PAETEC Holding Corporation Q4 2008 Earnings Call Transcript

PAETEC Holding Corporation (PAET)

Q4 2008 Earnings Call

February 26, 2009 9:00 am ET

Executives

Chris Muller – Investor Relations

Arunas A. Chesonis – Chairman & Chief Executive Officer

Keith M. Wilson – Chief Financial Officer, Executive Vice President & Treasurer

Analysts

Frank Louthan – Raymond James

Donna Jaegers – D.A. Davidson & Company

Robert Dezego – SunTrust Robinson Humphrey

Todd Morgan – Oppenheimer & Company

Presentation

Operator

Good day ladies and gentlemen and welcome to the fourth quarter 2008 PAETEC Holding Corporation Earnings Conference Call. My name is Dan and I will be your coordinator for today. At this time all participants are in listen only mode. We will conduct 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 call over to your host for today's call Mr. Chris Mueller. Please proceed sir.

Chris Muller

Thanks Dan. Good morning everyone and welcome to PAETEC's fourth quarter 2008 conference call. With me on today's call are Chairman and CEO, Arunas Chesonis; Chief Financial Officer, Keith Wilson, and Chief Operating Officer, E.J. Butler. Following our prepared remarks we will then conduct the Q&A session.

Before we get started I need to remind everyone in the 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 10-K for 2007 fiscal year, and other filings with the SEC. We disclaim any obligation to update publicly any of our forward-looking statements. Please note that in 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 website at paetec.com.

Finally, now that we've done the Safe Harbor formalities all the way, please note that we have posted on the investor relations portion of our website, a supplemental presentation that will be discussed on this call regarding market share opportunities for PAETEC. With that I am going to now turn the call over to PAETEC Chairman and CEO, Arunas Chesonis.

Arunas A. Chesonis

Thanks Chris. Good morning everyone. Today we are very pleased to share with you our fourth quarter and fiscal year 2008 results. In a challenging economic environment, we are able to achieve our 24^th consecutive quarter of free cash flow generation. We also met our updated guidance for both revenue and adjusted EBITDA and slightly outperformed on capital expenditures. PAETEC's ability to not only weather the current downturn, but to position ourselves for future growth has been critical maintaining our company's competitive edge and employee morale. I've personally never been as excited about our future prospects as I am right now.

Today, our core customers and prospects require PAETEC's value proposition, cost savings, and flexible product bundling options combined with superior customer care on a nationwide platform. The large incumbent providers simply cannot be as attentive to enterprise customers compared to PAETEC. Our solid financial position ask PAETEC to continue investing in additional sales and service personnel, product enhancements, and IT automation programs over the next several years. Keith and I are actually speaking to you from our Dallas Sales Office. Since Monday, we have been part of offshore sales blitz throughout Texas including stops in Austin, San Antonio and Houston.

We have already met this week with over 200 prospective and existing customers, agents and partners. Our executive team travels extensively with our field operations and I will have made trips to over 50 cities myself through the first half of 2009. These ongoing discussions across the country, not only provide valuable training and support to our employees, but we generate additional business and gain real-time market and operational insights for our senior leadership team.

During 2009, Keith and I will also spend a great deal of time visiting with the investor community and communicating the progress we are making on sales and integration activities. We are planning to host an Analyst Day after our first quarter 2009 earnings. But before I hand you over to Keith for a more detailed discussion of our financial results, I would like to share a few thoughts with you regarding our ongoing integration activities, our strategy concerning debt and stock purchases and our goals for market share expansion.

We are currently on schedule with McLeodUSA integration activities. We launched our unified product portfolio last month as expected and are actively selling across all geographies for new and existing customers. Our US LEC billing conversion is also on schedule for an estimated completion date of first quarter 2010. We have built-up our sales teams in legacy McLeodUSA cities like Portland and Seattle and we will continue to grow the sales organization throughout 2009. Our San Francisco area-switching center just went live for network services and we expect our first sales team in the Bay Area to be in place during the second quarter. The alignment of regional service delivery teams with their regional sales counterparts was also completed last month and is already showing signs of improved service levels.

And even with the workforce reduction, which took place in December our employee morale and excitement is high. We continue to be enthusiastic about the future and during the last three months we have also been focused on creating long-term shareholder value by pursuing stock and debt repurchase options. During the fourth quarter, we purchased an additional 3.4 million shares of common stock for approximately $4.5 million. We also tended to work with our bank debt holders to be allowed to repurchase up to $100 million worth of bank debt and senior notes, but were unable to agree on the framework that we believe would have been acceptable to our shareholders. We will continue to thoughtfully review investment opportunities for the excess free cash flow we generate.

Now, let's turn to the supplemental presentation again located on our website under Investor Relations, so that we can review market share opportunities for PAETEC. And please turn to page three to get started. As you can see from the network map it's a refresh of the nationwide network, which again is one of the largest competitive infrastructures in the U.S. over 4.5 million access line equivalents, over 17,000 miles of both Intercity and Metro fiber, a complement of data and voice switches throughout the U.S. and significant collocation assets around the country. Again, we are in 82 of the top 100 MSAs in the U.S. and over the next several years we may grow organically in a few more.

If we move over to page four, you can see a market share slide based on GeoResults data. This is based on our market share of T1 enterprise customers only, our network services only. This includes no wholesale data or other products like our data hosting, colo, software, or hardware services. And as you look at the map in the Northeast, we have divided the retail regions into four sections throughout the country and these represents the legacy PAETEC business that we grew over 90% organically, since we started the company. You can see we are running around 3.8% of our target addressable market.

In the south, which is primarily the legacy US LEC business we're running around 2.5% market share. In the central region, which was the older McLeod markets you can see we're running around 1.3% market share. And in the west, which includes the legacy PAETEC Southern California business, and the rest of the McLeod markets that were newer to the company, we are running around 1.1%. If you move to the next stage, we are showing the actual sales productivity by region as well. And again these market share numbers and sales productivity numbers are something we are going to try to share with you on an annual basis.

You can see the legacy PAETEC sales organization is running pretty well about 4,000 per month in new business per headcount. In these type of sales organizations especially during the integration it takes a good two to three years to get people up to speed to what was the earlier PAETEC legacy. You can see the improvement in the legacy US LEC territories we are running productivity around $3,100 per salesperson. And the real movement that we see over the next several years will be in the central region and the west region, when you're looking at those sales productivity numbers.

Let's move to page six and do a deeper dive into the east region. You can see in 2008, we generated about $549 million worth of business. It is the second largest market opportunity of the four regions throughout the U.S. about 28%. We do have the highest regional average market share at 3.8% again legacy PAETEC organically grown and 63% of the markets meet or exceed the regional average market share. So, we do have some opportunity for growing market share again in other areas. You can see in some of the most competitive markets in the world, Austin, New York, Philadelphia, D.C., we have done fairly well since we started the business.

Let's move to the next slide, and show a little bit about the south region again 2008 revenues for us there about $320 million. The total market opportunity is about a quarter of the national. And we have the second best regional average market share of 2.5%, but only about half of the markets meet or exceed that regional market share. So, again we have additional opportunities to grow that base in the Southeast.

Moving on to the central region, you can see that the revenues are lighter at $206 million. It is the smallest market opportunity almost 20% of the U.S. coverage and has the second lowest regional average market share of 1.3% and less than half of the markets even meet that average. So, again more opportunity for PAETEC as we drive the training and sales productivity in those territories. And finally on the western region, almost $200 million in revenue again for 2008. It is the largest market opportunity in the country, 28%.

We have the lowest regional average market share at 1.1%. And that includes the legacy PAETEC's Southern California business, which we grew organically since we started the company and that's about half of the entire regional market share. And less than a quarter of the markets meet or exceed the regional average market share. So, again huge opportunity and we saw evidence of that just being in Texas this week meeting with those folks.

And go to the next slide, page 10. So, what does this mean to all of us? Is that shareholders and investors. Well, if we were able to improve the other regional market shares to be equivalent over time to the PAETEC market share average, we would realize almost $800 million in annual revenues incremental to where we sit today. And that's exciting to me as a shareholder and to our employees as well. Now, and if you go to the next slide, why do we think we can achieve that 3.8% in the west, the central and southern region? Well historically we have already achieved that regional average in the east region, legacy PAETEC doing that primarily, organically we were very comfortable utilizing our direct sales and direct sales channels to really drive business and up sell existing customers over time.

Our sales force capabilities, Selling Power Magazine again for those of you not, aware of this named PAETEC the 2006 and 2007 Telecom Sales Organization of the Year. On top of that we feel very comfortable that we can cross train and develop our people in these other regions. Just a few weeks ago, we were named the Number 45 ranked training organization corporately throughout the world actually surpassing great organizations like Intel and others. We feel very comfortable we can move people up market, which is our focus the next several years and the sales tools that we are using internally now. Having recently launched the unified product portfolio, which will allow all of the sales personnel through the country to use our call the assistant online and put flexible bundled solutions together, very cost-effectively for new and existing customers.

We are absolutely, our customer and prospective customers are as open as they have ever, I have ever seen them in the last 10 years to someone who can provide savings flexibly and that really shows that they care about them and we will service them with the appropriate attention. So, again with that Keith, why don't we hand it over to you to go through some of the financials.

Keith M. Wilson

Thanks Arunas and good morning everyone. As Arunas indicated, despite unprecedented economic turbulence we are pleased to announce we met our updated 2008 guidance for both revenue and adjusted EBITDA and slightly beat on capital expenditures. As we have been doing for the past year, I will first discuss the actual results of PAETEC Holding for the fourth quarter 2008 and full year 2008 as it compares to PAETEC's fourth quarter of 2007 and full year 2007. I will then discuss pro forma results for the fourth quarter 2008 and full year 2008 versus the fourth quarter 2007 and full year 2007 giving effect to PAETEC mergers with McLeod and US LEC as if they had occurred 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 company's results of operations actually would have been if the merger had been completed on the dates indicated. So, first the actual performance. Total revenue for fourth quarter 2008 increased 38.7% to $400.2 million from $288.6 million for the fourth quarter of 2007, principally due to the addition of the operating results of McLeodUSA, which PAETEC acquired on February 8, 2008. Networks services, which accounted for 78.7% of fourth quarter 2008 total revenue increased 33.5%, year-over-year to $314.8 million.

The growth in network service revenue was due to the addition of McLeod's operations and the growth in PAETEC’s Dynamic IP and MPLS VPN revenues and network security products. IP services performed particularly well during the period and was up 53% from the prior year period as PAETEC's broad geographical reach, highly reliable network, and award winning customer service organization have established us as a key player in the IP services market. However, broad economic softness continues to impact overall network services revenues by slower growth in billable minutes of use, pressure on carrier access, and an increase in disconnects. Carrier services represented 17.8% of fourth quarter 2008 revenues and grew 78.4% year-over-year to $71.4 million, largely reflecting the addition of McLeodUSA’s operations, which had a larger percentage of carrier services revenue than PAETEC did previously.

Integrated solutions accounted for the remaining 3.5% of fourth quarter 2008 revenues. This business, which tends to generate uneven results on a quarterly basis, experienced a 9.5% increase in revenue over the fourth quarter 2007 to 14.1 million. Well equipment sales were relatively stable during the period our software sales experienced a 40.5% increase over the same prior year period. We believe the strong value proposition offered by our pinnacle product line offers a very attractive solution for large enterprises to manage their internal communications departments more effectively and that was evidenced by a solid fourth quarter.

Adjusted EBITDA for the fourth quarter 2008 increased 8.2% to $60.3 million over adjusted EBITDA of $55.7 million for the fourth quarter 2007. Adjusted EBITDA margin, which represents adjusted EBITDA as a percentage of total revenue was 15.1% for the fourth quarter of 2008, compared to an adjusted EBITDA margin of 19.3 for the fourth quarter of 2007. The decrease in margin was largely attributable to the addition of lower margin McLeodUSA revenues for the quarter as well as an increase in network spending enhancements to the IP network and higher SG&A expenses resulting from the acquisitions.

Investments in the IP network were directed to support the rapid growth in IP sales and the high-quality delivery of our product offering was necessary to be competitive in the market. Net loss for the fourth quarter of 2008 decreased to negative $114.4 million, compared to net income of $15.5 million for the fourth quarter of 2007. The increased net loss was a result of a $15 million non-cash charge to our third quarter goodwill impairment charge estimate and an increase in income tax expense related to the establishment of an income tax reserve of approximately a $104.3 million against PAETEC's deferred tax assets.

Due to the year-to-date pre-tax loss among other factors, we concluded that this was an appropriate reduction of the deferred tax asset at this time. Increased debt levels resulting primarily from McLeodUSA acquisition and the $50 million in revolver draw down in the fourth quarter, increased interest expense for the fourth quarter of 2008 to $18.9 million from $17.4 million for the fourth quarter of 2007 and was an additional contributor to the increase in net loss period-over-period. Pro forma quarterly comparison. The following pro forma results for the fourth quarter of 2007 and the fourth quarter 2008 give effect to PAETEC's acquisition of McLeodUSA as if had occurred at the beginning of 2007 and 2008.

The pro forma information is not necessarily indicative of what the combined companies results of operations actually would have been if the acquisition had been completed as of the dates indicated, nor did the pro forma results intend to be a projection of results that may be obtained in the future. Total revenue of $400.2 million for the fourth quarter of 2008 represented a decrease of 3% compared to pro forma combined PAETEC-McLeod total revenues of $412.7 million for the fourth quarter in 2007. The decrease in pro forma revenues was attributable to customer attrition at approximately the anticipated rate in the non-core sub T1 business and a reduced focus on fiber IRU sales, which together accounted for a $11.4 million of the difference between periods.

As discussed earlier, worsening economic conditions also contributed to slower than anticipated growth in network services in the form of lower usage-based volume, pricing concessions on contract renewals and a marginal increase in customer churn. Adjusted EBITDA of $60.3 million for the fourth quarter of 2008 represented a decrease of 15.9% compared to pro forma adjusted EBITDA of $71.7 million for the fourth quarter of 2007. Adjusted EBITDA margin was 15.1% for the fourth quarter 2008, compared to a pro forma adjusted EBITDA margin of 17.4 for the fourth quarter of 2007.

The positive effects of leveraging PAETEC's network and realizing synergies related to McLeodUSA acquisition were more than offset by network related expenses as a percent of total revenue. Although, gross margins declined from 51.4 in the fourth quarter of 2007 to 50.1 in the fourth quarter of 2008. Fourth quarter 2008 cost of sales were slightly lower than 2007 costs. The employee reductions in August and December of 2008 reduced SG&A expenses 3.2%, $4.8 million-year over year, but SG&A expenses as percentage of revenue only declined 10 basis points.

Pro forma net loss was $114 million for the fourth quarter 2008 compared to pro forma net income of $9.4 million for the fourth quarter of 2007. The pro forma net loss was driven primarily by the inclusion of the $15 million adjustment to our third quarter non-cash goodwill impairment charge estimate as well as a non-cash accrual of approximately $104.3 million as a reserve against previously recognize deferred taxed assets. Pro forma depreciation and amortization expense, $28.7 million for the fourth quarter 2008 represented a decrease of 1.9% compared to fourth quarter 2007 pro forma depreciation and amortization expense of $29.3 million primarily due to the finalization of valuations and related adjustments of tangible and intangible assets acquired in the McLeodUSA acquisition in 2008. Pro forma interest expense of $18.9 million for the fourth quarter of 2008 represented an increase of 2.4% over pro forma interest expense of $18.4 million for the fourth quarter of 2007.

Now the full year results. Total revenue for 2008 increased 50.9% to $1.57 billion from $1.04 billion for 2007 principally due to the addition of McLeodUSA's results and continuing strong organic growth of new integrated T1 services multi-site MPLS VPN sales as well as the deepening of our existing share of business from the installed customer case. Adjusted EBITDA for 2008 increased 21.2% to $237.7 million over adjusted EBITDA of $196.2 million for 2007. Adjusted EBITDA margin was 15.1% for 2008 compared to an adjusted EBITDA margin of 18.8% for 2007. Adjusted EBITDA margin was pressured by the inclusion of lower margin McLeodUSA revenues, as well as investments in the broader IP network previously discussed.

Net loss for 2008 was $487.9 million compared to a net income of $10.5 million for 2007. The 2008 net loss was largely as a result of a non-cash goodwill impairment charge of $355 million, and an $81.8 million increase in tax expense related to the tax reserve against PAETEC's deferred tax assets. Depreciation and amortization expense for 2008 increased to 131.6% to $174.3 million compared to $75.2 million in 2007 primarily due to the addition of McLeodUSA's asset base. Increased debt levels incurred primarily in connection with the McLeodUSA acquisition and revolver drop draw down to $50 million in the fourth quarter of 2008, increased interest expense for 2008, $73.7 million from $68.4 million for 2007.

Now the pro forma full-year comparison. The pro forma results for fiscal years ended December 31, 2008 and 2007 respectively, give effect to PAETEC's acquisition of US LEC as if it had occurred on January 1, 2007 and the PAETEC's acquisition of McLeodUSA as if it had occurred at the beginning of each fiscal year presented. The pro forma information is not necessarily indicative of what the combined company's results of operations would have been if the mergers have been completed on the dates indicated. Pro forma total revenue for 2008 increased seven tenths of a percent to $1.62 billion over pro forma total revenue of $1.61 billion for 2007. Pro forma adjusted EBITDA for 2008 decreased 7.4% to $243.3 million from pro forma adjusted EBITDA of $262.8 million for 2007.

Pro forma adjusted EBITDA margin of 15% for 2008 decreased from pro forma adjusted EBITDA margin of 16.3 for 2007, largely as a result of continued network investments and expansions, lower margin wholesale traffic and lower billable minutes. Pro forma net loss for 2008 was $507.9 million compared to a pro forma net loss of $24.5 million for 2007. The primary drivers were previously mentioned, goodwill impairment charge of $355 million and the 104.3 million tax accrual. For 2008, pro forma depreciation and amortization expense decreased 1.3% to $182.1 million from 2007 pro forma depreciation and amortization expense of $184.4 million. Pro forma interest expense increased 5.2% to $74 million from 2008 pro forma interest expense of $70.3 million for 2007.

Capital expenditure for the fourth quarter of 2008 increased to $32.1 million, or 8% of total revenue from $29.3 million or 10.1% of total revenue for the fourth quarter of 2007. For full year 2008, capital expenditures were $119.5 million or 7.6% of total revenue compared to $81.5 million, or 7.8% of total revenue for 2007. Capital expenditures for the fourth quarter 2008 were largely applied to investment enhancements to the PAETEC network including significant investment in PAETEC's IP facilities. On the same quarterly pro forma basis described above, capital expenditures decrease 28.8% from $45 million or 10.9% of total revenue for PAETEC and McLeodUSA in the fourth quarter 2007 to $32.1 million or 8% of total revenue in the fourth quarter 2008, mainly due to the timing of certain investments including the IP Network investments.

On the same annual pro forma basis described above capital expenditures decreased to 11.6% to $122.4 million or 7.5% of total revenue compared to $138.5 million or 8.6% of total revenue for 2007. PAETEC had a year end cash balance of $164.5 million compared to the third quarter 2008 level of $72.2 million primarily as a result of the $50 million revolver draw down described above, and increased cash flow from operations. Additionally, during 2008 PAETEC repaid $15.8 million of principal debt under the senior credit facility, and repurchased $13 million in capital stock representing $28.8 million in balance sheet management initiatives during the year.

Cash flow provided by operations was $80.6 million in the fourth quarter of 2008 while cash flow provided by operations was $62.6 million in the fourth quarter of 2007. As indicated above, PAETEC achieved fourth quarter 2008 free cash flow of $28.2 million. Indebtedness. As of December 31, 2008, PAETEC had $929.7 million in long-term debt under its term loan credit facility, senior notes and revolver. PAETEC drew down its $50 million revolver in full on October 15, 2008, when the revolver has a maturity date of February 28, 2012. At December 31, 2008, $579.6 million was outstanding under PAETEC's senior credit facility term loans, which have a maturity date of February 28, 2013. Before their maturity, PAETEC is required to make scheduled principal payments of $6 million annually on term loans.

At the end of the fourth quarter of 2008, PAETEC was well within the sole financial maintenance covenant in its credit facility, which provides for a maximum permissible ratio of consolidated debt, defined as consolidated debt less cash on hand in excess of $20 million to consolidated EBITDA as defined in the credit agreement of 5 to 1. During fourth quarter 2008, PAETEC reduced principal on the term loans by $1.5 million. At December 31, 2008, PAETEC had outstanding $300 million principal amount of 91/2% senior notes, due 2015. The senior notes have no financial maintenance covenants.

Turn to our common stock repurchase program. PAETEC repurchased shares of common stock for an aggregate price for approximately $4.5 million in the fourth quarter of 2008. A total of approximately 3.4 million shares were repurchased. For 2008, PAETEC repurchased approximately 5.9 million shares of common stock for an aggregate price of approximately $13 million. PAETEC made these purchases under its previously announced program to repurchase up to $30 million of common stock through August 2009. Subject to conditions. As of December 31st, 2008, PAETEC had 140.9 million shares outstanding.

But due to the uncertain economic conditions and events, PAETEC will not be providing 2009 financial guidance. Despite the challenging economic environment in 2009, PAETEC expects to deliver solid returns by focusing on reducing costs, capitalizing on the release of our national unified product portfolio, and providing superior customer service and support. In addition, PAETEC believes it has significant capital spending flexibility to continue to generate positive free cash flow in 2009. 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 the line of Frank Louthan from Raymond James. Please proceed.

Frank Louthan – Raymond James

Great. Thank you. Have you seen any customers coming to you trying from and changing to your service is part of their cost-cutting measure? Is that driving any business and does your service for equipment [piece] work currently, and give us an update on where you are with billing system changes with McLeod and any leftover systems that with US LEC have those been converted and at what point will you all be on some unified systems across all three platforms?

Arunas A. Chesonis

Sure Frank. It's Arunas how are you? I think you hit it exactly right. The customers out there that we have, the prospective customers that we are bidding on, are all so open minded, they have a much greater need to show cost savings immediately than they ever had before get those two things for you. For people that are not your customers, sometimes their current providers will write-down businesses just like we have been on our side, and you may not get as much business as you would hope for. But so many of the customers are on the legacy, large carriers, AT&T, Verizon, and Qwest, to a large extent they are not focused on sort of the medium enterprise sector as we are. So, we are able to really show them some savings, to be very flexible with them, and when there is a capital expenditure required that equipment-financing program is really taking off for us. I think you have to be careful, there are some types of customers that you want to make sure you do not just give them a blank check on the financing. Some people in the retail sector and the mortgage sector you have to be very careful and vigilant on your credit worthiness. But by and large, our funnels are growing significantly as we go through this down cycle. On the back office systems, again on the big-ticket items, we are on schedule for the billing conversion, the US LEC their Kenan system, our Kenan system, over to the PAETEC legacy system on route change that's on schedule for the first quarter. We think it will take us another 9 to 12 months after that to convert to MacLeod billing system onto a unified billing system for the entire organization. But as you know there is lot of other little systems that you use to manage a company of our size. Just as an example, we did not have a single view for Network Management throughout the entire organization for all legacy companies. We were getting bids from outside sources and from other providers, to unify that across the country. They were projecting a 24-month project with at least a $1 million price tag. And we were able to just complete that this fourth quarter, internally, save significant dollars, and we currently now do have a single view of network management throughout the U.S.. So, but again there is a, this system is like that they are much smaller, if you think about something as simple as the toll-free service, the SCP features that we inherited with McLeod, which were phenomenal, on the enhance side we have a great team in Salt Lake City, about a dozen people that write the code for that. We've provided services to folks like American Idol and National Star on some of their needs. And during the fourth quarter, we just completed the transitions so now we have all the enhanced 800 features for all our customers throughout the U.S. in legacy, US LEC and PAETEC territories. So, again a lot of little systems Frank that we are just knocking off, and it's something that we are going to really look forward to dig deeper with you on the Analyst day sometime in May.

Frank Louthan – Raymond James

Okay great. And then I know you made some changes last summer to the sales force incentives to try and sell more monthly recurring charge type revenues versus the usage base, where are you on that? And if we look for 12 months, where do you expect usage-based revenue to be as a percentage for your total revenue versus say where you existed '08?

Keith M. Wilson

Yeah Frank, this is Keith. As we direct incentives to try and continue to drive people towards maybe a better balance, and again I think we've talked about this. We don't want to eliminate usage-based component entirely from the product offering because we think it's both attractive to customers and beneficial to us over the long term. That being said, we would like to see some pickup of a couple of points in terms of greater fixed versus usage. Today, we are probably at about inclusive of carrier access, which is about 8% of total revenues. On a total basis you're looking at about 30% of the total revenues. So, somewhere, my guess is somewhere inside of kind of two to five points. I think we do that as a real success in terms of making progress as long as it doesn't come directly at the expense of things like cabs, where we're seeing pressure from external usage. I hope that that's not a kind of key driver to lowering that percentage.

Arunas A. Chesonis

I think Frank also, I mean every company tweaks their commission program on an annual basis. What you try to do is not disrupt the flow of the sales organization and make too many hardcore changes, some companies fall into that trap. Prior to the most significant change we made to it at the beginning of this year was to focus and provide a little bit more incentive on the gross margin aspect of the deals that our sales organization, what they are submitting. They have greater incentives to drive that gross margin higher. They have higher floors that they can work with. And by training the entire organization throughout the legacy MacLeod new territories and having the same unified sales tools, they are now finally encouraged to price the deals well enough to get the contract from the customer, but not to leave any cash left over on the table there. And I think the combination [rules] to changes will again help to drive that productivity up.

Frank Louthan – Raymond James

Okay great. Thank you.

Operator

(Operator Instructions) Your next question comes from the line of Donna Jaegers from D.A. Davidson. Please proceed.

Donna Jaegers – D.A. Davidson & Company

Hi guys. Thanks for taking my question.

Arunas A. Chesonis

Thank you.

Donna Jaegers – D.A. Davidson & Company

Keith or Arunas, can you talk a little bit more about what you are seeing with customer churn in disconnects?

Keith M. Wilson

Sure. We continue to see churn creeping up a little bit. Donna, we talked last quarter about line churn being in kind of the 1.1 range blended and across the country. This quarter we saw that a little bit higher at about 1.3. We continue to keep a close eye on that. That's a balance between the force churn and voluntary churn. From a voluntary churn standpoint, we are not seeing that number up significantly. But on the less attractive stuff, we are happy to kind of move that on, largely because when we look at both the revenue churn that comes off those lines it's extremely low, it's more like 50 basis points as opposed to the 1.3 on the line, and the overall customer churn is very low as well and it continues to be in kind of that 50 to 60 basis point range. So, when the line churn is definitely up a little bit, we view the kind of churn that we are experiencing right now as generally a little bit more positive to the overall makeup of the business.

Arunas A. Chesonis

Most of the time Donna, it's Arunas. The customers that we are talking to are tending to disconnect lines in offices that they are closing down, locations are closing down, as opposed to reducing significant lines within offices that they are keeping. To give you an example, with a customer in Boston, $30,000 a month filler, just laid off over the past six months, about 40% of the workforce. We worked with them cooperatively to reduce their spend about $20,000 a month, by shutting down 10 other offices, but we extended their contract terms and the commitment to PAETEC. So, again keeping the customer extending the contract, but a combination not so much of the writing down the actual price per unit, but just a fact that they were downsizing, and hopefully as the economy gets better, they will be reinvesting again, and driving that additional service with us.

Donna Jaegers – D.A. Davidson & Company

Two other quick questions. I know you guys, the sales force, your sales force is getting, it sounds like they are trying to be very creative with packaging, the pinnacle software or equipment in with the services, this sort of put you guys a little bit more at risk as far as if you are betting on a bad customer and they end up defaulting and you spend more money…

Arunas A. Chesonis

Can you say that again Donna? I just want to understand the question?

Donna Jaegers – D.A. Davidson & Company

Okay. The question is, what sort of credit checks do you do for your customers, and have you increased those because what I hearing from some of your sales force is that they are getting, is that they are trying to be creative in going after customers and then bundling more software be at the Pinnacle System and with that or equipment. So, I’m wondering what have you done to step with your credit checks to make sure that you are not at risk for this sort of increased equipment that you maybe bundling in with the service?

Keith M. Wilson

Yeah Donna. I think, couple of different moving pieces there. On the Equipment for Services type of sale, there is no credit risk to PAETEC on that because we are using a third party vendor to provide the capital. On the Software for Services type solutions, yes, theoretically there is little bit more risk there, but I think as a reminder, our bad debt expense this quarter was about 70 basis points, that's up a little bit. And we continue to be very cognizant of watching kind of our receivables and bad debt, but we firmly believe that we’ve got one of the vast credit processes in the business and I think that's evidenced by the extremely low numbers. Now, we have talked about and I know, we have talked to you specifically that our expectation for next year is that that number will go up, but, we are very comfortable with how tight the processes are and I know some of the folks that you've talked with they're absolutely being encouraged to go and aggressively work on a more complex sale largely because that's where the value proposition is going to be the strongest for PAETEC and that's a new process for many of those folks in the western markets. So, I don't know, let Arunas kind of…

Arunas A. Chesonis

Well, I mean Donna it's a great question I think again, we always were very aggressive on our credit policies ourselves, but we also have that second line of defense, which other credit checks being done by these third-party financing organizations. They are tighter than they were two-three years ago. We are seeing a little bit higher percentage of customers that don't qualify for those equipment for services financing, but because we are dealing with larger entities, the medium, large enterprise business as opposed to the very small, $500 a month business clients. We tend to have a better history with those folks and it does pass through we aren't taking the credit risk of the equipment financing ourselves for the most part. On something as large as a pinnacle opportune again, unless you have, at least a 1,000 to 2,000 users within your company and a couple of thousand devices that you're tracking, you're not going to be able to afford the pinnacle service, you could not have the infrastructure needs anyway, and once you install it that's almost mission critical for you to run your IT and telecom infrastructure. So, once that's embedded there, they're not pulling it out. And many people are going on a sort of a hosted basis right now. So, if they were ever to leave you, they don't have any other software to run their critical applications any more. The bad debt historically has been virtually nil with the pinnacle customers. The biggest issue we have now is just what you said is a lot of people have cut their CapEx budgets both software and hardware and it's more difficult and people are delaying some of those purchases, but the fact that we can bundle in large network deals to help subsidize the ongoing monthly hosted business we are doing with them is really helping us to continue growing the sales side there.

Donna Jaegers – D.A. Davidson & Company

Great. Thanks for the answer. Keith just one more quick question on housekeeping do you have an approximate number for shareholders' equity, I realize that with the goodwill charges things are flexing around, but can you give us a [right] number?

Keith M. Wilson

I am not sure whether that's been finalized Donna for the, I think with that's going to come out with the K.

Donna Jaegers – D.A. Davidson & Company

Do you have a total asset number or anything?

Keith M. Wilson

What's that?

Donna Jaegers – D.A. Davidson & Company

Do you have total assets?

Keith M. Wilson

Net PPD of 638, [payors] of about 202, cash 164. So, I apologize I don't have the balance sheet sitting in front of me here.

Donna Jaegers – D.A. Davidson & Company

Okay. All right. I will follow-up with you later. Thanks.

Keith M. Wilson

Thank you.

Operator

Your next question comes from the line of Robert Dezego from SunTrust Robinson Humphrey.

Robert Dezego – SunTrust Robinson Humphrey

Hi. Good morning guys. Thanks for taking the call. I was wondering a couple of quick housekeeping kind of questions. D&A is kind of floating around obviously with some of the charge you're taking do you have a kind of a number that we should look at kind of a run rate heading into 2009?

Arunas A. Chesonis

Yeah, Rob I think you should be looking at the 45.25 kind of number.

Robert Dezego – SunTrust Robinson Humphrey

Okay. And then on your NOLs, what kind of your cash tax expectation for the year and how is that going to flow through on the income statement?

Arunas A. Chesonis

In terms of cash taxes next year we think, we are talking about income taxes we think, it's going to be nominal where it flows through. The charge that you saw this year was really just an accrual that we took for a previously recognized deferred tax asset. So, really it's a non-cash event, it's just more of a timing of being able to recognize and utilize those NOLs.

Robert Dezego – SunTrust Robinson Humphrey

Okay. And then the kind of last question is just looking through the sales cycle for your customers coming in, could you comment on kind of where that is today and where it was three or six months ago or last year kind of the changes you're seeing and the trends you're seeing in sales cycles?

Arunas A. Chesonis

Sure, it's actually shorted up. So, whether they stay with existing vendor or they got to someone to us, I mean people are being forced to make decisions much faster. I was with a client yesterday in Houston. Typically, someone like that we have dealt with two or three bidders on a brand new MPLS tender network, very conservative person, you could tell, the CIO. He wants to make a decision, he has kept all the bids in the last three days, he is going to make a decision in at the end of next week. Typically, you'd see something like that goes 60 days before they make a call with someone with that kind of personality. So again, I can't quantify exactly for you how fast people are making decisions, but the economic pressures are absolutely affecting sales cycles on operating type services, something that would affect OpEx, if you're talking CapEx, a lot of these people are just deferring the decision till later this year, early next year, they're trying to conserve cash just like a lot of folks that are out there.

Robert Dezego – SunTrust Robinson Humphrey

Okay. Can you maybe just talk a little bit about maybe some of your expected uses of cash, as we go into 2009? Obviously, with the draw down revolver you're sitting all a little bit of extra cash, whether it's, do you expect to complete that stock buyback? Is there anything you can do on the debt front and just, any kind of M&A opportunities in this environment?

Keith M. Wilson

Yeah Rob. This is Keith. I mean I think what the board has approved, the stock buyback program, and we have the cash obviously to execute that. We did go out with what we thought was a very balanced proposal out to our lender group. This is a pretty dynamic time for those folks as well, and well everyone was very constructive in the process, we just didn't think that at this point there was a mutually agreeable transaction that we could get done with that group now. Look if folks change their minds, we would be open to rediscussing, but I wouldn't necessarily count on that. And that's traded up significantly from where it has been a couple of months ago, but I wouldn’t rule it out, but I’d say that the debt buyback is probably less likely at this juncture. From an M&A standpoint look we've got a lot on our plate right now. We think we are making great progress on the integration and we've got a lot of, as Arunas talked about earlier opportunity in the markets that we have acquired. So, well, you never say never, I would not anticipate seeing us be someone who is looking aggressively at assets this year.

Arunas A. Chesonis

I mean, look, we have a history as a company as a management team being shareholders in PAETEC from 2003 to 2006. Where pay down debt out of our excess free cash flow, we thought that was a good use of that cash, I think and where we sit today going out just the last few months into the community, really purchasing just bank debt, which was kind of what was mostly offered, on the floaters that are interests crosses about 250 points above LIBOR. Buying bank debt at 2.9% interest, I am not sure is the best use of the cash for all shareholders. And again I think Keith was absolutely correct reviving the feelings of the Board and the management team, he never say never, he always talk to folks in the future. But we have a lot that we can do growing the company organically and putting good projects together to grow that top line and EBITDA line.

Keith M. Wilson

And I would also say Rob just to point out because I think sometimes if we step back a little bit with LIBOR being at 30 day LIBOR being at some 50 basis points. Our negative ARP on that all of that cash is essentially 1%. So, from a negative ARP standpoint, it's, I mean, it's not bad just kind of hang on to that if you don’t have an immediate use for it.

Robert Dezego – SunTrust Robinson Humphrey

All right. Thank you guys. Best of luck.

Keith M. Wilson

Okay. Thank you.

Operator

Your next question comes from the line of Todd Morgan from Oppenheimer. Please proceed.

Todd Morgan – Oppenheimer & Company

Thank you. Good morning.

Keith M. Wilson

Hi, Todd.

Todd Morgan – Oppenheimer & Company

Two general topics. First of all, can you talk about your ability to improve the relationship between the revenues and network related expenses, you had pointed that out is one of reasons why the pro forma of yours is always down in the fourth quarter, basically it sounds to me like we are still under utilize the infrastructure and your ability to do that. You're secondly, falling apart, I guess a previous question, can you provide a little bit more detail on the cash restructuring payments you think you are going to owe in 2009, and also can you give us a sense of working capital trends, that you try and continue to integrate McLeod as well as try and operate in this kind of environment?

Keith M. Wilson

Yes at all good questions. I will take some of the latter half ones and Arunas wants to talk a little bit about the revenues and cost of sale relationship. Cash restructuring charges, we had a couple this year, we don't really anticipate anything next year. So, there may be a little bit here or there, but I would say I would be surprised because it's more than $5 million and, I think it will be pretty small if anything at all from a working capital standpoint, one of the things if you look that fourth quarter, the year-ended on a Wednesday. So, typically you make payments on Fridays, and so the working capital was I think abnormally high to the positive for us and, in the fourth quarter we think that working capital will generally be pretty stable throughout the year. So, we may get a little bit of a lift, but generally we have got everybody's policies kind of inline between payables and receivables and, we think that in classic, growth accelerates a little bit, we may see some negative working capital, but generally stable we are going to expect to see the same thing on working capital.

Arunas A. Chesonis

And again I mean you asked the an eight-hour question on the network, the cost side as well as so the revenue generation kind of I think rest assure that we are working very hard at improving network cost, there are underutilized assets, which we are going through the reconfiguration process now. Just this past fourth quarter, we did expand the McLeod least cost routing capabilities that they had on their SIP platforms into the PAETEC footprint for least cost routing within legacy PAETEC that's begun. You're seeing an aggressive sort of internal campaign with every network provisioner or network planner through the U.S., really optimizing each sort of regional switching configuration. There are ways for us to continue to groom our customers off of higher priced loops into more of the network hubs that's an ongoing process we are going through right now. Part of the issue for us as well is now that we've got a lot our customers moving through MPLS network to the SIP Trunking opportunities other ancillary services you can start offering those folks that are very high margin that don't significantly add your network cost, the network based firewall services, the managed router services and that's going to be really one of the opportunities we have over the next year or two is to really up sell that base on other high-margin data products. So, again lot of initiatives going on and I think, during that Analyst Day in May I think you can expect us to dig pretty much in detail for at least an hour or two on network optimization.

Todd Morgan – Oppenheimer & Company

But I guess if, modest revenue growth trends continue, I guess as they have, there is the big network that the margin can at least improve in 2009?

Arunas A. Chesonis

Well, again it's a combination of, what price per unit you're selling at your core business and if, right now we are not seeing.

Keith M. Wilson

Todd, this is Keith. I mean I think, look what you're asking for is guidance on the gross margin for next year. Do we think that it can improve with fairly stable revenues. Yeah, absolutely. The real question is and the reason we didn't give specific guidance for this year is because I think it's difficult for anybody to forecast where some of the volatility in the economy is going to drive as it relates to our business. So, we most certainly think that there is opportunity, we made significant investments in the IP network this year to upgrade most of our staff to east data network from OC3 and 12 up to 48. That's done. Now there is recurring cost associated with that, but we continue to see very nice sales volumes, new logos, new customers up selling. So, we are working very hard to continue to drive margin but I cannot tell you where, carrier access billing volumes inbound coming from AT&T and Verizon customers are going to go and those are all dynamics that will affect the gross margin as well. So, I think – I appreciate the question, we are working very hard to drive that, but I am not going to give you specific number in terms of where we think that's going to go this year.

Arunas A. Chesonis

And again, we had to make those investments over the last year, just this past fourth quarter as an example, we have got the QoS, Quality of Service across the entire MPLS network nationwide now, across all legacy companies, I mean that's the it doesn't sound that big a deal, but it's a huge deal for us in offering those services to people across the country. Now, we are going to be able to reap the benefits of it over the next couple of years. So, again love to spend more time with you on that.

Todd Morgan – Oppenheimer & Company

All right. Fair enough. Thanks again.

Keith M. Wilson

Thanks Todd.

Operator

At this time we have no further questions in queue. I would now like to turn the call back over to Mr. Chesonis for closing remarks.

Arunas A. Chesonis

Well again, thank you for everyone joining us on the call. We are very happy with the fourth quarter results on the revenue side, new sales are still strong, we are going to keep watching the expenses to make sure that we keep them inline with sort of the ongoing business trends as we see them over the next couple of quarter and I think everything that's going on in the business, all the initiatives that we have cooking is really going to help position us for the future and again thanks we look forward to talking to you next quarter. Bye, bye.

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Good day.

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