Misty Wells - IR
Steve Oldham – President and CEO
Fred Arcuri - COO
Dan Bessey - CFO
Barry Mccarver - Stephens Inc.
Jonathan Levine - Jefferies
Chris King - Stifel Nicolaus
SureWest Communications. (SURW) Q3 2008 Earnings Call Transcript November 6, 2008 11:00 AM ET
Good day, ladies and gentlemen, and welcome to the quarter three 2008 SureWest Communications earnings conference call. My name is Nora, and I'll be your coordinator for today. At this time, all participants are in a listen-only mode. We will be facilitating a question-and-answer session towards the end of this conference. (Operator Instructions). As a reminder, this conference is being recorded for replay purposes.
I would now like to turn the presentation over to your host for today's call, Ms. Misty Wells of Investor Relations. Please proceed, ma'am.
Good morning, everyone, and welcome to SureWest's third quarter 2008 earnings conference call and webcast. SureWest reported financial results for the quarter this morning. The earnings press release is available on our investor relations section of our website, at www.surw.com and the third quarter 10-Q will be filed soon.
With us on today's call are Steve Oldham, President and Chief Executive Officer, Fred Arcuri, Chief Operating Officer, and Dan Bessey, Chief Financial Officer.
Before we begin, I would like to cover the safe harbor statement and remind you that some of the statements, comments and discussions which occur during this call are forward-looking in nature and relate to future events and/or performance. These statements should not be relied on as historical or absolute fact, as future performance and future events are subject to numerous risks and uncertainties that frequently cause actual results and actual events to change. There are many such risks and uncertainties which could affect the economy or industry and our company in particular, some or all of which could affect future results.
Before making any investment decisions about our company, we encourage you to review the company's most recent filings with the Securities and Exchange Commission, which contain a description of many of these risks and uncertainties under the heading Risk Factors. These reports are available on the investor relation section of our website, at surw.com.
Also, our discussion may contain certain non-GAAP financial measures. The non-GAAP financial measures are defined and reconciled in the tables attached to the quarterly press release, which are available for review on our website.
I would like to now turn the call over to Steve Oldham, President and Chief Executive Officer.
Good morning, and thanks for joining us here today. I'm going to spend a few minutes discussing the progress in our long-term strategy to grow the company. I'll then ask Fred Arcuri, our Chief Operating Officer, to discuss our third quarter operations and initiatives. After that, Dan Bessey, our CFO, will present a financial result -- the financial results for the quarter. After the -- that session is over, we'll have time for your questions.
Let's review some important elements of our long-term strategic thinking before getting into detail about the progress we've made in the third quarter towards achieving our objectives.
First, we deploy advanced fiber-rich networks to markets that have desirable customer demographics and robust commercial business opportunities. Secondly, we aggressively compete for new customers using every advantage we have, including the highest performing data products in the markets we serve, feature-rich HDTV, and creative new services, like our Voice over IP products.
And finally, we seek today diversify our economic, regulatory and political risks by providing both residential and commercial services to customers in multiple market locations. This long-term broadband network strategy has positioned SureWest as the premier broadband service provider in the communities we serve, and addresses the unique competitive and regulatory challenges facing many in the ILEC industry today.
We are very competitive in our traditional Sacramento ILEC, because we have made the decision to overbuild our copper network with fiber and compete not only for traditional voice and data customers, but for ILEC video customers as well.
In those portions of the ILEC where we will not upgrade to fiber, we're deploying abundant copper pair technology to more than double the effective bandwidth to those customers. Couple this with the MPEG-4 compression tool, and we'll be able to provide a very competitive video over copper product, as well. Our ability to remain technologically competitive has allowed us to mitigate the access line revenue loss experienced by most in the ILEC sector.
We are a unique company due to our telecom-to-broadband transformation, and even though the industry wide trend of declining telecom access lines and loss of some regulatory subsidies is impacting our overall growth, we’re building a network that is providing substantial growth opportunities for the future.
To review a few highlights, our employees did an outstanding job of significantly growing the number of RGUs and subscribers during the quarter and over last year, which was demonstrated by our residential RGU growth of 9% year-over-year and 3% growth over the second quarter. They also did a great job of selling more services to existing customers, such as upgrades to HD and our relatively new HD DVR in the California market.
Our growing broadband segment now accounts for 60% of the company's total revenues. We experienced significant growth in business customers during the quarter, and the business product line represented the largest year-over-year revenue increase for the company.
Also during the quarter, we reached the 100,000 broadband customer milestone, a testament to our successful transition from a local telephone company to a leading broadband communications provider.
We are excited by our strong year-over-year growth in what has been a challenging economic climate. By competing aggressively for new customers and marketing new and enhanced products to our existing customers, we are supporting our long-term goals of increasing revenue and EBITDA.
As an over builder that's deploying a superior network, our growth opportunities come from competing for existing broadband customers, which means we are not dependent on new home construction for customer growth. We've been successful with growth on our best-in-class fiber-to-the-home network, and we continue to expand our reach in Sacramento and our Kansas City high-performing HFC network.
Today, nearly 75% of our residential total marketable homes are on what we call our advanced broadband network, which consists of either fiber-to-the-home or that high performing HFC technology.
Two-thirds of our customers on these advanced networks are taking three services -- voice, video and data. And over 90% take at least two of these services. These are important statistics, because the more products and services a customer subscribes to, the more likely they are to remain with SureWest in the long-term. When a customer takes two or three services over one facility, our cost providing that service is significantly less than the combined costs of three separate providers. This cost efficiency provides us with the ability to compete for those customers very effectively.
Success in marketing to new customers underlies our decision to continue with the fiber expansion plan, and we are excited by the upcoming opportunity when we release an additional 12,000 new fiber-to-the-premise marketable homes in the fourth quarter of this year -- 8,000 in Kansas City and an additional 4,000 in the Northern California Sacramento region. We hope to realize the benefits of these expenditures during the fourth quarter and into next year.
We're a little behind on our scheduled release of new fiber marketable homes in the third quarter, which Fred will discuss shortly, and it did have an impact on our third quarter results, as most of the expenditures occurred in the quarter, while the benefits themselves to new customers will not be evident until late in the fourth quarter and into 2009.
However, the fiber-to-the-home build in Kansas -- in our Kansas City market is now fully underway, and already we are seeing a very positive response from customers. We believe that growth in this region provides continued opportunity, and we intend to capture it.
As we've indicated previously, we are mindful of both the competitive nature in this industry and its seasonality, particularly the impacts on churn and sales growth. Our recent historical experience indicates that more customers move between homes during the summer months of the third quarter, thus stopping and restarting service. Because some customers move out of our service territory altogether, our net churning increases slightly in the third quarter, and broadband residential churn was 1.7% compared to the second quarter's 1.5%.
We're not immune to today's economic environment. We have found that customers have become more value conscious. However, we have not seen customers giving up broadband voice, video and data services as a result of the economy.
In response, we are promoting our suite of products through an aggressive sales and marketing tactic with the short-term strategy of growing RGUs and subscribers by adjusting our promotions to accommodate current customer preference. We believe it is important to continue to acquire new customers and grow RGUs with a long-term focus on growing RPU and revenue.
We're excited about a rollout of MPEG-4 in early 2009. This tool allows us to reduce the bandwidth required to deliver HDTV content, and it creates bandwidth for additional channels and potentially new services. It also allows us to improve the stability of our video service in Sacramento, and potentially provides us with the ability to deliver HDTV to customers on a copper network. These network improvements support our growth objectives and afford us with the opportunity of providing superior customer experience.
In September we announced that we refinanced a $30 million short-term loan, and extended the maturity date from February 2009 to May 2012. That this agreement was consummated during the period of historic levels of turmoil in the bank and financial markets speaks volumes about the confidence our banking partners have in our long-term business plan and growth opportunities. Our credit facilities remain unsecured and provide us with the flexibility as we continue with our strategic plan to drive growth and profitability.
Finally, I want to touch on an important issue that is affecting our industry. As many of you know, there are pending proceedings at the FCC regarding former -- reforming the Intercarrier Compensation and Universal Service Fund, which may have -- may be reviewed during the December agenda of the FCC. The changes could lead to a significant alteration of existing compensation arrangements among providers of telecommunications services.
Although reforming intercarrier compensation in universal service support will have varying effects on the telecommunication companies, projected impacts are expected to be relatively minor for SureWest, particularly when compared to some in the ILEC space.
As the industry appears to finally be heading towards reform, we have positioned ourselves to manage this risk by building a broadband business that is not dependent on subsidies. We have taken great care to diversify our business geographically and from a regulatory perspective.
Taking a look at the remainder of the year, we will continue to capture efficiencies, and we will continue to dispose of assets, such as real-estate, that are no longer necessary to growing our network business. For example, we're consolidating space and employees in Sacramento from multiple locations to one facility, with plans to sell or lease the vacated space. We are currently in the process of the move, that will result in an estimated annual savings of $300,000 of expense and provide the opportunity to generate cash when the vacated facilities are sold.
I also wanted to remind you of our recent announcement that we've entered into a definitive agreement to sell our wireless communication towers for a price of up to $10.2 million to Global Tower Partners, and we have a goal of closing that deal later in this year.
We continue to grow the broadband segment using intelligent, flexible marketing designed and executed by a talented team of employees. We have a significant effort underway to provide what we call a revolutionary customer experience in order to improve on our already solid churn statistics and drive penetration on our expanding fiber network.
I'll now turn the call over to Fred Arcuri, our Chief Operating Officer, who will discuss our operations in greater detail. Fred?
Thanks, Steve. Good morning, everyone. We experienced solid results in the core areas of our business this quarter. And as Steve said, we did a great job of selling more services to existing customers during the quarter.
We also succeeded in a key area by growing broadband and residential RGUs by 9% year-over-year and 3% sequentially. In Sacramento alone, RGUs grew 16% year-over-year. Business growth was highlighted by a 26% year-over-year increase in broadband business revenues, to $9.3 million.
Despite a significant slowdown in new housing in California and some slowdown in Kansas City, our employees' efforts delivered strong year-over-year growth. As we've stated in the past, third quarter trends have been slower in recent years than first or second quarter.
Growing subscribers and RGUs is our top priority, and we recognize that, in this economy, it is not business as usual. Consumers exercise more restraint in spending. As a result, we've accelerated our sales promotions to continue growth rates, and have found that the demand for SureWest's Triple Play value package of voice, video and data remains strong.
We believe we can capture additional customers now, while they're looking for value, and then continue to add new features and upgrades for them in the future, which will have a positive long-term impact on RPU and revenue. We expect RPU to fluctuate in the short-term as we roll out new and aggressive promotions.
Starting with the broadband residential segment, we continue to see growth in Kansas City, and expect this to continue as we expand the network in the region. All new residential construction going forward will utilize our most advanced fiber-to-the-home technology.
Kansas City's new 50-megabit symmetrical data product, which we also offer in Sacramento, is easily the fastest Internet product offered where we serve. We've been in the process of installing this new technology for some time now and due to some standard startup delays common to launching a new network, we were not able to pass as many fiber homes during the quarter as we had initially hoped. Our success in marketing to these new homes will be apparent in the fourth quarter and into the next year.
To date, the fiber rollout in Kansas City communities continues to go very well. We are installing up to 25 fiber customers each day. Early take rates have easily exceeded our expectations in the first month of marketing to these homes, and we have a fair amount of capacity in this region. While this data is very preliminary, we are optimistic that we can continue to build on this great start. We are confident that we will pass 8,000 new fiber homes by the end of the year. This will bring the total marketable homes on our network in Kansas City to over 100,000.
Sacramento continued to experience strong residential broadband growth driven by significant increases in RGUs. This growth was attributable to the rollout of our Voice over IP product in the region, coupled with aggressive promotions and a video product that continues to gain momentum.
The newly released Voice over IP product remains one of the most exciting services we've ever launched. It's a win-win for customers and for SureWest. Customers are attracted to its advanced online and interactive technology, over 20 easy to use features, cost effectiveness, and reliability. SureWest benefits by selling more bundled triple-play services with the offering, thereby enhancing overall subscriber margins.
For example, we have converted nearly 2,900 customers from the telecom voice product to the new broadband Voice over IP service since its launch earlier this year. And of those converted customers, over 20% added SureWest Internet with their phone service, and over 10% added TV. So, as you can see, this product serves as a driver for the growth of our high-speed Internet and digital TV products.
Broadband residential voice RGUs increased 7% year-over-year and 5% sequentially. This was driven by the Voice over IP product in the Sacramento region, where we experienced voice RGU growth of 18% year-over-year and 13% sequentially.
We recently acquired our 10,000th Voice over IP customer, and we believe that the product will be a major factor in the landline telecommunications market for many years to come. It's also important to note that all of our Voice over IP customers buy their long distance from us, as well.
Voice over IP is proving to be a proactive marketing tool for SureWest in offsetting traditional telephone access line losses reflected by our consolidated voice RGUs, which decreased by 1,000 sequentially, or 1%, compared to a sequential loss of 3,100 in the prior year quarter. It has also offset year-over-year losses in consolidated voice RGUs by 2%, resulting in a 5% year-over-year decline, compared to a 7% decline without this new service.
Looking at our other broadband residential products, high-speed data has been a flagship product in Sacramento due to our network capabilities, and we are already receiving a similar response to our new fiber-based Internet services in Kansas City.
As I mentioned earlier, growth in data services continues to be positively impacted by the success of SureWest Voice over IP in Sacramento, because customers must have a SureWest Internet package in order to utilize the voice service. Data RGUs increased 7% year-over-year and 3% sequentially.
Video product delivered outstanding RGU growth in our advanced broadband network of 9% year-over-year and 4% sequentially. This is due to strong customer response in our Sacramento -- in Sacramento to our recently launched feature-rich HD DVR and robust HDTV channel lineup. RGU video growth in Sacramento was 18% year-over-year and 8% sequentially. DVR and HDTV are both more mature products for us in Kansas City.
HD penetration rates among video subscribers in both markets grew to 29%, up 26% last quarter. We believe our HDTV offerings in both regions are incredibly attractive to consumers and competitively priced, with 52 HD channels in Sacramento and 42 HD channels in Kansas City.
We will also be launching HD On Demand in Kansas City this quarter, and we regularly look at adding additional HD channels in both regions to ensure that SureWest continues to lead the premium television market in HD offerings.
DVR penetration among video subscribers in both markets is currently at 44%, up from 38% last quarter. With DVR becoming almost a standard purchase with new customers, we anticipate penetration rates to continue to increase. Although DVR has been offered in Sacramento for less than a year, the growth in this region has exceeded our forecast and expectations, making it one of the fastest growing product lines that we've launched in a long time.
Although telecom residential continues to see the previously discussed decline in access lines, we are able to capture a lot of this revenue by switching existing customers to Voice over IP. We anticipated this movement in the company's revenue structure, and are excited to offer customers a new more advanced product to meet their needs.
Moving on to an area of the company where we are seeing considerable growth, I'll now discuss our business revenues in broadband and telecom segments. We serve four categories of businesses, small office customers, small- to-medium size businesses, and enterprise or large business customers, and carriers.
We believe SureWest has a competitive advantage that sets us apart from traditional companies, and we view business growth as an important way for us to diversify our revenues. In fact, broadband and telecom business represented 32% of total revenues this quarter.
In Sacramento, the small-to-medium business market has been a driving force for growth. We are working hard to expand our reach by leasing networks and enhancing our services in this region to capture additional value. Some of our efforts this quarter include expanding network coverage via the type two product line to drive growth in the small-to-medium business markets, expanding the space in our second Sacramento facility to drive growth in the data center product line, and expanding enterprise and wholesale network through high-end bandwidth product extensions.
We are pleased with our many accomplishments to date, which have resulted in double-digit year-over-year growth in revenues, customers and RPU.
Another area of business revenue growth has been in our data center offering in Sacramento. When our first data center location became full, we made a decision to convert an existing central office space so it could accommodate additional co-location equipment for business plans and drive additional business revenue.
We have more than doubled our total available data center space by opening this new facility, and we already have commitments for almost 40% of this new capacity. The fact that both of our locations are in a seismically stable area and out of the Sacramento area regional flood plan, and we have low energy costs, make them uniquely appealing to customers.
We have also seen success with our recently completed upgrades to the metro Ethernet product offering, which we enhanced by upgrading the network core to a multi-node 10-Gig solution.
In Kansas City, our business focus has been on increasing sales and installations. We have worked very hard to create a successful business sales unit, including enhancing training, realigning our sales positions and reporting lines, hiring additional sales managers, and establishing incentive programs to ensure that all employees are aligned towards the same goal. The results have been excellent.
September was our largest sales month ever in Kansas City's market six-year business sales history. Similar to Sacramento, we've seen great success with medium-to-large and multi-location businesses in Kansas City. Business segment continues to be a major factor in our growth and profitability. By offering highly reliable business products and customized solutions, we set ourselves apart from our competitors.
With that, I'll turn the call over to our Chief Financial Officer, Dan Bessey, who will discuss our financial results in greater detail. Dan?
Thanks, Fred. SureWest has continued to perform well in the third quarter of 2008. The initiatives we are taking in both regions, and the progress we are making, continue to reflect positively in our financial results.
As with the previous two quarters, we have broken out residential and business service revenue and the related operating metrics for the broadband and telecom segments. Our results of operations are provided on both a GAAP and pro forma basis to include the results of the Kansas City operations for periods prior to the February 2008 acquisition for comparability purposes.
On a GAAP basis, consolidated revenues for the third quarter of 2008 totaled $60.8 million, an increase of 39% year-over-year and 1% sequentially. The year-over-year increases are primarily due to the Kansas City acquisition. The sequential increases are driven by continued growth in broadband segment revenues of $1.1 million. This broadband revenue growth more than offsets expected revenue declines in our telecom segment of $542,000.
Consolidated EBITDA totaled $18.6 million, an increase of 23% year-over-year and a decrease of 8% sequentially. The Kansas City results of operations are the primary contributor to the year-over-year increase. The decline in sequential EBITDA is due primarily to expected revenue declines in the telecom segment, resulting from residential RGU loss and the declines in mega access revenues.
Additionally, broadband costs increased in the third quarter, as we made deliberate investments in resources to expand both the residential and business operations in our Kansas City market. We expect to realize the benefits of this investment in the coming quarters, as we release 8,000 marketable homes in the fourth quarter and continue to take advantage of marketing opportunity -- or business opportunity in the region.
Lastly, we continue to adjust our marketing tactics in both the Sacramento and Kansas City regions to proactively respond to current market conditions. We believe that our performance during the quarter is reflective of the successful execution of our strategic plan.
Consolidated income from continuing operations was $756,000 in the third quarter of 2008, compared to $1.7 million in both the third quarter of 2007 and the second quarter of 2008. This was primarily due to depreciation and interest expense related to the Kansas City acquisition. Earnings per share from continuing operations for the third quarter was $0.05, compared to $0.12 for the same period last year and $0.12 per share sequentially.
Net income decreased to a loss of $101,000 from a gain of $736,000 in the prior year quarter due to interest expense associated with the Kansas City acquisition and a loss on discontinued operations primarily due to a downward adjustment on the gain of the sale of directories. The sequential quarter change from $20.9 million was due to the gain from the sale of the company's wireless assets in the second quarter of 2008.
Operating expenses, exclusive of depreciation and amortization, increased 47%, to $42.2 million, in the third quarter of 2008 from the third quarter of 2007, and 5% sequentially. Cost of services increased 74%, to over $25 million year-over-year, and increased 11% sequentially, primarily as a result of including expenses of Kansas City and increases in costs relating to the growth in broadband subscribers.
Customer operations increased 19%, to $7.6 million year-over-year, due primarily to an increase in sales and advertising costs to promote subscriber growth and new product offerings within the broadband segment, and decreased 11% sequentially due to a reclassification of expenses and labor savings associated with ongoing cost reduction initiatives.
General and administrative expenses increased 20%, to $9.5 million year-over-year, and increased 5% sequentially due to information systems, maintenance and development costs, including integration of the Kansas City operations and fees related to strategic initiatives.
As previously announced, on October 10, 2008, we entered into a definitive agreement to sell our wireless communication towers. The estimated aggregate purchased price will be based on the tower cash flow generated by tenant leases, and is expected to be in the range of $9.5 million to $10.2 million. The closing of the purchase agreement is expected to occur in the fourth quarter, and is not subject to financing.
Now I'll discuss the broadband results on a pro forma basis. For the third quarter of 2008, total broadband revenues were $36.7 million, an increase of 13% over the prior year and 3% sequentially.
Year-over-year, residential subscriber growth increased roughly 6%, to 100,600 subscribers. Total subscriber penetration of marketable homes increased year-over-year to 33.9%. Total residential RGUs increased 9% year-over-year and 3% sequentially, driven by year-over-year Sacramento RGU growth of 16% and 3% in Kansas City.
As for our Triple-Play offering in Sacramento and Kansas City, RGUs per subscriber were 2.6, and the average revenue per subscriber remains stable year-over-year at $106, and declined $3 sequentially.
To elaborate on the impact of our marketing tactics on broadband residential RPU, our marketing strategies change frequently in response to our competitors as well as general market conditions. As a result of these marketing strategies, our RPU has declined sequentially due to promotional offerings that were targeted to drive subscriber and RGU expansion.
Additionally, we offer Triple-Play services to customers on both a contract and non-contract basis. When promotional offerings for a free month's service are offered on a non-contract basis, RPU temporarily declines as the subscriber base increases during the period of free service. This occurred in the third quarter as we ramped up sales in our Kansas City market. Our ongoing strategy is to continue to focus on growing subscribers and RGUs in the near term, and up-selling customers with enhanced services over the life of the customer relationship.
I will now turn to broadband business revenues, which increased 26% year-over-year and increased 11% sequentially to $9.3 million. Business customers grew 11% from the prior year and 2% sequentially to 6,300 customers. Total business RPU grew 12% from the prior year and 8% sequentially to $494.
Kansas City's business operations once again experienced solid results with customer growth rates of 27% year-over-year and 7% sequentially, and RPU growing 8% year-over-year and 9% sequentially to $698. We started to advertise to business customers this year, and we are confident that our enhanced efforts will continue to bear fruit in this area. Broadband business in Sacramento remains strong with customer growth of 6% year-over-year and 1% sequentially, and RPU growth of 12% year-over-year and 6% sequentially to $405.
Broadband revenues for the third quarter of 2008 represent 60% of our consolidated quarterly and year-to-date pro forma revenues. As we continue to focus on the growth of both our residential and business revenues, we expect the broadband segment will be a primary source of both revenue and EBITDA for the company.
Let's move on to our telecom segment results, which continue to represent a smaller portion of our overall revenues. In the Sacramento market, telecom segment revenues were $24.1 million in the third quarter of 2008, declining 8% year-over-year and 2% sequentially.
Telecom residential was impacted by continued anticipated losses in telecom voice RGUs. However, as discussed earlier, the company is offsetting these losses by migrating these customers to our broadband based Voice over IP product.
Telecom voice RGUs declined by 12,600, or 18%, year-over-year and 4,400, or 7%, sequentially. However, telecom voice RGU losses were offset due to a migration of 2,900 customers year-over-year and 1,500 sequential to Voice over IP. As a result of the successful introduction of Voice over IP in April of this year, the loss in consolidated voice RGUs was minimized to 5% year-over-year and 1% sequentially.
Moving on to telecom business revenue, 42% of the telecom segment's revenue streams are derived from the business service offerings, and we continue to pursue customers in this segment aggressively. Telecom business revenues increased 9% compared to the third quarter of 2007 and 3% sequentially, and RPU grew 14% from the prior year and 4% sequentially to $354.
Telecom business subscriber count decreased 5% from the prior year and 2% sequentially. The RPU increase and subscriber decrease were a result of the company losing very small business customers in our ILEC territory due to the economy and competition, while maintaining our larger customers and delivering new features and upgrades to them.
Telecom access revenues, which consist of the company's switched access revenues and subsidy revenues from the California High Cost Fund, decreased 14% year-over-year and 2% sequentially due to scheduled reductions in the high cost fund subsidy as well as a decline in the mega and switched access revenues.
With regard to the balance sheet, third quarter cash and short-term investments was $3 million, compared to $52.3 million at December 31, 2007. The decrease in cash is due to the purchase of the Kansas City operations. We are very pleased with our capital structure. Our total debt-to-EBITDA ratio is 2.9 times, our interest coverage ratio is 6.4 times, and our weighted average cost of debt is 5.9%.
As Steve mentioned, we refinanced our short-term $30 million term loan, which extends the maturity date to May 2012. This extension places the remaining loan in line with the maturity date of our other bank loan facility. In addition, our credit facilities remain unsecured, and we have significant cash flow from operating activities, as well as a $60 million revolving loan facility available that provides us with the flexibility to continue to implement our strategic capital expansion and operate from a position of financial strength.
Consolidated capital expenditures for the quarter totaled $20.9 million, and $64.6 million for the nine months ended September 30. We continued to direct capital expenditures to our targeted network builds and success-based capital associated with increased penetration, RGU growth, and long-term focus on RPU.
The company is increasing its projections for 2008 capital expenditures by $3 million to $5 million, with an expectation of up to $87 million for the year, to take advantage of the 2008 bonus depreciation provision of the economic stimulus package put into place earlier this year.
This provision allows companies to take a tax deduction for depreciation of 50% of all assets placed into service in 2008. This unique benefit allows us to offset our taxable gains from the sale of our wireless and tower assets. We are also executing on our desire to accelerate work already in progress so that it can be completed by year end to further take advantage of this provision.
Year-to-date, we have added 14,200 fiber homes in the Sacramento market, of which 4,200 were ILEC copper upgrades to fiber. Although we did not add new marketable homes in this quarter as we anticipated, we are expecting to pass over 12,000 new homes with fiber-to-the-home technology in the fourth quarter, with 8,000 in Kansas City and 4,000 in Sacramento. Most of these homes will be delivered late in the quarter, but will successfully position us for penetration and revenue growth in the first quarter of 2009.
In conclusion, we're pleased with the financial results and operating metrics for the third quarter, as well as with the great progress we have made to grow our business. We are confident that our strategy is working and excited about the positive trends we are seeing.
I'll now hand the call back to Steve to conclude today's call.
Thanks, Dan. The company was pleased by our ability to grow RGUs and subscribers during the third quarter, and believe that this strategy will translate into RPU and revenue growth over the long-term.
While customers are looking for value, we're finding that there is continued strong customer demand for voice, video and Internet services. In fact, we believe they will continue to respond to us because of the value provided by the superior products and the triple-play network platform.
The business product line continues to deliver solid results for the company. We expect this to continue, as we have expanded our reach by leasing networks and providing new and expanding services such as data centers.
We continue to focus on what we do well and, in doing so, we have divested of non-core business assets and consolidated key areas such as real-estate and office space. We are working from a position of strength as a result of our advanced broadband network and our flexible financial position, which allows us to concentrate on our strategy of growing the company through network expansion and acquisition.
So, with that, I think we can open it up to some questions.
Thank you. (Operator Instructions) And your first question comes from the line of Barry Mccarver of Stephens Inc. Please proceed, sir.
Barry Mccarver - Stephens Inc.
Hey, good morning, guys.
Barry Mccarver - Stephens Inc.
I've got a handful of questions here. Let me just get to a couple. I guess, first off, would you mind discussing a little bit more specifically some of the enhancements you made in your business product offering that's driving that really good growth there? Secondly, I was hoping that you could give us some examples of -- well, I guess, first off, I see that, on the residential side, RPU came down for the different products there. I'm assuming that has to do with some promotions, bringing in new customers during the quarter. I was hoping you could give us an example there. And then, the last question was -- I know you're spending some money to build out the data centers. You were hoping to convert some unused space there. I wanted to get an update on how that's going.
Okay. We'll have Fred address all -- actually, all three of those questions.
When it comes to -- hi, Barry. This is Fred Arcuri.
Barry Mccarver - Stephens Inc.
When it comes to the business products enhancements, one of the things that we've done over the course of the last probably 10 years, since we launched our CLEC business, is to not offer our customers a simple menu of services the way the telephone companies used to. You know, you went to the telephone company, you had to buy a T1, a DS3, a voice whatever. We actually try and sit down with our business customers and find out what it is they need and create a solution.
As a result of that, we've migrated our networks from what were typically telco networks to IP Ethernet based networks. And as the economy starts to swing and customers are looking for ways to cut their costs and enhance their ability to deliver their services, they're migrating what used to be parallel networks of telco and Ethernet to just Ethernet services.
So, what we've done is enhanced our network backbone, increased the bandwidth demands so that we can continue to accommodate those Ethernet IP based service requests that we're getting from companies. So, it's not so much just a product as more an overall architecture and design to make sure that we're accommodating what we see coming forward.
With regard to the data center, what we've done is -- data centers are extremely expensive to build. If you've looked at them before, they're incredibly expensive. What we've done is we've tried to accommodate a little niche market that we found. Data centers are pretty typically set up in four categories -- a class 1 to a class 4, class 4 being very high end, things like multiple generators, multiple commercial power providers, that sort of thing, level 1 being an acceptable level of redundancy to some customers -- one generator, one power provider, that sort of thing.
We've taken our existing central office space as we decommissioned transmission and switching equipment from the telco, taking out TDM switches, putting in over -- Voice over IP switches, which have a much smaller footprint, taken that space and accommodated this data center with very little upgrade and provided class 1 type data center services. And then, on top of that, we get to sell the customers bandwidth and power and some other stuff. So, we're just taking existing central office space and converting it so we don't have this huge outlay of capital to create a data center.
Barry Mccarver - Stephens Inc.
Is some of that affecting the bump up in costs of service and products that we saw in the 3Q? That $25.1 million seemed a little bit high.
The cost of product and service increase you're seeing specific to business customers is coming from type 2 type services, where we are purchasing a type 2 service from one of the other carriers and reselling it. So, the more of that we purchase, the more you're going to see that cost of service increase take place. But, we do it off of about a 50% gross margin sale, Barry.
Barry Mccarver - Stephens Inc.
Okay. Okay. So, just some clarification on my first question about your business application, so nothing there really new in the last couple of quarters or year? That's kind of been an ongoing thing?
That's an ongoing thing. And again, we don't have a list of menu items or products that we sell to customers. We try and sit down with the customer and accommodate whatever their need is. That's our niche, and we've found it to be very successful.
Barry Mccarver - Stephens Inc.
Okay. Thanks a lot, guys.
And next comes from the line of Jonathan Levine of Jefferies. Please proceed, sir.
Jonathan Levine - Jefferies
Yeah, I was wondering if you guys could talk a little bit more kind of about the build-out delay that you’ve talked about in terms of KC, and if you could quantify the cost that you had in Q3 -- that we're really going to see the benefit in Q4? Thanks.
I'll talk about the delay, and maybe Dan can address the cost. This is Fred Arcuri, Jonathan. How are you? The delays are the typical delays you see in construction -- the permitting process. We ran into a little community in Kansas City that's got some rather strict CC&R kind of requirements. It's made it a little bit difficult for us to find easement for cabinets and that sort of stuff. So, you know, no big rocks. Just kind of the typical stuff that you run into.
Dan, I don't know if you want to cover the costs.
On the cost front, we have made investments in primarily two areas. Number one, we've really looked at the residential sales force in Kansas City as well as the business sales force in Kansas City, and sought to fortify those functions as we anticipate the marketable homes coming on and the continued opportunity for commercial services in Kansas City. So, the lion's share of our cost increases are really labor costs to grow those, as well as the type 2 types of costs that Fred is referring to on the business sales.
Jonathan Levine - Jefferies
Do you have a ballpark number what -- you know, how much that was?
It -- when you look at the cost from Q -- the increase in the cost from Q2 to Q3, the lion's share of them relate to our Kansas City operations. There's another component that relates to system improvements and so forth that we're making in the Sacramento area, but the majority of the costs really relate to our Kansas City expansion.
Jonathan Levine - Jefferies
Okay. And in terms of, I guess, the timing, is the -- in terms of all the permitting issues that you were kind of dealing with, is all that kind of behind you now?
This is Fred, Jonathan. It's never always behind us, unfortunately. But, it is -- we are past the big hurdles. And again, we expect to get that 8,000 homes done by the end of the fourth quarter. So --.
And this is Steve, Jonathan. One other thing is we can always direct our construction efforts in those places we already have permits and then, while we're working in parallel, getting through this permitting issue. So, we want to continue to keep the growth rates up. We're going to be releasing in the third and fourth quarter, and primarily the fourth quarter, roughly half the homes we're releasing for the whole year. And we'll be marketing those aggressively through the fourth quarter, as we are now, and into early 2009.
Jonathan Levine - Jefferies
Okay, great. Thank you.
(Operator Instructions). And your next question comes from the line of Chris King of Stifel Nicolaus. Please proceed.
Chris King - Stifel Nicolaus
Good morning. Just one quick question for you. I just was wondering if you could comment on kind of your -- just broadly speaking, on your longer-term CapEx trends and commitments that you see going forward, just, you know, really kind of looking out towards 2009, 2010 with respect to your CapEx budget for this year, where you see kind of longer-term CapEx trends going? And then, as a corollary to that, I guess, you know, how flexible might those CapEx commitments be, depending on the macro economic environment going forward? Thanks.
Chris, this is Steve Oldham. We comment almost every quarter about what we consider a great deal of flexibility in our CapEx expenditures. We have 300,000 homes or so passed, marketable homes passed, that, if we were to pull back on network expansion, would be -- still have a fairly robust number of homes that we can continue to market to, as well as upping our RGUs and RPU to the existing customer base.
So, with that in mind, we have not yet announced our 2009 CapEx expenditures. We're looking very hard to see where the best application is for those expenditures going forward. We hope to have an estimate out a little bit later this year of what we intend on doing in 2009. We're going to take into account the current economic conditions. We feel that we have a good deal of flexibility with our cap structure and lines already in place if we decide to move forward as aggressively as we have this year.
The flip side of that is that we have the flexibility to pull back and go for more penetration, and also, by the way, to continue to say are acquisitions perhaps a better use of CapEx in the shorter term. So, we'll have some announcements about our CapEx plans here towards the end of the year, and we're continuing to say that we're going to exercise the flexibility if that appears to be the best thing to do.
Chris King - Stifel Nicolaus
Could you give us, then, maybe just a broad breakout of how much of your, you know, current CapEx, be it 2008 year-to-date or even in the third quarter, is caused by the geographic expansion of your footprint versus offering new products and services and trying to up-sell your current homes passed?
Yes. The success-based capital on our system is somewhere about one-third of total capital. About 45% of total capital is for network expansion. And then, 20% to 25% of capital is for what we call maintenance capital, replacing our electronics and the sorts of system improvements that need to take place that are capitalized. So, in that 40%, 45% of our capital range is etch out of the network. Success based capital is about one-third. And if you don't etch out the network, you won't have quite as much success based capital.
And so, we could cut capital back in half or so, in that range, if we wanted to cut it back that far. And frankly, we could also, I suppose, cut it back to that 20%, 25% that's related to maintenance capital. That'd be fairly drastic for us.
Chris King - Stifel Nicolaus
Okay, that's very helpful. Thank you very much.
I'd now like to turn the presentation over to Misty Wells for closing remarks.
Thank you. Since there are no more questions, we will conclude the call. Thank you all for attending, and have a great day.
Ladies and gentlemen, thank you for your participation in today's conference. This concludes your presentation. You may now disconnect. Have a great day.
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