Level 3 Communications, Inc. Q1 2009 Earnings Call Transcript

Apr.28.09 | About: Level 3 (LVLT)

Call Start: 10:00

Call End: 11:25

Level 3 Communications, Inc. (NASDAQ:LVLT)

Q1 2009 Earnings Call

April 28, 2009 10:00 am ET

Executives

Valerie Finberg – Vice President of Investor Relations

James Q. Crowe - Chief Executive Officer, Director

Jeffrey K. Storey - President, Chief Operating Officer

Sunit S. Patel - Chief Financial Officer, Executive Vice President

Charles C. Miller III - Board of Directors

Analysts

Michael McCormack - JP Morgan

Jason Armstrong - Goldman Sachs

Colby Synesael - Kaufman Brothers

Chris Larson - Piper Jaffray

Romeo Reyes - Jefferies & Co

John Hodulik - UBS

Ana Goshko - Banc of America Securities

Simon Flannery - Morgan Stanley

Jonathan Schildkraut - Jefferies & Co.

Michael Rollins - Citi Investment Research

Michael Funk - Bank of America

Donna Jaegers - D.A. Davidson

Frank Louthan - Raymond James

David Dixon - FBR Capital Markets

Operator

Good morning, I would like to welcome everyone to the Level 3 Communications Incorporated First Quarter 2009 Earnings Conference Call. (Operator Instructions) At this time I would like to turn the call over to Valerie Finberg, Vice President of Investor Relations. Please go ahead.

Valerie Finberg

Thank you, Jessica. Good morning everyone, and thank you for joining us for the Level 3 Communications First Quarter 2009 Earnings Call. With us on the call today are Jim Crowe, President and Chief Executive Officer, Jeff Storey, Chief Operating Officer and Sunit Patel, Executive Vice President and Chief Financial Officer.

Before we get started I wanted to mention that in addition to the press release and financial exhibits, a presentation summarizing our results, which Sunit will be referring to in his remarks, is available on our web site at www.level3.com on the Investor Relations home page. To view this presentation, from the Investor Relations home page click on the link titled 1Q09 Earnings presentation.

I also need to cover our Safe Harbor statement which can be found on page 2 of our 1Q09 earnings presentation and that says that information in this call and in the presentation contain financial estimates and other forward-looking statements that are subject to risks and uncertainties. Actual results may very significantly from those statements. A discussion of factors that may affect future results is contained in Level 3’s filings with the Securities and Exchange Commission.

Also, please note that on today’s call we will be referring to certain non-GAAP financial measures. Reconciliations between the non-GAAP financial measures are available in the press release, which is posted on our web site on the Investor Relations home page.

With that, I’ll turn the call over to Jim.

Jim Crowe

Thank you. In our prepared remarks Sunit will discuss financial results for the quarter. Jeff Storey will discuss operational matters including recent organizational changes and segment results, and then I will provide a summary and a business outlook and then we will open it up for questions. Sunit?

Sunit Patel

Thank you, Jim, and good morning everyone. Before I get into the details let me start with some high level comments on our results, which are highlighted on Slide 4 of the presentation Valerie was referring to.

Despite the challenging economy and top line pressure, compared to the first quarter last year we have been able to significantly increase our margins, adjusted EBITDA, and free cash flow. We continue to execute well on cost savings initiatives and further improve our liquidity position. After the close of the quarter we raised $220 million in senior secured debt and including the net proceeds from this transaction we have approximately $886 million of cash on the balance sheet as of the end of the first quarter. Our results for the first quarter were in line with our full year 2009 outlook.

Now turning to detailed results for the quarter on Slide 5, as we expected Core Communications Services revenue was under pressure during the quarter at $899 million in the first quarter of 2009, compared to a normalized $949 million in the first quarter of 2008.

Core Network Services revenue was $729 million during the quarter, a decline of 5% compared to the first quarter of 2008 and a decline of about 3.5% on a constant currency basis.

Wholesale Voice Services revenue was $170 million for the quarter compared to $184 million in the first quarter of 2008. We continue to expect volatility in Wholesale Voice Services as we manage for margin contribution versus revenue growth.

On the bottom of Slide 5 you can see the breakdown of Core Communications revenue by market group for the quarter, which was $513 million for the Wholesale Markets Group or 57% of revenue; $223 million for the Business Markets Group or 25% of revenue; $85 million for the Content Markets Group or 9% of revenue and $78 million from the European Markets Group.

We saw revenue performance weaken generally as expected. Jeff will discuss specific market trends more thoroughly, but at a high level, revenue performance was impacted by continued softness and demand and disconnects, both driven by economic conditions as some larger customers continued to optimize their costs, lower usage revenue and some seasonality in broadcasting and content.

Turning to Slide 6, Communications cost of revenue was $390 million in the first quarter of 2009, a 15% improvement compared to the year earlier quarter. Despite the top line pressure this quarter Communications gross margin as a percent of revenue improved significantly this quarter to 59.5%, compared to 56.9% in the first quarter of 2008, showing that we continue to take our fixed and variable costs where appropriate.

On the bottom of Slide 6 you can see that our Communications SG&A expense, excluding non-cash stock based compensation charges and restructuring and impairment charges, and normalizing for the fourth quarter 2008 adjustments, SG&A expense improved for the fourth straight quarter to $322 million, declining 18% compared to $395 million in the first quarter of 2008.

Communications SG&A as a percent of revenue was 33%, compared to 7% in the first quarter of 2008.

Turning to Slide 7, consolidated adjusted EBITDA increased year-over-year to $250 million and Communications adjusted EBITDA increased to $249 million during the first quarter of 2009, a 21% increase over $205 million in the year earlier quarter.

Communications adjusted EBITDA margins increased from 19% in the first quarter of 2008 to 26% in the current quarter.

Capital expenditures decreased to $78 million in the first quarter of 2009 from $107 million in the fourth quarter of 2008 and $113 million in the first quarter of 2008. This is commensurate with a decline in our revenues as the vast majority of our capital spending is driven by sales and revenue trends.

Turning to Slide 8, Unlevered Cash Flow improved by $64 million year-over-year, primarily from higher EBITDA and lower capital expenditures. Consolidated Free Cash Flow improved by $78 million to -$82 million in the quarter versus -$160 million in the first quarter of last year. As we noted on the fourth quarter earnings call, we expected to see negative free cash flow this quarter. Our first quarter typically requires a heavy use of cash as a result of negative working capital in the quarter. The negative change in working capital for the first quarter included our annual bonus payments and severance payments, as we discussed last quarter, of about $65 million; prepaid expenses of about $15 million; deferred revenue payments offset by amortization of about $17 million; and approximately $15 million for the combined changes in accounts receivable and accounts payable.

Turning to Page 9 we announced earlier in April that we raised $220 million senior secured Tranche B Term Loan with net proceeds of $214 million. Including the net proceeds from this transaction our cash balance was $886 million as of the end of the quarter, leaving us very comfortable with our liquidity position. Clearly, as we continue to grow EBITDA and as we pay down debt with cash on hand, we expect our debt to EBITDA ratio to continue to improve in 2009 and forward.

Depreciation and amortization expense was $222 million in the first quarter of 2009, compared to $240 million in the first quarter of 2008. As mentioned in the previous quarter, we expect depreciation and amortization to average $225 to $235 million per quarter in 2009.

With the closing of the $220 million senior secured loan in April we now expect net cash interest expense of approximately $525 million and GAAP interest expense of approximately $610 million for 2009.

Turning to our outlook for the year, we feel good about our previously announced guidance and adjusted EBITDA and free cash flow. The near-term revenue pressures we discussed last quarter have been mostly worked through. Our sales activity picked up nicely in March, and April sales also looked good.

Churn trends are stabilizing. We continue to manage our costs tightly in this environment. Overall customer experience continues to improve, and we expect to make significant improvements again over the course of this year.

Also, our European Markets Group continues to provide steady growth. In 2009 we expect to improve adjusted EBITDA margins from normalized 2008 levels. These improvements are expected to come from continued network optimization and operating expense reductions. We continue to expect capital expenditures will be significantly less in 2009 compared to 2008. As a result of all the expense improvements offsetting any revenue pressures we expect good free cash flow performance in 2009.

With that I will turn the call over to Jeff.

Jeff Storey

Thank you Sunit and good morning everyone. Since joining the company my primary objective, as you would expect, has been to grow revenues. Initially efforts are focused on the following, and I will elaborate on these through out my remarks this morning:

First, creating a sales channel and a support structure that better aligns to our customers needs; secondly, improving the customer experience from quoting through billing; third, focusing on a more localized business market strategy that increases our addressable market and drives decision making closer to the customer; and finally, continue to optimize our cost structure and improve our operating leverage.

Given these goals, we have decided to flatten the organization to drive greater accountability and improve our customer’s experience. As a result, approximately 150 positions are being eliminated; this is proportionately focused on directors and above, and several hundred more are being repositioned.

With these changes, we flattened our organizational structure and aligned it around the way our customers buy services. Specifically, we are realigning our customer facing groups in North America. Within our Wholesale Group we have established a national accounts organization focused on large, nationally oriented, enterprise customers who tend to buy services and need support much in the same way as our carrier and other large service provider customers.

This National Accounts Group will manage the relationships with our largest enterprise customers from across the company: Financial services or healthcare companies that were previously managed within our Business Markets Group and portal or large software companies that were previously looked after by our Content Markets Group have been consolidated with the large enterprises already served by the wholesale team.

This change not only aligns our largest enterprise customers, but also enables our business and Content Market organizations to better focus on their respective customer bases. Our Business Markets Group, focusing on mid-market enterprise customers who tend to buy services locally, and our Content Markets Group which supports customers that purchase broadcast and content distribution services, television networks, sport leagues, and internet based video distributors are an example of these customers.

I firmly believe that these changes will provide increased accountability internally and improve our ability to focus on our customers and revenue growth. Please note these are internal changes only and that we have not changed our external revenue reporting structure.

As part of these organizational changes, Kevin Hart our CIO and Grant Van Rooyen the President of our Content Market Groups have left the Company. We have begun a search for a new CIO and Peter Neill has now been appointed to run the now more narrowly focused Content Market organization replacing Grant. Peter will report directly to me in this capacity. I would like to thank Kevin and Grant and the other individuals leaving the Company for their years of service to Level 3.

Regarding our enterprise customers, I would like to take a moment to discuss some changes we are making in the way we support these customers. We have historically been very successful in serving our large, national customers, who have significant bandwidth demands and sophisticated network needs.

Our traditional sales and support model has served this part of the customer base very well and we’ve been able to grow this segment of the enterprise business and, as I noted a moment ago, we are now focusing our efforts for those customers in a single national accounts organization. This traditional, nationally oriented sales model has not been as well suite to many of our enterprise customers who operate and purchase services locally. We are reemphasizing a more local approach for our mid-market enterprise customers.

Customers in this segment should expect improved service from Level 3 as we increase our local and support resources on their behalf. Our goal is to more completely serve the business community in each market where we have a significant physical and operational asset.

Now I would like to turn to a discussion of the business trends and opportunities we saw in the first quarter.

Our Wholesale Markets Group was negatively impacted due to disconnects from large carriers generally as expected. Within wholesale the wireless carriers, Federal Government, and system integrators showed stable performance. The underlying demand environment remains solid as consumers view more and more video over the internet and continue to ramp their wireless devices for data. The Telefonica announcement is one example of a customer needing large amounts of capacity to satisfy underlying demand growth. Our sales orders and disconnect trends are improving from the environment we saw late last year and early this year.

For the Business Market Group large enterprises, state and local governments, and research and educational customers showed relative stability. Revenue from our medium and small enterprise customers was down as expected, thus overall revenue declined this quarter compared to last year due to customer disconnects and a decline in usage revenue. Also, keep in mind that we sold a large portion of the smaller end customers in the fourth quarter which also affected revenue compared to the prior year.

In the early stages of implementing our local strategy we’ve seen an increase in quoting and proposal activity and while we are cautious, we would expect this increased level of activity to have a positive effect on revenue trends over the course of the year.

Our European Market Group continues to perform well, despite the economic conditions in Europe, and grew 23% year-over-year in constant currency terms. Continental Europe continues to experience solid growth from traditional carriers and content customers.

In our Content Markets Group, we had pressure primarily from broadcast customers due to normal seasonality of events, but also as these customers generally cut back in the first quarter on the number of events they covered and the level of redundancy they purchased. In contrast to the overall weakness in broadcast media and entertainment customers, the portal and search customers were relatively stable.

The Fox announcement and corresponding announcement of our managed video network services is an example of how our broadcast assets and deep experience in delivering quality broadcast services, combined with our IT and data services, uniquely position Level 3 to grow revenues with this segment of the market.

I will now spend a moment on pricing and demand trends.

While we have seen some competitive pricing pressure, overall pricing has remained relatively stable across our services. We continue to see stable to increasing pricing for infrastructure and stable to declining pricing for transport and certain Ethernet services. As we have indicated previously, services such as high-speed IP display a different dynamic. We continue to expect long-term price declines offset by increases in unit demand.

While short-term demand for our services has been under pressure due to global economic conditions, we believe that fundamental underlying demand that drives growth in our services continues to be strong, as evidenced by recent reports of growth in wireless data and online video distribution.

In summary, while we remain cautious, we are seeing sales and quoting activity pick up again. The organizational changes we made should continue to drive better customer experience and streamlined decision making, which will allow us to better capitalize on demand growth. Our focus on cost management and investment to improve productivity and efficiency continues, and will serve us well in terms of EBITDA growth and cash flow in 2009 and going forward.

With that, I’ll turn the call over to Jim.

Jim Crowe

Thanks, Jeff. As I mentioned last quarter and I want to reiterate, given continuing economic uncertainty we have taken actions to ensure we meet three goals:

First, we want to make sure our cost structure is appropriate for a wide range of potential revenue growth rates. The actions to streamline our organizational structure, which we have discussed, help accomplish this goal, and it also helps improve our responsiveness and the speed of our decision making.

Second, we want to continue to improve our credit quality through improving operational results and appropriate deleveraging transactions. Both the improvement in EBITDA and cash flow, and the increase in liquidity this quarter, which Sunit discussed, demonstrate the significant progress we’re making in this regard.

Third, we want to make sure we are positioned to take advantage of the opportunities that will certainly emerge as the long-term positive fundamentals of our business displace short-term challenges.

We said last quarter that we expected the revenue pressures we anticipated were temporary and that given underlying growth and demand for bandwidth remains strong, we expected that the lengthening of sales cycles and the reduced customer purchases we were experiencing would be temporary. As both Jeff and Sunit discussed, recent reductions in churn, our solid forward sales funnel, increases in our quote and proposal volumes, and in the actual signed orders later in the quarter all indicate an improving market. This stabilization is consistent with comments made by some of our larger competitors.

I want to emphasize that levels of uncertainty are still high and we remain cautious, but these are positive signs.

I will conclude by commenting on another matter. As both Jeff and I noted, we have taken steps to streamline and remove layers in our organization. Any time you do that there is a risk that some executive will not like the changes and that leaves no choice, of course, but to part ways on the basis of mutual agreement. For this reason, both Kevin Hart and Grant Van Rooyen, our CIO and the President of our Content Markets Group respectively, are leaving the Company. I do want to thank both of them for the contributions they have made and wish them well in their future endeavors.

Operator, that ends our prepared remarks, so would you please explain the Q&A process.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Michael McCormack from JP Morgan.

Michael McCormack - JP Morgan

I would like an update on what is going on with the Unity program. Just looking at the Business Markets Group revenue, it seems like it is significantly worse than a lot of the peers out there and you guys obviously should be a share taker, relatively smaller provider in that marketplace. Could you give us an update on those two issues?

Jim Crowe

I will handle Unity and Sunit do you want to comment on revenue?

With respect to Unity, I think we’ve said over the course of the last year and summed up that the framework for Unity was in place and that we met our target of getting 2/3 of up order volume through Unity by year-end. The best measure of the success of Unity, which for those of you who don’t track that day-to-day, is the term we use to refer to both the processes and the systems which support those processes from quotes to collecting cash. The best measure of how we’re doing is how we’re meeting our customer promises, particularly on install intervals. We said over the course of the year that we are meeting our targets. That is what we track; that is what our customers care about, and that is what we’re going to continue to focus on.

Of course Unity is always something that we can improve on. I think Jeff Storey has said a number of times that our focus has now shifted from the framework and maybe some of the systems work, to making sure that our network inventory, and that is key for any communications company, that is knowing what’s in your networks, what is utilized currently to provide service, and what’s available for new service, that that inventory is accurate. That is tens of millions of records that we need to make sure have high levels of data integrity and that is what where we will be spending our time.

Sunit, can you discuss Mike’s question about revenues?

Sunit Patel

On revenues what I said. I mean first of all Mike, on an overall basis and then I will get to BMG, our year-over-year revenues were down about 3.5% on a constant currency basis. I think if you compare that to Verizon who just reported about 5.8% down year-over-year excluding consumer and wireless; if you look at T it’s about 4.5%.

You are right in that our BMG business the performance year-over-year is a little worse than people who have reported so far and I think some of that is, as we have talked about over the last couple of years, is we, as part of all the acquisitions we did, we had a customer base that at the very low end wasn’t part of our normal target customer base. These were customers that were residential customers in very small businesses billing less than $400.00 a month and those weren’t really the target of our focus and we have been accreting the revenue down.

Having said that, I think with all the things that Jeff talked about and my remarks on improvement in sales performance more recently, and churn trends stabilizing as we have largely worked through that customer base, that is not part of our customer base, we expect better sequential performance going forward. We talked about how the revenue trends have stabilized. That certainly also applies to the BMG group.

Michael McCormack - JP Morgan

Are you seeing any meaningful difference between customer churn versus monthly occurring revenue churn?

Sunit Patel

I think the customer churn obviously started worsening because of the general economic backdrop in the fourth quarter and early in the first quarter, as we have talked about. I think stepping back overall, looking at our business market groups; there were three sets of issues. One was the one I just talked about, which are non-target customers.

The second one, which is over the course of the last year, we have been dealing with customers leaving because of the integration issues and the customer experience issues that we have created for ourselves. As we have said, we have largely been climbing out of that over the last year.

Then the third set of issues is just what with the general economic backdrop impacting customer churn.

I think the last one, where so many are seeing stabilization on and obviously with respect to the overall customer experience churn over the last year, we have been making improvements on that over the course of the last year.

Jim Crowe

I want to emphasize that, as it says in the press release and both Jeff and Sunit mentioned, we have seen positive signs in churn, in sales, quoting activity are up quite substantially, and in sales themselves. We are still cautious. We are still going to make sure that we can accommodate a wide range of outcomes. Anybody that doesn’t remain cautious in this market, we do not think is being prudent, but we are seeing positive signs and that is no different than, I think, a number of our competitors have reported over the last week or so.

Operator

Your next question comes from Jason Armstrong with Goldman Sachs.

Jason Armstrong – Goldman Sachs

I have questions on the revenue trajectory. As we think about your comment around revenue pressure moderating into 2Q is that a year-over-year comment, is that a sequential moderation? Could you give us some parameters there, because on the sequential you were down $70 million this quarter? That leaves quite a bit of room for movement in 2Q. I am just wondering how to think about that.

Then, Jim, to your point on seeing incremental positive signs exiting the first quarter, I am just wondering when do we sort of hit the tipping point in terms of the positives overcoming the cyclical negatives in the business and we can start growing revenue sequentially again.

Sunit Patel

I think our comments were specifically, and I think I said, that we mostly worked through the revenue pressures we’ve talked about and then in the press release we talked about the significantly moderating impact; and that really spoke to a sequential performance. I think it also speaks to what we just talked about, which is good improvement in sales late in the first quarter and that continuing into April and churn trends improving.

Then to your point on revenue trajectory over the course of the year, certainly I think, as Jim said, we are cautious. We don’t have enough data points to say we have a trend, but we are seeing signs of life in terms of customers buying again and quoting activity going up a lot. So, that should start turning the other way over the course of the year.

I don’t know if Jim wants to add anything.

Jim Crowe

I would just say what we’ve said a number of times in response to that question. We would emphasize roughly 2/3, 70% of our business is created by underlying consumer demand for broadband of the home and smaller, but certainly increasing at a very rapid rate is wireless data adoption. We serve that demand, obviously, through our wholesale customers. That is what causes growth in Europe, which is pretty much a pure play on consumer broadband demand and wireless data growth and that’s the driver of our content markets activities.

We have seen, and I think this is consistent with other observers, we have seen no reduction in that underlying demand if anything, of the adoption of video distribution and obviously the very rapid adoption of wireless data continues to grow. That kind of demand means that, as we have said a number of times, the pause in purchasing, which we began to identify late last year and which continued into the first couple of months of this year, we believe, and continue to strongly believe, was temporary. You can only run networks so hot before you need to begin to purchase again.

I would simply say we remain cautious. We don’t have any special views into the macroeconomic situation, but we are seeing signs and consistent with other commentators who see signs, we are seeing signs that, as we’ve said, our customers are going to need to start buying again.

The other 30%, roughly, of our business is our Business Markets Groups and its described that those trends, that Jeff talked about, are moved towards adding resources in local and regional areas and we expect to see the results of that over the course of the year.

Operator

Your next question comes from Colby Synesael with Kaufman Brothers.

Colby Synesael - Kaufman Brothers

My first question, as it relates to cost output both on the operating side as well as on the CapEx side, how much further do you guys think you can go in terms of reducing the cost before it starts to impact your long-term growth opportunities. Obviously, on the CapEx side I think you hinted in the press release that that $75, $80 million range is probably appropriate for the remainder of the year and that is somewhere around 8% to 10% of revenues, according to my calculations, versus historically 12% to 14%. On the OpEx side you guys are cutting another 150 people. Where do you start to get concerned that you’ve cut too deep?

Then my final question has to do with your debt. You did raise $220 million in April. If you guys get the opportunity to raise more money during the course of the year, is that something that you would want to do, or do you think that your current debt/cash structure is where you want to see if for the remainder of the year?

Sunit Patel

With respect to the debt, I think that the cash that we now have on hand essentially let’s us, even without assuming pre-cash flow generation, which I will come to, takes care of all our debt maturities through ’09 and ’10 and a reasonable chunk of ’11 also. I think with cash that we would generate over the course of this year, next year, and 2011, we think we are fine and can work our way right up to the end of 2011.

In short, we don’t need to raise any capital over the course of this year or next year. But, as we have pointed out, we always try to be conservative in terms of maintaining high levels of liquidity. So, if we see the opportunity, as we pointed out last time, there are a couple of avenues that we would tap, but certainly, from my perspective, they would just be that type of opportunities that we have some incremental capacity for. But, we do that on a very opportunistic basis like we did with the $420 million.

On the OpEx side, I think that we continue to manage costs tightly as we have for the last couple of years. I think that approach will continue. I don’t think that any of the OpEx reduction so far is impacting our ability to grow revenue today or in the future. That is just business as usual for us in terms of managing OpEx tightly. Similarly, on the network expense side we use the same approach.

With respect to CapEx, Jim will comment.

Jim Crowe

I would emphasize that non of the cuts we make are in the areas that affect our ability to sell, to provision service and to provide an excellent customer experience and in fact we have been adding sales people over the course of the year. We are adding people and will be adding people in local and regional business markets and CapEx self adjusts. We are certainly not cutting any capital that is success based. So, I would emphasize what Sunit said, we are aimed at growing revenue appropriately and we’re not going to cut any expenses that affect that ability.

Colby Synesael - Kaufman Brothers

So you are not necessarily concerned that some of your competitors continue to invest in their networks. Not necessarily driving revenue for the next quarter, but in terms of improving their network as it relates to Ethernet and improving the speed and efficiency, you are not concerned that six months a year from now when the markets hopefully start to improve that they are going to have a different type of product set, or a different type of network which is better than yours, because they have continued to invest when you haven’t been able to?

Jim Crowe

That is a good question. I would refer you to our continuing set of remarks over the last three years, four years, five years, supported by the many presentations that are available publicly. I think in particular if you look at investments in network technologies, which then turn out to lead to new products, we haven’t followed we’ve led. We’ve led clearly with the development, in fact including a great deal of intellectual property, in the move from circuit switching to soft switch. We led clearly in the move from TDM to IP.

We were the, very early, perhaps one of the first if not the first to indicate that we believed that Ethernet switching tied together by proprietary software that we developed was the right way to go, including in the core of the network. We announced that a few years ago. Our CTO in a number of presentations described in detail why we were making that switch. I think others are catching up as we speak.

I think we led, clearly, in the switch from discrete Optronics to photonic integrated circuitry, PIC technology and I think we are clearly a leader now in content distribution. I think that has been and will continue to be a strength of Level 3 and not a weakness. And, we have not cut back on those investments at all.

Operator

Your next question comes from Chris Larson with Piper Jaffray.

Chris Larson - Piper Jaffray

In the press release you did reiterate that you are maintaining your guidance, but one sentence read differently that you dropped language talking about an improvement in free cash flow. I just wanted to know if there is anything to read into that?

Then Sunit, I want to clarify, on the free cash flow positive for ’09 is that the levered free cash flow or is that the unlevered and are you using cash interest? I would assume you would be using cash interest on that.

Then Verizon yesterday said that they had raised some pricing. You said that pricing is getting stability. Have you seen anything in the marketplace or have you been able to take advantage recently of Verizon’s willingness to raise prices and go in there and steal from share from them on the wholesale side?

Sunit Patel

On the guidance side, no I don’t think anything has changed. We said we would be free cash flow positive for 2009 as a whole and I think we are just reiterating that. Keep in mind we are reiterating that even though we have taken additional cash interest expense from the issuance of the $220 million in April. By free cash flow we do mean levered free cash flow. I think unlevered cash flow that is before interest expenses, I think, last year was close to $500 million, $480 or so and last year we had a free cash flow loss, so obviously we expect unlevered cash flow being up a fair bit this year; so free cash flow is levered, just to make that clear. It is EBITDA minus adjusted EBITDA, minus CapEx, minus or plus any working capital changes, and less cash interest expense.

Jim Crowe

He may be referring to the change in GAAP with respect to derivatives and converts, is our free cash flow guidance cash interest or GAAP interest.

Sunit Patel

As I said, it is cash interest.

Jim Crowe

With respect to your question about pricing, obviously we don’t have insight into the specifics that Verizon is referring to in detail. We’re making outside assessments, but it is consistent with what we’ve been saying, I think, since the time consolidation began in earnest in 2005. That is, expect that as you get closer to the edge of the network and as you get closer to the infrastructure layer, that is big transport pipes, Ethernet, and in particular metro fiber, but clearly including access you should expect that prices will increase. Now, we have said that over and over again.

I think there was some controversy, or at least some questions about whether it would happen. We have said now for a year, it is clear that the dominant providers, AT&T and Verizon, who own access facilities are raising rates and that if you are a net seller of facilities, particularly metro so called middle and last mile you are going to benefit. If you are a net purchaser you are going to be squeezed and we think the truth of that statement is now becoming obvious. I think Verizon’s comments are just supportive of the trends that we’ve been talking about for some time.

Directly to your question, yes we think we are a net seller of facilities and therefore long term overall we benefit from those kinds of trends.

Operator

Your next question comes from Romeo Reyes of Jefferies.

Romeo Reyes – Jefferies & Co

On Q1 on the cost structure, you guys have taken out some $300 million of costs from the SG&A line in about a year, which is great news. Are there any 1-x items in there that we should normalize for either a positive or negative here soon?

Secondly, on BMG, the BMG revenue was soft here. Can you give us a sense as to how much of that was just the sales force not selling as much as you expected versus maybe a churn?

Sunit Patel

I think first, there were no unusual items in the quarter per se. I think that is a fairly normal quarter from that perspective.

Then on the BMG side, one, on the sales side, as we talked about, sales weakened for us beginning late in the third quarter that we have been talking about for a couple of quarters. That continued in the fourth quarter and early part of this quarter. So, the one was just sales weakening in general, but obviously that has picked up here more recently.

Then the second was churn, which as we talked about, was driven by just the economic backdrop, so a continuation of that, but again, we have seen some stabilization more recently in that trend. So, at a high level that is what it is.

I think within that, as Jeff might have pointed out, the large enterprise business continues to do relatively well, and we saw more of the economic impact on the small and medium size enterprises.

Jeff, do you want to add anything to that?

Jeff Storey

Romeo, there are kind of three factors going on there; one is disconnected service, the other is lower usage. I think the lower usage is generally driven by the macroeconomic environment more than anything else. Then the third is sales.

On the sales side we have been organizing our sales force more locally so that we can grow that customer set and so that we can focus on them market-by- market in a more productive way and we have seen early results saying that that is the right strategy. We have seen our quoting and proposal activity up substantially. As I said in the comments, we expect that while we’re cautious, we hope to see that increase in quoting and proposal activity turning into sales later in the year.

The disconnect portion, Sunit mentioned in his comments that we are largely through the disconnects that we expected, but this customer set we still see a certain amount of turn coming from them.

Operator

Your next question comes from John Hodulik with UBS.

John Hodulik – UBS

Just to focus on the content side, it looks like on an annual basis is any seasonality you saw a fairly dramatic slow down. Jim, in the past you have talked about the relationship between pricing and volume. Has that changed at all, or is there something going on inside the numbers that we’re not aware of?

Then, from an industry standpoint there has been some talk, at least in the papers, about Qwest potentially selling their long-haul business, the classic Qwest. Just from your perspective, does it feel like we may be in the midst of another round of consolidation to you, or do you expect? I would love to get your perspective on that, especially in light of your comments about the higher access costs squeezing some of these providers, such as Qwest, that don’t really have a very broad distribution network.

Jim Crowe

I will take the first one and then if we happen to be graced with the presence of Buddy Miller, who runs our strategy, M&A and a number of other things, and he can take the first shot at the second question about industry consolidation.

With respect to content, Markets Group let me make sure that that’s not confused with CDN. Some of Jeff’s comments bear directly on that difference, so I want to amplify a little bit. With Content Markets Group, which when Jeff reviewed it, it really broke into three pieces. Large customers who bought traditional services, our broadcast and Vyvx services which are generally live venue events, which we dominate. We have a great service.

We move the traffic from the venue of a sports facility, a live news event somewhere at a coliseum or a stadium, back to the production facility. In that area HD is becoming a major matter and we are expanding that business to Europe, for instance. Then our CDN services, moving video, either streamed or downloaded, over our network, storing as appropriate, forwarding as appropriate, directed by some fairly intelligent algorithm and some packing to intellectual property and software.

Jeff and I agreed strongly and Buddy Miller came to the conclusion that the first selling traditional services to content owners made more sense to include in our wholesale group and that had two good benefits, more focus on the needs of those customers, and more focus on broadcast and CDM. That is, we really want to focus in on what we think is going to be a big deal in the future.

The weakness that you are referring to really was in the first two segments, that is some of our larger customers simply stopped buying and running their networks harder, moving some of their traffic to their to own networks, as we expected.

The second part of the weakness had to do with our broadcast segments. Some of that is just seasonal, but a lot of it is news organizations and others who are simply covering less events and are trying to conserve or to cut costs.

CDN is a whole other matter. That continues to grow. We continue to be excited, but it is on a smaller base. The changes that Jeff mentioned are an expression of our interest in and conviction of that that is a big business, but not today. It will be in the future.

Buddy, do you want to take it from here?

Buddy Miller

Yes. As you know, we don’t comment on any specific rumors or transactions unless and until we have something to really report on that, so we won’t comment on any particular company that you mentioned, but certainly we believe that the consolidation has more room to go. One of the factors, of course, is the metro facility squeeze that Jim expounded on earlier, that I will only mention in passing here.

The second one is just in the back bone there is enough out of pocket costs from running each one that there tend to be synergies, cost savings, from taking traffic that was on two networks, putting it onto one and there are a lot of cost savings from that. We, of course, have participated in that part of the consolidation because given our cost structure it is fairly logical for us to be a consolidator in that area. And, since we have some metro as well, it was fairly logical for us to continue to look out at the consolidation as being part of it. We will continue to look at it and we will continue to expect it to happen in the industry one way or the other.

Jim Crowe

I would add one comment, only the same statement, just in financial metrics. If your gross margins, particularly your incremental gross margins, indicate you are a net purchaser of middle and last mile you are getting squeezed. Someone asked earlier about Verizon’s comments. We just simply say that is one more piece of evidence that if you hit gross margin performance that means you are a net purchaser of facilities you are getting squeezed.

Operator

Your next question comes from Ana Goshko from Banc of America Securities.

Ana Goshko – Banc of America Securities

On the wholesale revenue side one of the factors that you mentioned in the weakness, in particular the sequential weakness this quarter, was wholesale triggered disconnects. I know you mentioned that as a factor last quarter in your earnings call and press release. But, I wanted to get some more color about what the factors were behind losing the wholesale customer. Was it price driven or other? And, is most of that now factored into the quarter? Do we have a good base or do you see more disconnects from the wholesale customer of putting pressure on wholesale revenue in the future?

Secondly, just on the capital structure. Are there any other things that you feel you can do to capture some of the discounts in your securities? In particular you said that you felt comfortable with your maturities through 2011, but the 2011 converts really have a pretty nice discount on them still; so are there things in the way of more tenders or debt for equity swaps that you believe you can take advantage of to capture the discount in the marketplace right now?

Jim Crowe

With respect to your first question it kind of fits into that whole commentary of the last number of questions, including Buddy’s comment. Larger, and really just a couple of them, AT&T and Verizon, larger competitors who are facilities based, we have known for some time were going to consolidate traffic onto their network. Timing maybe has been affected by the economic situation. Obviously that puts even more emphasis on moving traffic to your own less costly facilities. We are doing that and we have continued to do that. That wasn’t surprising. That is what perked. That is what we were referring to.

To answer the second half of that question, yes we think that is largely behind us.

Jeff, do you have any comments?

Jeff Storey

We are cautiously optimistic that slides are behind us.

Jim Crowe

Yes okay and obviously we have insight, because there is only so far that can go. Sunit to you want to add anything?

Sunit Patel

Yes. I think, Ana, as we have said for some time, we continue to look actively at anything we can do from a liability management perspective. Beyond that it is really tough to make specific comments and any of these debt trounces of a different sets of owners sets of views on the value of the securities, but as always we continue to take a look at pricing at all our securities and see if there are any opportunities to exploit.

Jim Crowe

I think it would be accurate to say that Sunit and his team have used essentially every tool that I am aware of, and Ana you are more than familiar with those tools, every tool that is in the bag to manage liabilities and I expect that they will continue to use them as appropriate.

Operator

Your next question comes from Simon Flannery with Morgan Stanley.

Simon Flannery – Morgan Stanley

Sunit, if you look at the sequential improvement in free cash flow last year, you have got a big lift Q1 to Q2 and given the improvement in Q1 it seems reasonable to expect you can have a nice positive free cash flow in Q2 if the trends continue as you projected. Is there anything on the working capital side, or others, that might make that more difficult to achieve?

Then, you had great SG&A improvement sequentially. Can you just drill down a little bit more into what the buckets were there? How much of that was headcount and other expense categories?

Sunit Patel

In general, without referring to any particular quarter, yes we do expect the cash flow year-over-year to generally be very positive over the course of this year. We don’t expect anything unusual from a working capital perspective over the rest of the year, with all of the items I went through on the working capital changes in the first quarter; obviously a fair amount of those flow back to us. For example the bonuses are annual in nature, so that is 1x, so that doesn’t recur. Severance payments, we said last quarter that we’d have $12 million in severance costs, so that obviously happened in the first quarter. There will be some more severance costs, as we indicated in the press release, but other than that some of the other items should flow back the other way. So, working capital generally will be a source of cash, but that was also the case last year. So, we do expect year-over-year improvements there for the rest of the year.

I think your question on SG&A specifically in the quarter, in the first quarter we just reported, as you know at the tail end of 1008 we eliminated about 450 positions and that that benefit would start showing through in the first quarter, so you are seeing that. Most of it is that. Then there are the other areas of non-headcount expenses where we have continued to manage tightly and that is business as usual.

Again, nothing unusual other than the headcount reduction we talked about at the end of fourth quarter.

Simon Flannery – Morgan Stanley

When will be the timing on the 150? Is that sort of happening by the end of April or sort of more spread out?

Sunit Patel

It is generally happening in May.

Operator

Your next question comes from Jonathan Schildkraut with Jefferies & Co.

Jonathan Schildkraut Jefferies & Co.

Sunit, can you run through the details of the working capital changes again for us? Then in terms of the business one of the things you talked about was weakness on the SME side. I was wondering if that was just the fact that you’re not really focused on that segment or if there was some economy impact there.

Then is you could give us a sense as to what some of the traffic trends were in the quarter on the IP side that would be great.

Sunit Patel

I will take the working capital question. As I said, during the first quarter annual bonus payments and severance payments aggregated to about $65 million with prepaid expenses, which is typically prepaid maintenance on software and hardware contracts, those payments, as I said, were about $15 million.

We had deferred revenues being offset, meaning IAU collections, offset by non-cash amortization. That gap was about $17 million. Obviously that will improve, for example given the kind of Telefonica contact we talked about. Then it is combined changes in accounts receivable and accounts payable took up about $15 million, obviously that will flow back the other way to us over the course of the rest of the year.

Jim Crowe

With respect to your questions about BMG, I want to put that in a little bit of perspective, because it reflects back on a comment that Jeff made in his prepared remarks.

Historically, and Jeff said this, I will reemphasize it, we have been a company that focused on larger accounts, $20, $30,000 and above per month kinds of billing rates. In 2004 when we believed consolidation was occurring, we got in a hurry to make sure we had facilities in the metro, we said at the time that meant we needed to broaden out our offering. It makes no sense to have facilities and then not sell to all of the sets of customers that you are equipped institutionally to serve, and that we desired to begin serving smaller customers. Now, for us smaller customers might be 2,000 to 5,000 a month and above, not 500, not 200, because, as I say, we are not institutionally geared to that market, but that is a huge market.

We have said that even within business markets we have been quite successful and have grown our 10,000 and above market segment and continue to do so. But, I have not been happy with our ability to serve the so called middle part of the market, which is a huge market. Historically it has been a good market.

When Jeff came on board that was one of his major undertakings. I might add Jeff helped build that business for Cox, that is the Cox Sea Life business he participated in building, so by experience he has quite a bit of insight into that market. When he surveyed the situation he came to the conclusion that institutionally we need to make some changes, which he described in his prepared remarks: a continuing emphasis on more local sales, more local operations, and city managers who have the feel of their local regional markets. Now he described the flattening and streamlining we’re doing. He has also mentioned that we are actively hiring, as we speak, people to move into those areas. So our ability to serve that market, I would describe as more our own internal capabilities rather than any overall market weakness or growth. I mean when you’ve got 3% of the market, whether it grows 5% or shrinks 5% is less important than whether you take share.

Jeff Storey

I think that is exactly right and we see churn across our customer set, but when you have 3% of the market you ought to be able to outgrow that churn and the churn that comes from the macro environment., they will be able to outgrow it. That is what we’re really designing our strategy around is how to grow that business.

Jim Crowe

I think it will be accurate to say you will hear more and more announcements about the specifics of this roll out, in the short term, over the course of the year.

Regarding IP, as you know and I want to reemphasize we say this each time we don’t have anything against reporting IP traffic growth. We think it is absent definitional work on the part of our industry about what you mean when you talk about internet growth, IP growth, all of the substitution effects that we’ve talked about at length between CDN, IP, Ethernet, transport services, which we see all the time, in and of itself IP traffic growth is only one piece of a much larger picture.

To answer your question we now have roughly I think a 17% growth rate quarter over quarter and that is oddly both in the US and in Europe. We are approaching a terabyte of traffic in Europe and we are at about 1.6, I think, terabytes in the US. So, it is a huge base and it is a pretty rapid quarter over quarter growth rate. But, the substitution effects are large and anyone on the call who has an academic bent would do our industry a good service by defining sort of an I1 and I2, that is a series of metrics that define internet growth. One that might be IP and then one or two others that are more expensive and capture all of the various components that make up what we call the internet today. But, that is the growth rate, 17% quarter over quarter and coincidentally it was the same in the US and Europe.

Operator

Your next question comes from Michael Rollins with Citi Investment Research.

Michael Rollins – Citi Investment Research

You have talked now for a few quarters at least about the churn issues for the sub $500.00 customers in the Business Markets Group. I was wondering if you could gives us some more details on the dollars that that represents, in terms of that group of customers that spend at or below $500.00. So, could just give us a sense of the revenue movement in that segment of BMG versus the other part of GMB.

My second question is you talked a little bit about churn and some of the trends you saw in churn over the course of the quarter and exiting the quarter. Can you throw some numbers around that in terms of maybe what churn was in ’08 on a revenue basis per month, how that might have moved earlier in the year then coming out of the first quarter? Just so we can put some sense of magnitude on the changes that were occurring within that metric over time.

Sunit Patel

Let me go with that question on the BMG side. I think we have said this in the past, but that less than $500.00 of customer revenue base has been coming down pretty sharply over the last couple of years because we have been purposely accreting that away. As we mentioned in the fourth quarter, we sold a big chunk of that remaining base in the fourth quarter. It was about $8 million of annual revenues at that time, so that gives you an idea in terms of the overall base.

I think currently it is not even meaningful, I mean it is less than 1%, I would say, at this point In time. As we have been saying, we have largely worked through that through attrition and through the selling of some of that base in the fourth quarter, as we talked about.

On churn, we haven’t provided overall churn numbers. It gets tricky with the usage components and the recurring revenue components and the various geographies we serve, CDN or some of our business, our broadcast revenues are more on an event basis, so it is tough to really describe to you in that respect unless you get into pretty sharp detail like for this particular segment of this particular product.

We would say just overall as we look at churn, whether that is disconnects or net rate changes or pricing re-rates, in aggregate all of those trends have shown improvement or stabilized here more recently.

Operator

Your next question comes from Michael Funk with Bank of America.

Michael Funk - Bank of America

You talked for a couple quarters now about capacity utilization being higher or your customers running hot networks. Can you put some numbers around this for us; give a sense of how they’ve run their networks in the past, some of the peak levels where they are today?

Then back to the consolidation question earlier. One of your wireless peers recently commented that he spoke with the FCC and he felt a regulatory hurdle was significantly higher now for additional consolidation in wireless. Do you feel the same way about long haul and if so what kind of conditions do you think could be on an additional merge or consolidation?

Jim Crowe

I am going to let Jeff think about the first question you asked. He has actually had some conversations both with international carriers and domestic carriers. He got asked that question by our board of directors, so we will see how consistent he is on his answer.

With respect to your question about the Federal, broadly defined, the FTC, the Trade Commission, the Justice Department, the FCC, so it is probably a little early to be declaring too much and I would also note that the administration has so much on its plate you have to wonder whether they focused on this issue. Additionally, what we have heard, for what it’s worth, is that the focus will be more on broadband to the home and making sure that the digital have nots have access than any other single issue.

So, with all of those broad statements, I would say by definition if consolidation occurs at some point then you are going to see some push back from the Feds. I don’t have a comment on wireless that is not our business.

On the wire line side I would make a distinction between the core of the network, that is pop to pop, edge of city, edge of city where, as we have said over and over again, that isn’t our focus. Its barriers to entry aren’t all that high and there is still plenty of competition. And, metro facilities where, if Verizon was referring to those facilities when it says it’s raising price it is certainly some evidence that the amount of competition is limited.

How the Feds will react, I think, is a political question that it may be too early to answer.

Jeff, have I bought you enough time?

Jeff Storey

Sure, sure. We often talk about capacity utilization as a single number, but you have to first realize that networks are run link by link and so capacity utilization is associated with an individual route. Typically companies operate those at different utilization factors, depending on how long it takes them to augment, how fast the growth is. It is not uncommon to say that you are going to launch and augment around a 60% utilization. That is a general rule, but I can’t give you any specifics that are going to cover an entire network. It is route by route. An engineer is going to look at how long it takes to augment.

Where our customers are running today, they are running them hotter. I can’t tell you exactly where they are running, but I can tell you the consequence and how they do it. If you look at a route between two locations, you have a direct route, but you also have alternative paths to get there. So, once that direct route gets filled up they’ll overflow traffic to an alternate path and just offer a slightly lower quality of service, either greater latency or more delay along the circuit.

So, running a network hot is something that every operator does. They can easily manage it. It doesn’t last forever, because eventually as the demand continues to grow eventually you have to start augmenting and you have to start adding capacity.

If you wanted me to pull out my crystal ball and say how long that would last I can only reference back to historically in previous times we’ve seen companies do this, it has probably been an three to five quarter event, depending on where they started out at the beginning of it all. From my point of view we are probably two quarters into that.

Jim Crowe

It may be obvious, but just to complete the thought, that 60%, such as it is, is to allow a margin of safety for event driven traffic spikes and outage driven traffic spikes, both of which are very burst like and your margin of safety as it erodes isn’t all that big a deal until it becomes a big deal. Judging when that occurs is the art of engineering a network.

Operator

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

Donna Jaegers - D.A. Davidson

Jeff, I was wondering if you could just go into a little more detail about your local sales focus. Are you focusing on specific metro markets where you have metro facilities and adding sales people there? Can you give us a little more detail on your plan there?

Jeff Storey

Sure, we are trying to take advantage of the metro markets where we have significant physical and operational assets. We have people in these markets. We have local fiber in these markets, on that building, local infrastructure, all of the infrastructure. We will focus on specific markets. We are not announcing any particular ones, but over the course of the next year we want to increase our focus in every market that we serve.

By hiring local sales people in that market, a city manager, as Jim mentioned, aligning our operational resources around those markets so that everybody has a stake in how we grow that individual city.

Sunit Patel

Not only to that point, we also now internally providing to that group the revenues and anyone further down the road gross margins and direct costs buy on a geographical basis, so we can tie it into financial performance [interposing].

Jeff Storey

With the profitability and performance we can buy it on a [interposing].

Sunit Patel

Sales performance and profitability and revenue we’ll…

Donna Jaegers - D.A. Davidson

Great and the Unity platform, I mean one of the problems it seems like you guys ran in to before was obviously this was on Telcove’s or progress Telecoms inventory system, so do you have the inventory system cleaned up on a local level so that you can deliver circuits on a timely basis?

Jeff Storey

Inventory is one of those things you never have cleaned up to where you want it to be. Jim mentioned that Unity is in place. We have a good repository for all of the data. We are going to continue to work to clean up that data over time. TelCove and some of the progress in some of the others are not as clean we would like and we are going to work to physically improve the integrity of the data, to go out and audit the networks and look at what equipment is out there and what services are riding on that equipment and import all of that into Unity in as clean a fashion as we can.

That is a long-term project. We have good data about TelCove and progress and other pieces of the network. We don’t have as good as we want and that is what we’re going to continue to work on.

Jim Crowe

So if the answer to the question was absolutely yes, we would have local sales, local ops and city managers in 80 cities tomorrow. Pacing the deployment and our ability to turn up service is a key to all of this and it is where Jeff is spending a great deal of his time. I can tell you we’ll make some mistakes, but we’ll try really hard not to make the same mistakes we’ve made in the past. Making sure that we can meet our commitments to turn up service in our promised intervals is one of the things we are really focused on.

Operator

Your next question comes from Frank Louthan with Raymond James.

Frank Louthan - Raymond James

On the SME side, can you give us a little bit of color on what sort of products that you’re going to be offering? Exactly what are you going to be selling to them? Also, where are you on the sales force ramp? Do you have the sales force in place? Are you just waiting for them to hit their stride or is there still more hiring to do?

As far as the disconnects, I understand the carrier disconnects putting back on their own network, but can you give us an idea of what some of the other, the top two or three main reasons that you are seeing customers leaving. Are they going to other providers, or just shrinking their spend, or Chapter 11? If you could give us some color there, that would be great.

Jim Crowe

Jeff is thinking about the first question. The disconnects, we said, were not unexpected. These disconnects are not aren’t something that blew up and then went away. We have said that we saw an abatement.

Let me make sure that we have the terms carefully defined here, because that word churn is used pretty broadly and not very carefully in our industry.

We refer to erosion which has three components: Price changes, cancellations, which are a customer indicating he no longer needs the service prior to you installing the service, and then disconnects. Disconnects meaning you have a service and for whatever reason, including a customer substituting one of your products for another product, a customer changes whatever he has.

When we said disconnects spiked up, we were largely referring to customers who accelerated their drive towards moving traffic to their own networks. I already mentioned who the names were. They are not surprising, who they would be. And, we have said that wasn’t unexpected, and we have said that we saw it tail off towards the end of the quarter, although we remain cautious given the economic backdrop. Jeff?

Jeff Storey

Sure. On the products for the small mid market customers, they’re the typical products you would expect, everything from local dial tone and voice services, whether voice over IP or TDM to direct internet access, virtual private networking services, Ethernet services, transport services, connecting data centers and it is the typical range of products.

You also asked a question about our sales staff and the ramp of the sale staff and do we have to, that is an ongoing process. We will continue to hire sales people. We will continue to refine the sales capabilities that we have and frankly we will hire as many sales people as we can get up to generating our quota and generating the sales in as many as we can successfully install and perform on behalf of the customer. So, we will continue to grow and add sales people over the course of the year.

Operator

Your last question comes from David Dixon with FBR Capital Markets.

David Dixon with FBR Capital Markets

Sunit, I have a question on the wholesale mention. You have mentioned in the past, I think, that wholesale voice is a low margin business and you’re managing that for profitability, which I can understand. I am wondering if you can share with us to what extent you are seeing material shifts in profitability in that segment. One thing we’re seeing is the economy is driving a secular down shift in the higher margin international traffic segment towards substitute services. I am just wondering if you were seeing that.

Secondly I have a question on expanding relationship there with Telefonica. Is that expected to revert the deferred revenue line back to its historical run rate?

Sunit Patel

I will take the second question first and come back to the wholesale. As I mentioned earlier, certainly signing deals like Telefonica helps the deferred revenue and so that will certainly help. Then we will see how the rest of the year goes.

Back to the wholesale business, this is a business we have actually been improving gross margin. I think as we have said in the past and we will just repeat again, unlike a lot of our competitors, because of our local facilities that we have established for quite a bit of time, starting with our dial up access business, our incremental margins in the wholesale voice business are on the order of about 30%. We really focused on how we can improve those margins. Typically the international voice business has been lower margin.

The shift from voice traditional circuits to voice to voice or IP has been going on and will continue to go on domestically and internationally. Our focus continues to be leveraging the metro connectivity we have and continue to expand our gross margin dollars out of that business. I think our wholesale voice group has done a really good job of that, and also diversifying the revenue base while they have been doing that.

So, the volatility that we see quarter over quarter is fairly typical of any trading type business, but at the same time, if you look at the overall base of revenues we managed to keep it in a $700 to $800 million sort of annual revenue base and we have been improving our gross margins over the last years and we think that we’ll continue to do that on margins.

Jim Crowe

Okay, well thank you. In closing, I would like to emphasize a particular point: As we have repeated a number of times, we remain cautious. This is a time of uncertainty; however industry conditions and our own position are far better today than they were during the industry difficulties in the earlier part of the 2000’s. Consolidation in the industry, broadband option, internet content distribution, particularly video and wireless data grove have all resulted in the pricing and demand environment that is much, much better than it was as the beginning of the decade. I guess we have said it and quite a number of other observers have made the same point.

For the company we have a much more diversified revenue base. It is growing in the right areas. We have had pressure, but we expect it to continue to grow. We have the right products and we certainly have the right kind of operating margins and most importantly, as Sunit focused on, we have improving free cash flow. For both reasons we expect that our industry and our company are going to rebound much more rapidly during this slow down than what was the case in the previous slow down. While it is still early and we remain cautious, we do see some evidence that this may be starting to occur.

Thanks for listening; operator that is the end of the call.

Operator

Thank you. This concludes today’s Level 3 Communications Incorporated First Quarter 2009 Earnings Conference Call. Thank you for attending and everyone have a great day.

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