps is 7.9%.

Yesterday, Paetec executed a $400 million forward swap to replace existing swaps as they mature on April 30 and June 30 of 2009 respectively. The new $400 million two year swap will mature on June 30, 2011 and carry a blended all in rate of 5.3%. Once the new swap becomes fully effective on June 30, 2009, Paetec believes its annual interest expense will be reduced by approximately $10 million.

Just to summarize my remarks, I do not believe that Paetec's strong business prospects and overall financial strength are currently being fairly reflected in our share price. Our Board of Directors feels the same way as seen by the purchased we have already made under our share repurchase program of up to $30 million.

During the third quarter we bought back $8.5 million in Paetec stock and we believe we remain in a position to consider additional purchases under the program subject to overall market conditions, black out periods and other requirements.

Now let's turn the call over to Keith who will take you through our third quarter results.

Keith Wilson

As Arunas indicated, our third quarter results came in as expected and we are reaffirming our guidance for the remainder of the year. As we have done for the past several quarters, I will first discuss the actual results of Paetec Holding for the third quarter as it compares to Paetec's third quarter of 2007. I will then discuss pro forma results for the third quarter 2008 and third quarter 2007 giving effect to Paetec's acquisition of McLeod as if it had happened on January 1, 2007.

As a reminder, the McLeod acquisition closed on February 8, 2008. The pro forma information is not necessarily indicative of what the combined companies results of operations actually would have been if the mergers had been completed on the dates indicated.

First, the actual performance. Revenues for the third quarter of 2008 were $406.1 million which was a 43% increase over the third quarter of 2007. Network services grew by 36.9% year over year to $319.7 million largely as a result of the McLeod acquisition which was the core driver of revenue growth.

This business accounted for 78.7% of our third quarter revenues and continued to see solid increases in MPLS VPN network sales as well as increases in our dynamic IP and network security products, resulting in an annual growth rate in this product set of over 51.1%.

Overall, we continue to see firm sales of our core integrated voice and data T1 products which make up the bulk of the revenues in the network services business. Similar to last quarter, third quarter 2008 revenue experienced softness due to use of pressure and increase in turn and a desire by some of our customers to negotiate lower rates upon contract renewal.

The softer areas for the quarter were long distance with growth of only 30.3% and carrier access revenues which grew at just about 37.1% year over year. As discussed earlier, lower than expected uses which we believe resulted from a number of factors was the primary driver for this softness, while our rate per minute was for the most part stable.

Carrier services which accounted for 17.3% of the third quarter revenues grew by 75.2% to $70.3 million largely due to the inclusion of the McLeod revenues which as a reminder, has a higher percentage of its revenue base coming from carrier customers.

Despite the higher growth rate within carrier services, the pressures on carrier access led to head winds within this business and are continuing. Year over year comparisons were also impacted by the loss of some wireless customers that occurred prior to the third quarter 2008 primarily due to consolidation in the wireless industry.

Integrated solutions made up the remaining 4% of revenues and grew 58.5% year over year to $16.1 million. The addition of All Works which was acquired during the fourth quarter of 2007 contributed $2.9 million to the top line results for this segment.

Core integrated solutions continues to be well received by the broader customer base with an annual growth in the VAR segment of 45.6% year over year.

Adjusted EBITDA for the quarter was $57.8 million which was a 7.4% increase from the prior year. The improvement in adjusted EBITDA was largely driven by the inclusion of the revenues from McLeod.

As a percentage of revenue, adjusted EBITDA declined to 14.2% down from 19% in the prior year period which was largely impacted as anticipated by the addition of lower margin McLeod and All Works revenue contributions.

Network investment focused on merger related network enhancements, more robust MPLS infrastructure and network expansion in markets like eastern Massachusetts and Maine. Additionally, pressure on certain products including the POTS business and usage sensitive products, resulted in margin pressure associated with existing network assets.

Our margins were also affected by higher SG&A expenses. Overall, SG&A expenses were more or less in line with expectations in key areas as payroll, sales and marketing, and outside services. The one noticeable increase as a percentage of sales was facilities expense necessary to support the significantly broader infrastructure that is in place due to the McLeod acquisition.

Due to the lack of maturity of a number of acquired markets, there is an operating leverage opportunity in this area and we hope to benefit from that opportunity during 2009.

Net loss for the third quarter of 2008 was $355.8 million versus a net loss of $5.1 million in the third quarter of 2007. The net loss included a preliminary $340 million non cash good will impairment charge driven by Paetec's significant decline in market capitalization as a result of a decrease in our share price.

Any adjustment to this estimated impairment loss based on the completion of the measurement of the impairment loss will be recognized in the fourth quarter of 2008.

Third quarter 2008 also included a significant increase in depreciation and amortization expense to $53.4 million versus $35.2 million in the third quarter 2007. The increase in D&A resulted from growth of our depreciable asset base as well as the recognition of increased intangibles due to the McLeod acquisition.

CapEx for the third quarter 2008 was $31.3 million or 7.7% of revenues versus $18.3 million or 6.5% of revenues in the third quarter 2007. The change was largely due to the timing of certain investments and going forward we generally expect CapEx to be in the range of 7% to 9% of annual revenues.

Free cash flow which we define as adjusted EBITDA less CapEx was $26.4 million which marks our 23rd consecutive quarter of free cash flow generation.

Now I will discuss the year over year results for the third quarter 2008 and the third quarter 2007 giving effect to Paetec's acquisition of McLeod U.S.A. as if it had happened on January 1, 2007. Once again, please keep in mind that the pro forma information is not necessarily indicative of what the combined companies results of operations actually would have been if the mergers had been completed on the dates indicated.

Pro forma revenues for the third quarter of 2008 were $406.1 million up four tenths of a percent in increase over the third quarter of 2007 pro forma revenues of $404.4 million. While Paetec has historically enjoyed higher levels of year over year growth, transition of certain segments such as the POTS business inherited from the McLeod acquisition, the migration of wholesale wireless business and macro economic head winds all contributed to the drag on the top line.

Pro forma adjusted EBITDA for the third quarter of 2008 was $57.8 million versus pro forma adjusted EBITDA of $64.1 million in the third quarter of 2007. This is a 9.9% decline period over period.

Pro forma adjusted EBITDA as a percentage of revenues for the third quarter 2008 was 14.2% versus 15.9% on a pro forma basis for the 2007 quarter. Continuing operating leverage of the company's network and employee base was offset by the lower margin McLeod and All Works revenue base as well as by the increase in network expenses mentioned previously.

While SG&A expenses tracked as expected and declined nine tenths of a percent year over year on a pro forma basis, cost of sales increased $8.9 million year over year resulting in a 200 basis point decline in gross margins on a year over year basis. Contributing factors included an increase in equipment sales that amounted to roughly half of the $8.9 million increase, an upgrade in our southeast data network which cost $500,000, our continuing efforts to disconnect underutilized facilities which amounted to $500,000, and an overall increase in wholesale traffic which tends to be lower margin.

Pro forma net loss for the third quarter of 2008 was $355.8 million compared to a pro forma net loss of $18 million for the third quarter of 2007, once again reflecting the preliminary non cash impairment charge just mentioned.

Now for Paetec's expectations for the remainder of the year. With the third quarter results coming in as anticipated and based on our expectations for the remainder of the year, we are reaffirming our 2008 guidance on both an actual and on a pro forma basis.

The pro forma guidance represents the anticipated results of the combined Paetec and McLeod business for 2008 as if the acquisition had occurred on January 1, 2008 instead of on February 8, 2008. Paetec's actual 2008 results will not include the results of McLeod from January 1, 2008 through February 8, 2008.

On an actual basis, Paetec anticipates generating revenues between $1.545 billion to $1.585 billion, adjusted EBITDA in the range of $224 million to $249 million and capital expenditures between $122 million and $147 million.

On a pro forma basis, we expect revenues between $1.6 billion to $1.64 billion, adjusted EBITDA in the range of $230 million to $255 million and capital expenditures between $125 million and $150 million.

That concludes our prepared remarks, and I would like to ask the operator to open the call to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Frank Louthan – Raymond James.

Frank Louthan – Raymond James

Can you give us an update on some of the voice and volume based business and what are your plans for that business longer term? Are you looking to diversity away from that and how have you changed the comp structure in the quarter? Can you give us an update on that and when you expect to start to see the impact from that as you try to incent revenue and try and decrease the churn that we saw earlier in the year?

Arunas Chesonis

I think on the voice side, again it's one of those products that although it does fluctuate depending upon any individual customers situation, it is also good revenue stream, and its something that can generate free cash flow for us in the long term. I do think the technology will be changing over time, but we are not shying away from driving more monthly recurring charges or variable usage charges with our customers. It's really about servicing them and what's the best solution for their organization.

I do think you're going to see as you mentioned, our compensation structure support a greater focus on not just bottom line EBITDA performance and return on any capital investment, but we're focusing more on the actual gross margin contribution per customer as we move forward. That's probably the most significant change we're making.

What's allowing us to do that is some of the enhancements in the IT infrastructure that allows us to look at actual gross margin per account on a much easier and real time basis. So that's beginning early in 2009 and we think that's really going to help us drive additional free cash flow looking out the next few years.

Frank Louthan – Raymond James

Is that system going to be in place across all the Paetec like the McLeod territories?

Arunas Chesonis

Absolutely. It's in place now. It's being utilized for people on a voluntary basis. We've done for a three to six month period, and what we're doing is cutting off the ability not to be required to use it on January 1. So right now it's actually being used by a significant part of the organization throughout the U.S. and it will be the standard way that we manage our new prospective customers and our existing customers' profitability going forward throughout the country.

Operator

Your next question comes from Tim Horan – Oppenheimer.

Tim Horan – Oppenheimer

Where your stock is trading it seems to be that the market thinks that you're going to go bankrupt or be under massive duress which looks fairly logical given these results and you balance sheet, but nevertheless that seems to be the concern out there. Can you talk about a little bit on your expectations to the economy, what you're planning for? I'm not looking for '09, '10 guidance, but if the economy worsens and unemployment continues to go up to 8% or 9% do you think you can hold margins and free cash from margins where they are?

Do you have enough flexibility to cut both OpEx and CapEx to maintain margins in a really down case scenario? And maybe, revenue is more flattish, can you expand margins from here? Your debt is kind of trading at $0.57 on the dollar, it looks like in the $0.50 range anyway, I guess the market is kind of concerned with the amount of leverage that you currently have. Could you talk about your appetite for buying back debt in the open market?

Arunas Chesonis

I think our view is typically a conservative one. At Paetec, our management team has historically tried to play things very carefully ever since we went through that first down turn in 2001 and 2003. For us, we're hoping it's not going to be the case but we're planning as if 2009 will be a more difficult year for our customers than this year was.

That's why we are taking the aggressive actions now to prepare for something like that. We hope it doesn't happen, but if it does, we'll be able to hold the free cash flow margins comparable to what we have today. I think 2010 we believe that we should see some improvement. That's the way we're planning it internally.

As far as some of the comments on people's perceptions on whether we're able to make it through this down turn, I frankly don't understand when people look at the facts why they are as nervous as they are about Paetec. When I talk to my employees internally, we have a business that really can weather down turns reasonably well because of the importance of our services to the underlying retail customers that we have.

People shut down their electricity, their water and communications services last when they're going through these down turns so I'm puzzled sometimes by the nervousness of some of our shareholders and lenders. But as far as appetite for buying back debt, we do have restrictions placed on us by our senior credit facility/

Keith Wilson

Let me just kind of reiterate some of Arunas' comments. I think probably the most important thing for whether it be lenders or investors to remember with Paetec is management, Board; insiders own 20 million to 25 million shares. We're going to do everything in our ability to ensure long term stability for the company, and while we don't like either the price of the debt or the price of the stock, our job is to make sure that we run a good healthy business and that we create value and people will devalue where they view it.

I think it's as much a redemption dynamic as it is an overall market dynamic and we're part of that issue. So we appreciate that.

In terms of being able to manage the business in a down turn, we talked last quarter about us viewing this as a kind of 18 to 24 month down cycle. As Arunas said, the later half of 2010 we think we should anticipate seeing some firming up. That being said, we've run a number of different models to try to take a look at the variable components of the business and the flexibility that we have.

The challenge is, and again not ducking the direct answer, is that there are a lot of different scenarios in terms of how the business changes and how to manage that. In all of those scenarios, we believe that we have many leverages at our disposal to be able to effectively sustain free cash flow. And I think as the competitive provider that has had free cash flow multiples longer than anybody else in the space, almost six year running, I think we feel very comfortable that the business model allows us that flexibility and allows us to provide the same high quality service to our customers, because that's ultimately the balance, is delivering what you're promising to your customers and maintaining the financial stability.

Yes we have room in OpEx, cost of service and CapEx to be able to manage assuming that the economy gets significantly worse, and our business is directly affected.

Tim Horan – Oppenheimer

And on the debt repurchasing?

Keith Wilson

Well we have limitations on the credit facility so I know we've got a lot of folks on the call that are part of our bond and credit facility. Assuming that those folks give us the flexibility at a reasonable price to do it, I think the Board would absolutely look at it. Based on some of the other amendments that have gone to market, I'm not sure that that's an economically wise transaction for us.

Not to beat a dead horse but we just saved $10 million a year on interest by executing a swap yesterday that gives us null in cost of debt of 5.3% and in your note this morning you talked about AT&T printing paper at 6.7%. So I think we need to be very sensitive to the strength of the capital structure today for the company.

I'm thinking about the benefit of what it would cost us to go back out to the market to be able to take advantage of other's concerns in the company.

Operator

Your next question comes from Simon Flannery – Morgan Stanley.

Simon Flannery – Morgan Stanley

I was wondering if you could talk about the environment out there recently. It's good to hear you hitting your expectations and reaffirming your guidance. It seems like for you, things started to soften in this July/August time frame and we then saw a lot of companies during this earnings season saying that October was very weak. But it sounds like what you're saying, things really slowed in the summer and they've been relatively stable. You haven't seen any incremental weakness or not much if you could comment on that.

And any comments on the change of administration in Washington and inter-carrier comp and some of your thoughts around how that might affect you.

Keith Wilson

As it relates to where the business sits as we go through September and October, we've continued to see a balancing act of usage pressure on historically levels. So if you look at customers from their usage patterns, revenue spend, things like that, from last year during the same periods, we've definitely seen pressure on that in the 3% to 4% range in terms of volumes.

We've also seen stable rate per minute as an affective balancing act and what we've been able to do is, our new sales or new product development, some of those things have affectively offset those pressure points. What we haven't seen is increased pressure from the June, July, August time frame, and so we're seeing consistent trends through those months, and we continue to see relatively stable performance of the company on a month over month basis in those key business areas.

Arunas Chesonis

I tend to go on about 15 to 20 sales calls a week with existing customers or new perspective customers or agents. What I found the last two months is a real desire and an acceleration of decision makers in our customer base that want to offload as many expenses as they can to other carriers, to almost source as much as they can.

So where it took us six months to convince someone to go for a managed router configuration with us and trust us versus their own employees to manage that IT infrastructure for them, they're much more willing and excited about offloading costs because they're going through significant head count reductions in their organizations.

It applied towards not just the ancillary services for Paetec but other more traditional core products. We do see a slow down in people's capital spending, and new telephone systems, new IT equipment, and that's where our equipment services and financing opportunities where we bundle additional equipment in exchange for long term high margin contracts for customers, is really 90% of the conversation right now when I'm in sales calls.

People need additional support but they just don't have the dollars internally to be able to execute those contracts. We provide them that solution, so I think we see it in our customer base every week, what they're going through and it tends to help out not just companies like ourselves, but some of our competitors because people are willing to talk about things that a year ago they weren't really willing to.

I think on DC side, we've had inter-carrier compensation reform. You have all kinds of discussions going on for four or five years in Washington, and I find it a little curious and puzzling why the FCC Chairman would try to force that issue over the next four to five weeks. It's such a complex issue. It has so many constituents.

It affects thousands of telecom customers, the consumer and business sectors and not to provide the thoughtful balanced approach with a lot of different ideas, viewpoints, meetings and discussion, I'm skeptical that they're going to be able to do something in the next five weeks that they haven't done in the last five year, especially with the backdrop of a new administration coming in.

I just feel that we that we may get something but I'm not sure how that survives through next year, any kind of a decision that comes out right now.

Operator

Your next question comes from David Dixon – FBR Capital.

David Dixon – FBR Capital

Let me follow up on the question, in the context of what you're seeing is the steady pressure on the business, can you give us some percent of the balance that you're working with between shifting resources to more of a sales focus versus the cost cutting to reflect the lower demand levels that we're seeing in the SG&A line, and perhaps digging into the agility that you have on the cost of goods sold line going forward through '09.

Arunas Chesonis

I think for us when you're looking at the cost reductions, there are many activities that do add value for our company in the medium to long term, but there are areas where we haven't yet cut that we plan to for next year.

You can go through the marketing category as an example. The number of attendees and trade show expenses that we see ourselves being required to invest into in the next year versus just having a group of employees circulate within that conference, there's hundreds of examples of areas where we can cut expenses without cutting into the muscle of the organization.

We do see ourselves continuing to add people in the network operations center, in customer service, in sales and support, in areas that directly face the customer, touch the customer. But in some of the overlay positions and back office positions that are not quite as critical, that's where you'll see the shift on the SG&A line for the company over the next year.

And again, it's something that we can modify as we go through next year and into 2010. It's something that's very easily changed as we see the general conditions in the economy either worsen or improve.

On the gross margin line, I think that's one area where we're going to be spending an awful lot of time negotiating with our vendors, reconfiguring the network and just trying to accelerate some of the network redesign we've been going through over the last six months. There is more savings that we can get out of the network, and we're going to be very aggressive over the next six months in that area.

Operator

Your next question comes from Rai Archibold – Kaufman Bros.

Rai Archibold – Kaufman Bros.

Related to the usage revenues, I understand you talked about 3% volume year over year. Can you give us a sense what percent of the total revenues that represented? In the June quarter you talked about pricing as well being an issue, particularly in pricing some contracts, maybe you can bring us up to date in terms of what you're seeing in the pricing environment relative to your competitors and some of the one back initiative from Ilex.

Keith Wilson

I can start with the re-pricing. We haven't seen any significant change from where we were over the last two months. It's been just as aggressive on the re-pricing of contracts. We have seen though, something different than we saw last quarter. We've seen selected carriers and selected customers on selective services price increases going out and people trying to offset some of the decline in their cash flows with increasing rates to their accounts.

That's something that we want to keep an eye on the next couple of quarters because that could become a trend for a lot of carriers out there potentially depending on the service you're talking about. We don't see as many impacts on the win back programs once a customer has left one of the competitors.

Where we see people digging a little bit more is in re-pricing their existing contracts when we're trying to get that customer to move over to Paetec in the first place. That's where we see, depending on the carrier, depending on the city, people being more aggressive on their write downs to retain that business.

But as far as real substantial, impactful win back programs against our customer base, we just don't see that as much as maybe some other carriers do.

Rai Archibold – Kaufman Bros.

Where you've seen price increases, can you give examples of what types of applications or services where those increases are occurring?

Keith Wilson

What we've seen from our competitors is everything from incremental rate increases on the surcharges, on monthly recurring charges, on some of the facilities, on other ancillary products. It's across the board depending upon what customer base you're looking at and what carrier. I'm not trying to dodge your question, it's just that there's a variety throughout the entire industry right now.

Rai Archibold – Kaufman Bros.

Just the percentage of your total revenues that are usage based?

Keith Wilson

If you break out the usage base components, carrier access is about 9% and you have long distance usage and LMS usage or local usage that would make up right around 18% to 19% additional.

Just to be clear, the citation that I had earlier about the decline in minutes of use was not on that entire base. What we were doing is giving a snap shot of customers that were with Paetec last year versus customers who are with Paetec this year and the volumes that we've seen in terms of trending year over year.

So that's a sub set of our overall base and I just want to make sure that's clear. So as you're looking at your math, I don't want to suggest to you that you're seeing a 3% to 4% decline across that entire 27% of the business. It's more of a sub set to give you directionally what we're seeing and what some of the pressure points are.

Arunas Chesonis

Just to add to your question as well as Frank's earlier question on compensation structure, what we found the last couple of years, our organization in sales is so focused on getting the monthly minimum commitment over a long period of time from our accounts that we focused a lot on those traditional fixed monthly charges and some of our sales professionals ended up not focusing as much on the usage components of our customers spend.

Now with us changing to more of a gross margin across the entire customer base as opposed to just focus on those monthly recurring charges, I think we're going to see our sales organization in the next year or two refocus on getting some of that usage based traffic which will help the profitability from every single customer.

Operator

Your next question comes from Michael Rollins – Citigroup.

Michael Rollins – Citigroup

If you look sequentially 2Q to 3Q, can you talk about some of the areas where you had the best growth gains in revenue, if you try to drill down to network services in a little bit more detail, and maybe some of the incremental areas where you saw the most challenging churn whether it was on pricing churn, lower prices or customer loss?

And the other question I had was what was the average number of shares in the quarter? I saw you gave the ending shares in the release, but I was curious if you could talk about what the average was.

Arunas Chesonis

The areas of particular strength from a sequential basis really it's all about data. Data has continued to be very, very strong for us. LPS, VPN uptick continues to be very strong. Core internet product continues to be very strong, and basic monthly recurring charges, so essentially integrated T1's with the flat rate charges. Those were all areas of real strength for us.

As we talked about some of the year over year softness it continues to be similar to what we saw sequentially. So we saw effectively flat performance on long distance, a little bit of pressure on some of the local usage components and relatively flat cavs with down performance in POTS and things of that nature.

So pretty consistent thematic. New sales continue to be strong. New sales are about 50% data centric while not data exclusive, have some significant component of data, and so that continues to pick up as an important product set for us.

Average share is about 145.

Operator

Your next question comes from Donna Jaegers – D.A. Davidson.

Donna Jaegers – D.A. Davidson

Can you talk a little bit about what you saw as far as revenue or customer churn during the quarter? And what are you doing with your credit screens especially related to Arunas' comments as far as people being more anxious to go to manage services because they can't afford the CapEx. What are you doing to tweak your credit screens there to make sure that you're not being set up for somebody who may fail down the road?

Keith Wilson

Credit has always been a real strength of Paetec. We saw write offs of just shy of 80 basis points last quarter. That's up a little bit. Last year I think we averaged about 60 basis points for the full year. I think that the credit process is quite robust, is quite strong and historically it has been, especially with the nature of our customers.

I know as folks, especially on this call talk about enterprise, they tend to view us a little bit on the lower end of enterprise, but the core customer that we're serving is still a three to four T1 customer, and you're talking about 100 to 150 employees, fairly stable companies.

As we looked at these more managed applications and think about how we take greater ownership of the customer relationship, there's always going to be risk of future bad debt and write off, but we do believe that our process is very, very solid and has survived some softness in the past. It's an area of great focus for us.

From a churn standpoint, revenue churn continues to be very stable, 70 basis points or so. We're in the midst of a disconnect project that we have talked to everybody about on our last call, and so our churn levels were a little bit higher last quarter. Our enterprise churn on a combined basic across all companies was about 1% from a line standpoint and on the wholesale side was just shy of 2%.

The POTS business continues to trend in the 2.5% to 2.6% churn rate. So those levels are especially on the wholesale side, a little bit higher but the revenue components of what churned off of those DS3's were fairly small which was part of why we incented that stuff to move off the network to try to improve the network cost structure, really to David's question earlier, and some others about the things at our disposal, is that if we manage less profitable pieces of business off of the network, that should lead to enhanced profitability, especially on the gross side.

Donna Jaegers – D.A. Davidson

On access charges, level three has been pretty vocal about saying that they're seeing the bells, especially it sounds like Verizon or actually in AT&T creep up their access charges. Are you seeing any motion in those areas?

Arunas Chesonia

Not right now, we haven't.

Operator

That concludes our question and answer session. I would now like to turn the call back over to management for closing comments.

Arunas Chesonis

Once again, thank you everyone for joining us on the call. I know even with the difficult environment, we're pleased with our third quarter results. I think on the revenue side, we just want to remind you that new sales continue to be strong, and we're also closely monitoring the expenses to make sure that we stay in line with the ongoing trends.

We believe that the cost saving initiatives that are underway will help us really strengthen the company and position us well for next year and beyond. So thank again and we look forward to speaking to you next year.

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