Verizon Communications (VZ)
Q2 2006 Earnings Conference Call
August 1, 2006 8:00 am ET
Ivan G. Seidenberg - Chairman of the Board, Chief Executive Officer
Doreen A. Toben - Chief Financial Officer, Executive Vice President
Ron Lataille - Senior Vice President, Investor Relations
Jeff Halpern - Sanford C. Bernstein & Company, Inc.
John Hodulik - UBS
Timothy Horan - CIBC World Markets
David Barden - Banc of America Securities
Simon Flannery - Morgan Stanley Dean Witter
Good morning, and welcome to the Verizon second quarter 2006 earnings conference call. At this time, all participants have been placed in a listen-only mode and the floor will be open for questions following the presentation.
It is now my pleasure to turn the call over to your host, Mr. Ron Lataille, Senior Vice President, Investor Relations of Verizon.
Good morning, everyone. Welcome to our second quarter 2006 earnings conference call. Thanks for joining us this morning. I am Ron Lataille. With me this morning are Ivan Seidenberg, our Chairman and CEO, and Doreen Toben, our Chief Financial Officer.
Before we get started, let me remind you that our earnings release, financial statements, the investor quarterly publication, and the presentation slides are on the investor relations website. This call is being webcast. If you would like to listen to a replay, you can do so from our website.
I would also like to draw your attention to our Safe Harbor statement. Information in this presentation contains statements about expected future events and financial results that are forward-looking and subject to risks and uncertainties. Discussion of factors that may affect future results is contained within this presentation and is also contained in our SEC filings which are available on our website.
This presentation also contains certain non-GAAP financial measures as defined under the SEC rules. We have provided reconciliations of these non-GAAP measures to the most directly comparable GAAP measures on the same webpage as our presentation slides.
In early July, we filed an 8-K that contains some important information. In the 8-K filing, we provided un-audited historical consolidated financial information for the last five quarters, restated for the reclassification of Verizon Dominican and Puerto Rico Telephone as discontinued operations as a result of their impending sale. The income on discontinued operations of $119 million this quarter is part of our adjusted EPS. Also, we will no longer be reporting international as a separate segment.
The same 8-K filing also included pro forma combined and wireline financial results of operations for the last five quarters, reflecting our merger with MCI. You can readily obtain this information from our website.
Before turning the call over to Doreen for a review of our results, I would like to cover the differences between reported and adjusted earnings. Reported earnings per diluted share for the second quarter of 2006 were $0.55. On an adjusted basis, before the effects of special items, EPS was $0.64. The special items that make up the difference between reported and adjusted EPS are discussed in our earnings release and provided in reconciliation tables in the investor quarterly bulletin. Briefly, there are three special items which we are excluding from adjusted results:
- $186 million in after tax charges, or $0.06 per share, related to severance and related charges for 3200 people who will leave the company between now and the end of the year;
- $48 million after tax, or $0.02 per share, for merger integration costs; and
- $29 million after tax, or $0.01 per share, for relocation and other costs related to our move to the Verizon Center.
With that, I will now turn the call over to Doreen.
Doreen A. Toben
Thanks, Ron, and good morning, everyone. Let me start by saying that we had a strong quarter in terms of financial and operating performance. We are gaining revenue and earnings momentum and we have confidence that we will continue to make steady progress in all our businesses.
In wireless, we had another quarter of very strong profitable growth. We were strong in several key performance indicators -- customer growth, service, ARPU, churn, and margins. We have further demonstrated the sustainability of our results and continue to differentiate ourselves from the competition, particularly with our high quality retail customer base, which leads to higher margins.
We made solid progress in the wireline business. In telcom, we continue to position ourselves by investing in the platform for future growth.
We had another excellent quarter in broadband and video. In addition, aggressive cost control helped us offset the up-front costs of deploying new products.
We are making great progress in Verizon business. We had sequential revenue growth. We are seeing many encouraging signs in terms of improving trends. Our integration efforts are going well.
Overall, a very strong quarter. Let’s turn now to slide four and look at some of the details.
Total revenues were up 26%, and net income was up 6%, compared with second quarter last year. A comparison that is favorably affected by the inclusion of MCI this year. On a pro forma basis, consolidated revenue growth was 2.3% year over year and also up 1.8% sequentially. Revenue increases were driven by growth in wireless, broadband and enterprise data services.
Strong cash expense controls resulted in operating margin expansion in the quarter.
Operating income increased 12.4% and operating income margins increased 160 basis points year over year.
These results include the effects of net pensions and OPEB, which amounted to $384 million in the second quarter, $77 million more than last year. Remember that we do not exclude the effects of amortization of intangibles from our adjusted results. You will recall us telling you last quarter that amortization of intangible assets related to the acquisition of MCI will result in approximately $210 million of annualized expense.
Looking at our cash flow and balance sheet, you see that we continue to have very strong cash generation. On a year-to-date basis, CFFO totaled $11.5 billion, which is $1.6 billion better than the first-half of last year. Capital spending was $8.3 billion for the first half, of which $5 billion is wireline and $3.2 billion is wireless. At the half-way point in the year, we are on track to meet our stated guidance for full-year cap-ex spending. Debt was $42.4 billion at June 30, and all our credit metrics remain strong.
Let’s turn now to the wireline financials on slide 6. Starting with revenues, the encouraging news is positive sequential growth. We will review the drivers of this growth by market on the next chart.
Pro forma revenues were down 6.2% year over year, driven in part by continued and expected declines in the former MCI mass market business, which decreased $226 million, or 25.7% this quarter. Another cause of the decline was the absence of revenues from less strategic areas we have exited, like the logistics business. This is the last full quarter that we will see the effects of a large contract termination last summer.
The real story in wireline is our focus on expense controls and margin expansion, especially in light of increasing competition and the upward pressure on expenses from growth initiatives, particularly the fiber build. As you can see, on an all-in pro forma basis, second quarter cash expenses declined 6.7% year over year and 1% sequentially.
In telcom, year over year expense reductions were driven by headcount control, improved employee productivity, and ramping automation and self-service initiatives.
In Verizon business, headcount controls and reduction in access costs contributed to this decline.
Expenses related to FiOS increased both sequentially and year over year. All in, FiOS represented $0.07 of EPS dilution this quarter compared with $0.06 in the first quarter. Obviously we were able to more than offset expenses associated with the growth initiatives.
The set focus on cost management resulted in sequential operating income growth and margin expansion of 15% and 120 basis points respectively. If you exclude net pension and OPEB costs, the wireline operating income margin would be 12.5%.
We continue to see significant opportunities for additional cost savings in the wireline business. These opportunities are in addition to the synergy savings we have identified in Verizon business. We remain confident that wireline margins will expand and show sequential improvement as we go through the year.
The next chart gives us a closer look at wireline revenues by market. Consumer market revenues totaled $4.3 billion in the quarter. Revenues from the former MCI mass market business, which generated $582 million of that total declined 24% year over year and 6.6% sequentially.
Excluding the mass market effect reduces the consumer revenue decline rather dramatically. In fact, on a sequential basis, legacy Verizon revenues decreased only 0.4%, or $15 million, driven in large part to the success in broadband.
Looking ahead, we receive favorable regulatory pricing in a few states. These approved rate increases are worth about $100 million on an annualized basis and became effective in late second and early third quarter. In addition, we are looking at several other strategic pricing advantages in the second-half of this year that will increase revenues in the consumer market.
In the small-medium business market, revenues increased both year over year and sequentially. Again, revenues from the former MCI mass market, which totaled $96 million in the quarter, declined 15% year over year. Within this market, legacy Verizon business revenues grew 2% year over year and 2.4% sequentially.
Revenues in the enterprise business market, which represents a domestic retail portion of Verizon business, reported 1% sequential growth. As we will discuss shortly, total Verizon business revenues grew 1.6% sequentially. This is a very encouraging sign, and the first time we have seen sequential growth in quite some time.
Wireline wholesale, which includes both telcom and business wholesale revenues, increased 1.4% sequentially, driven by increased volumes and the domestic long-haul network.
Data is a growing percentage of our overall wireline revenues, now standing at approximately 31% of the total. Quarterly data revenues totaled $4 billion, representing nearly a 5% increase on a year-over-year pro forma basis and 3% sequentially. Within telcom, revenue growth is driven by consumer broadband, both DSL and FiOS, as well as a continued, healthy demand for wholesale services. As for Verizon business, data revenues totaled $2.5 billion, with approximately 30% of this revenue being IP related.
In Verizon business, as I said, we are focused on sequential improvement. Overall, in the first quarter since the formation of Verizon business, revenues grew 1.6% sequentially, which is very good progress in a very short period of time. The sequential improvement in enterprise business is a result of the continued traction and key products and better stability and growth in certain traditional services. Certain voice and private line pricing show early signs of stabilization, although some products are increasingly price competitive. Wholesale revenues were sequentially flat as improvements domestically were offset by some modest declines internationally.
Our focus within Verizon business is to increase revenues from strategic services. These include private IP, IP VPN, managed security, hosting, managed data network, and other internet services. Revenue from these services have been steadily growing and totaled more than $900 million in the second quarter, up 17% year over year. On a sequential basis, strategic service revenues were up 5.4%. We also intend to capitalize on growth opportunities by focusing on increasing market share penetration in the managed security and hosting markets.
We realized about $150 million in incremental synergies during the quarter, bringing our first half total to around $200 million. Most of these savings are driven by headcount reductions, sourcing synergies, network optimization, and traffic migration.
We expect to see a significant ramp-up in synergies in the second-half of 2006, particularly as we complete the migration of off-network voice and IP traffic onto our own network. We remain very confident that we will achieve at least the $550 million of targeted synergies this year.
Our integration spending is also on target. We have a number of system integration projects underway. We expect to see cost savings relating to these system integration activities later this year and into 2007 and beyond.
Let’s turn now to telcom and start with a look at some customer metrics. As I said earlier, we continue to make great progress in broadband. With 440,000 net new broadband customers in this quarter, we now exceed 6.1 million broadband connections, with 1.6 million being added over the last three quarters, which is industry-leading.
Total access lines were down 7.4% compared with a year ago, and 1 million lower on a sequential quarterly basis. One-third of the 1 million net lines lost in the quarter were a combination of wholesale lines and former MCI mass market customers in region. That said, the retail residential line loss of 553,000 was higher than the past few quarters, due in part to the expected quarterly seasonality as well as increased competition.
If we broaden the consumer picture beyond access lines and including broadband and video customers, a metric we call revenue-generating units, or RGU’s, you see that we are flat sequentially and actually up about 1% versus last year.
In addition to broadband growth, customer response to our freedom bundles has also been very positive. The number of total freedom customers has increased more than 40% in the past year alone. Our consumer freedom penetration is now nearly 22%, up from 16% at the start of the year.
I would also note that for legacy Verizon customers, the average revenue per household per month has increased more than 1% sequentially and year over year.
Within the telcom business, we remain focused and committed to our fiber initiatives, and we are making good progress in deploying FTTP, improving costs, increasing net adds, and increasing customer penetration.
As of mid-July, we have passed an additional 1.5 million homes, bringing the cumulative homes passed to 4.5 million. We are well on our way to reaching 6 million total homes passed by year-end.
As the scale of our deployment increases, we are seeing costs declining. We have taken and will continue to take actions which will result in improvements in the cost of pass and connect homes.
For example, we have renegotiated contractor rates and have implemented some pre-fabricated and pre-slicing work before going to connect homes. We are also realizing the benefits of lower fiber costs. Also, as many of you know, we just announced our GPON vendor selections. The adoption of GPON provides significant capacity improvement over DPON. This move to GPON will result in significant decreases in both current and future costs.
There are also some technology solutions which will make connecting homes a more efficient process. We recently introduced our new broadband home router, which is capable of providing connectivity to our FiOS network at speeds of up to 100 megabits per second. This router utilizes existing in-home wiring for broadband data and video signals.
Another technology, which should reduce installation time, is being developed by MOCA, or the Multimedia Over Co-ax Alliance. We hope to being using some of this technology as soon as this September.
As I previously indicated, as we gain experience and scale with FiOS, we will share this knowledge with you. To that end, we are planning FiOS briefing sessions within the next few months to further discuss these cost improvement efforts as well as other operating expense savings opportunities. In addition to adjusting FiOS economics, we will also cover our technology and marketing programs.
We continue to see a strong and growing customer response to both our data and video product offerings. As our fiber deployment continues and scale increases, we are really seeing FiOS data taking off. We now have a total of 375,000 FiOS data subscribers, having added 111,000 during this past quarter alone. To further illustrate our progress, net adds for the month of June were 25% higher than in the month of March.
Our total penetration across all markets now stands at 12%. The average penetration at the one-year mark is 15%. We calculate penetration based on the number of customers divided by the number of homes open for sale. We had 3.1 million homes open for sale at the end of June.
Speed is the winner in the broadband race. In key competitive markets, we have doubled the speed of entry-level FiOS data service to 10 megabits per second. We also offer 20 megabits. Both of these have 2 megabits upstream capability. We also recently introduced a 50 meg downstream and 5 meg upstream service in these markets. This is the fastest Internet connection speed in the country, and appeals to communications-intensive consumers, telecommuters, and small businesses.
As with DSL, we are finding FiOS data to be very retentive. FiOS churn is very low. In fact, it is similar to our wireless churn rate. This bodes well for us, as we continue to expand our video rollout and can offer more customers the triple play.
During the quarter, we made significant progress in gaining local video franchises, and now have secured more than 100 in total. We are currently offering FiOS TV in about 60 markets across seven states. We are seeing great initial acceptance by customers across our whole footprint, particularly in the more mature data markets.
Our average video penetration rates are 7% at the three-month mark and 10% after six months. 99% of our video customers choose a digital package. More than 60% have selected advanced set-top boxes with DVR’s and/or high definition capabilities. About 80% of our FiOS video customers get all three services from us -- voice, data, and video. Our churn rates are very low, and our video ARPU has been strong, benchmarking well with the competition.
In addition to an extremely robust and competitive video offering, including some great sports content deals, in the month of June, we launched our first interactive television service call FiOS widgets. This is a simple application enabling one-button access to local weather and traffic.
Now we are going to offer our next interactive service, the home media DVR. This innovation combines access to video recordings from any set-top box in any room, a multi-room DVR with the ability to access through the set-top box any photos and music stored on your computer -- a media manager. Customer research shows exceptional interest in these applications.
This is just the beginning of many new, innovative and differentiated services we have planned with FiOS video. Needless to say, we are very pleased with our progress in FiOS data and video, and we are quite optimistic about our future prospects to gain market share.
The best way to summarize wireline is to say we are positioning ourselves for future growth. As we invest in the platform for future growth, we are making very good progress at preserving our core margins. It is imperative that we reduce our cost structures in areas unrelated to the fiber initiative. We are preserving core profitability by driving at least enough cost out of the business to offset the dilutive effects of our FiOS initiative, which we estimate to be between $0.28 and $0.30 on EPS in 2006.
We must also offset the effect of declines in our traditional voice product revenue stream. We have seen strong broadband net adds during this transition, which have helped stabilize and grow our RGU’s.
In Verizon business, we are off to a great start. Customer receptivity to our management and sales teams have been excellent, and we are gaining share of spend with our enterprise customers. We saw sequential growth in revenues and are focused on sales of our strategic IP based services. The ability to offer integrated wireless solutions to business customers is providing another incremental revenue opportunity and we are positioning ourselves to be successful in this area.
We are also very committed to increasing efficiencies. I noted earlier that our integration efforts are going very well and the realization of synergy savings is on target. The bottom line here is we see wireline margin expansion opportunities and we are sharply focused on capturing those opportunities.
Let’s move now to wireless. Verizon wireless continued to post industry-leading results with another quarter of outstanding metrics. A big highlight is service ARPU accretion, which was up year over year and also sequentially. As you know, we added another 1.8 million net new customers during the second quarter. Of note, all of these are retail customers, both consumer and business. This marks the eighth consecutive quarter in which we added more than 1.5 million net retail customers. We believe we have the most retail customers in the industry. Our 52.6 million retail customers represents 96% of our total customer base of 54.8 million.
Retail has been a focus of ours for a long time. We server and manage these customers directly. They choose our brand. They know whose network they are on, and they are high-quality customers in terms of loyalty and lifetime revenue.
We are also the fastest growing U.S. wireless company in terms of absolute numbers of customers, having added 7.5 million new customers to our base in the past 12 months. Again, virtually all of these are retail -- very few are from our wholesale channels.
We also continued to set records for low churn, a key measure of customer loyalty. Total monthly churn of 1.13% was the lowest in the company’s history, and we believe the lowest ever in the wireless industry for a major carrier. Churn among our retail post-paid customers was exceptional at only 0.87% -- another company and industry record.
There are more customers choosing and staying with Verizon branded service than any other wireless brand. Beyond delivering the best network, we continue to work hard at earning customers’ loyalty. We recently announced plans to prorate early termination fees and to expand our worry-free guarantee beginning this fall. These moves are in keeping with our well-established track record of listening and making policy decisions based on customer needs.
Retail gross adds were sequentially higher, an increase of just under 3.5 million. Furthermore, 87% of our retail gross adds were post-paid. During the quarter, 75% of our retail post-paid gross adds came from our direct distribution channel. This is key, because we have found that customers who buy through our direct channel have lower churn and tend to return to us for services and upgrades.
At the same time, we continue to expand and diversify our indirect distribution channel, which includes individual agents and national retailers like Costco and Best Buy. In the second quarter, we also added our post-paid product line-up in some 1900 Wal-Mart stores nationwide. At present, we have 12,800 total doors in our indirect channel with a diversified product, distribution and geographic mix.
Taking advantage of new retail channels and models, both direct and with our indirect partners, has helped us maintain a high-quality base in our industry leading efficiency and profitability.
Let’s turn now to the financials on chart 19. Total quarterly revenues, which are now in excess of $9 billion, grew 18% year over year. Sequentially, revenues were up $449 million. I said earlier that we were the fastest-growing U.S. wireless company in terms of customer additions. Importantly, this growth was accompanied by continued industry best margins and profitability. The sustainability of our margins is driven by the quality of our customer mix, our efficient cost structure, and economies of scale.
EBITDA grew to $3.6 billion, a sequential improvement of 5.2%. The quarterly EBITDA margin was 44.4%, up from 43% a year ago.
Taking a closer look at revenues, growth in service revenues was again driven by increased data usage and the high-quality customer profile of new adds. Expanding data revenues are more than covering reductions in voice revenues per user. Total service ARPU of $49.71 increased both sequentially and year over year, as did retail service ARPU of $50.34.
Data revenue accounted for nearly 13% of service revenue. It was not long ago that we talked about data as a $1 billion business annualized. Now, data revenues are generating $1 billion per quarter.
Data contributed $6.40 of ARPU, up almost $3 year over year and $0.82 sequentially. More than half of our retail customers are data users, and 10 million of them have broadband devices. As we have said many times, the key to our success in wireless data is our commitment to investing in the network.
Our lineup of broadband devices for business is industry-leading. We continue to see strong up-take from business customers on broadband access cards, embedded laptops, and PDA’s.
In the consumer space, our customers exchange more than $12 billion text messages this quarter. We see a significant opportunity for growth in our V Cast and V Cast Music customers. Yesterday you may have seen our announcement of the music-centric chocolate phone from LG -- ours exclusively in the U.S. We are very excited about this device, which is wildly popular internationally. In all, we now have 9 phones for V Cast Music, many of which also include VZ navigator software.
To summarize, we have a long track record of consistent, sustained performance. This was the 16th consecutive quarter of double-digit, year-over-year revenue growth, the eighth consecutive quarter that the company added more than $1.5 million retail customers, the sixth consecutive quarter of EBITDA margins of greater than 40%, and the 14th consecutive quarter of year-over-year growth in gross adds, and churn, the best proof point of network reliability, has been 1.5% or below for more than two years.
We attribute this record of consistency to three key drivers -- network quality, industry-leading loyalty, and cost efficiency.
In closing, I would summarize this way -- again, our financial and operating performance for both the second quarter and first-half of 2006 were strong. In fact, we saw better-than-expected sequential growth. We are also on target to meet our full-year guidance. Our growth initiatives are gaining momentum, and we have confidence that we will continue to make steady progress in all our businesses.
Wireless continued to surpass its own milestones for growth, profitability and customer churn, reinforcing its industry lead. The transformation to broadband continues, with another strong quarter of customer acceptance of DSL, and particularly FiOS products. Verizon business integration plans are going well, and we are building momentum. We expect to continue seeing sequential improvement in both revenues and expenses as we move through the year.
On the revenue and cost side, we continue to see significant opportunities to drive margin expansion. We know how to control expenses and we have an intense focus on reducing costs.
Along with operational execution, we continue to increase our flexibility in returning value to our shareowners. The Verizon information services divestiture is on schedule to be completed this year. During the quarter, we accelerated our share buybacks, repurchasing an additional 600 million. This means we have already met our full-year target of 1 billion in just six months. We plan to continue our share buyback program and are targeting another 500 million in repurchases over the remainder of the year.
With that, I will turn it back to Ron so we can get to your questions.
Thanks, Doreen. Operator, Ivan and Doreen are now ready for questions.
Thank you. The floor is now open for questions.
Your first question comes from Jeff Halpern of Sanford Bernstein. Please go ahead with your question.
Jeff Halpern - Sanford C. Bernstein & Company, Inc.
Two questions -- first, for Ivan: last week, Verizon wireless obviously pre-announced its strong subscriber numbers. Concurrently, Vodafone’s -- some of their results. Your stock did not react, despite very strong movements from some in your peer group, and it seems to me that was in no small part a result of Arun making statements at his analyst meeting about how he would be willing to sell you his stake in Verizon wireless if you were only willing to pay a fair price.
I was wondering, Ivan, if you could just talk a little bit about how you are thinking about the ownership structure now, and then any perceived financial benefits you think might accrue to you if you owned all of it, and would those make you willing to pay more than the normal multiple?
Secondly for Doreen, in a press release last week, on the GPON announcement, in the bottom of the press release there was some qualitative statements about the cost savings of fiber versus legacy copper infrastructure. In the past you have given us some guidance on that subject, as far as what you are seeing and a more quantitative nature. Could you be a little bit more specific about the areas you are seeing operational expense savings from fiber? Thank you.
Doreen A. Toben
I am going to go first, if that is okay. Doing the GPON question first, I think what we would suggest, and actually I think we have seen one or two analysts estimate it pretty accurately, that we expect GPON will save us about $100 per home connected. Also, as we potentially get increased -- or decreased, I should say, pricing on BPON, we actually think we will get $100 from a BPON perspective as well for home connected.
I went through in the script some of the other things that we are seeing, as far as we have renegotiated contractor rates. We are doing some pre-fab work before we do that. We talked about MOCA. I will give you anecdotally something that we have looked at. We have looked at a group of customers that have trouble, a fair amount of troubles say over a 90-day period, and for those customers, they may have had 130 troubles over the past 90 days. After we migrate them to fiber, they go down to 14. So we are seeing an 80% to 90% reduction in trouble reports for those customers that we were seeing outside plant, and particular troubles with.
Our anecdotal evidence continues to be good. We did mention in the previous text that we will have some briefing sessions, which I know everybody has been interested in to go through even more details for you in the not-too-distant future.
Ivan G. Seidenberg
Jeff, on the Vodafone front, two parts to your question. The first one is when the net adds were released last week, there were some reports that indicated they thought the 1.8 million net adds would come at a cost to EBITDA margin, which is not the case, so hopefully people now when they see the whole picture, they will have a more positive view of the superior performance of 1.8 net adds.
Also, Arun was in New York last week and he and I sat down and we talked. So I think what is probably good for investors to understand is I think I can provide some clarity about what this whole partnership thing will look like. So very quickly, what Arun communicated to us was that Vodafone was extremely pleased with their position in the partnership. The operating agreement between the two of us is strong, is sustainable, it has stood the test of time over these five or six years, and their view is that the creation of value available to them over the next several years is far greater than any strategy that they might have to exit the partnership.
He reiterated that was exactly the position of Sir John Bond, his new chairman, and for all practical purposes I had the chance to meet John Bond also within the last month or so, and that is exactly the situation.
As we said before, the whole idea here is that this is a Vodafone-driven issue. If they feel like they want to stay in the partnership, that is their right and we frankly believe that is a good position for them to be in, and it is okay with us.
I had a chance then to sit down with Arun and go over what we thought was what we had communicated to them over the past year or so, what our operating philosophy would be over the next four or five years, and that would be that we are going to still run the business to seek market share growth, profitable growth. We are going to maintain margins in the low- to mid-40’s. We are going to invest in new technologies. We are going to acquire spectrum when and where we need it. We are going to de-lever the business and basically continue to improve the financial metrics of the business over the next several years.
Arun, who goes to all the board meetings and is very active in it, said “Ivan, that is exactly what we have agreed to do and so let’s both make sure that we clarify to our respective investors that at this point in time, there really is not much reason for people to speculate over any change in the whole arrangement between the two companies.”
So Jeff, as far as I am concerned, I think the issue here is pretty much resolved over the next several years. Unless there is a specific change on the part of Vodafone’s thinking, I think we now have clarity over the sustainability of the partnership. We will focus on running a great business. Both sets of shareholders will understand how we intend to drive value in the company.
Thanks, Jeff. Operator, next question, please.
Thank you. Your next question comes from John Hodulik of UBS. Please go ahead with your question.
John Hodulik - UBS
Good morning. Two quick ones for you. First, on the access line losses, the losses continue to accelerate, and obviously there is a number of cross currents. Could you comment on, I guess a negative note, increasing competition you are seeing from cable in your markets?
Secondly, obviously FiOS is I think a little bit ahead of where we thought it would be in terms of penetration. Can you comment on how you see the two of those coming together and potentially slowing access line losses over time, and essentially what kind of trends you are seeing in markets where you have FiOS?
Secondly, wireless ARPU, we were surprised at the ARPU growth there. Is this the beginning of a trend that we could see for the rest of the year and into next year, and just how you see data penetration continuing as EBDO start to gain some traction?
Doreen A. Toben
I will start with the access lines. I think it is fair to say that given the increased technology substitution, that we would continue to see access line continue to go down. I think you know that we are much more focused these days on RGU’s, of which we did see some growth in the quarter. With increasing success with our broadband products, we think that the RGU’s will have growth and we will see a different trend in the revenues.
Having said that, it would be fair to say, especially with the new Comcast turn-ups, that we did see increased competition in those areas that Comcast turned up.
Looking at the FiOS piece of it, obviously the reason we are doing FiOS is to decelerate the access line reduction. We have looked at, on a central office by central office basis to see where we have FiOS, has the trend changed. In general, I would say that is the case where you see a slowing. We also see obviously a higher FiOS ARPU than we do for the access lines.
It is early. We are tracking it real closely, and I do not want to give you a definitive answer, but it is trending in the right place where we have FiOS.
On the ARPU, obviously as you know, ARPU is a function of how much capital do you put in the ground and in all of your new products. We did see, we think this was great news, sequential plus year-over-year accretion here, obviously driven by the data component of it.
I would say that our plan would be to continue to see over the planning period, I am not going to be as specific as to say each Q, but over the planning period, we do think that the data, because of EBDO and the V Cast Music and what not, is going to allow us to have ARPU accretion.
Thanks, John. Operator, next question, please.
Thank you. Your next question comes from Tim Horan of CIBC. Please go ahead with your question.
Timothy Horan - CIBC World Markets
Good morning. Three questions, if you don’t mind. Ivan, maybe you can talk on the strategic front. Does this change -- the Vodafone issues, does that change what you are going to do with directories and maybe rural lines and maybe where you are at on the leverage side?
Two fundamental questions. Doreen, on the ARPU side, you definitely outperformed and the results are pretty incredible. Other countries around the world that have been at this level of data penetration have seen ARPU’s kind of flatten out. Is there some reason you think the U.S. might be different? I have some thoughts on that, but just your thoughts.
Third, on FiOS, it clearly is the best product on video and data when you are in these markets. Can you maybe talk a little bit more about your most mature markets, where you are at in penetration and why would you not ultimately get more like 50% penetration, or at least 50% market share on the video side? Thank you.
Ivan G. Seidenberg
I will take a cut at some of these. On the strategic front, as we have said all along, the transactions to sell international properties as well as to spin the VIS property, or spin or sell it, was never exclusively driven by any transaction with Vodafone. We think they would share all the friendly transactions that will help us in different ways return value to shareholders. We think it is a significant de-leveraging issue with the directories business, and we think we can deploy the capital better, and by selling international properties in a way to do that.
So we are going to proceed with those full speed ahead as we have committed, and we think that when you look at our company, toward the end of this year and into next year, our profile changes. Doreen made the key point that all three of our units made some contribution to value creation of this quarter, sequential growth in the business and certainly both sequential and year over year in wireless and significant new momentum developed in FiOS. I think we feel good about the strategic positioning of the whole company and we will continue down that track.
As far as any other activities, we always keep our eyes open, but there is nothing to report at this point.
The ARPU issue, we talk a lot about this. Doreen probably has a better answer than I would, but from an operating standpoint, when we sit around and talk about ARPU, we basically are talking about making the capital investments, investing in our distribution, investing in our applications, training our people, and in effect running an overall business that drives the quality of the customer we get. Remember we have a very high percentage of post-paid customers, which I think helps in the issue of ARPU because it drives a higher quality experience for both our customers and for the business. So we think we have a formula that has worked for us and we are going to continue to work it. I believe that it will lead to continued success down this path.
Again, as Doreen said, over the planning period, it has been important to us to develop in effect a business model that drives at not only growth in net adds but growth in profitability and to do that, you need to keep your eye on ARPU.
The last point about FiOS, I think our earnings release shows that, and I think Doreen said it in her remarks, that after 9 months, we are looking at 12% penetration in FiOS. In markets that we have been in a little bit longer, the penetration is higher. Could we go higher? The answer to that is I expect it to, and if we drive our people to make it go higher, at this point, our experience is what it is, so we are not going to come off the trends that we have, but we believe if we continue to do the things we are doing, we have the chance to continually beat the progress we have been making so far. We are feeling good about that.
What we did not talk about this release is that we are also in 50 markets providing video, and we are seeing some anecdotal evidence, just like we saw in data, that the take-rates are pretty good and that the ARPU’s associated with that are competitive. As we get more critical mass and scale, we will be able to do the same thing for you with video that we have done with data, and that is provide a little bit more transparency in the results as we get a bigger footprint in the video market.
Doreen A. Toben
The only thing I would add, Tim, is if you look at the data in Europe versus the U.S., Europe is primarily driven by SMF, and if you look here at our data ARPU, SMF, while a good piece and growing quickly, all the new services are really growing a lot more, so I think that gives us an opportunity that is different from over there.
I would just add on, the video and data ARPU in FiOS, if you look at some of our mature markets, we are significantly higher than what we are showing you, but at this point we are, from a modeling standpoint, being conservative.
Thanks, Tim. Operator, next question, please.
Your next question is from David Barden of Banc of America.
David Barden - Banc of America Securities
Good morning. First question I just wanted to hit Doreen on some of the FiOS growth, revisiting some of your prior comments in the past that you have been seeing a one-third conversion rate on DSL to FiOS, and that the rest of the FiOS growth was incremental.
It does look, if you subtract our FiOS from the combined broadband subscriber growth that it would suggest maybe some relatively faster DSL trajectory on the downside than we have seen from some of your counterparts in the [inaudible] community. I was wondering if you could talk about how you are thinking about DSL growth versus FiOS growth substitutions, strategically how you are trying to make sure this is additional as opposed to substitutive.
Second, if I could just ask more on the MCI enterprise business side, the color on the pricing commentary, both the retail and the wholesale level, especially how the competitive environment is shaping up there.
Last, if I could just quick, obviously it is not core business, but just on the revenue side in the directories year over year, it does seem it is a bit of a [inaudible] at the Verizon information services business with the high-single digit negative growth versus flat to positive growth at other directories that are out there. If you could just comment on that. Thank you.
Doreen A. Toben
On the directory one, there was a large piece that was international in the prior Q, so if you actually adjusted that out, the number is more like 4% or 5% down, so it is significantly different, so there was a one-time issue in that particular one.
On the FiOS, it is still maybe a 30%-ish conversion from DSL to FiOS. I would suggest that we are not seeing a slowdown in DSL at all -- really, at all. What we are doing in those areas where we have FiOS is obviously heavily promoting FiOS as opposed to DSL, but we are absolutely not seeing a slowdown in the DSL numbers. I think if you look at the absolute number, this was the best second quarter that we have had in DSL subs, so that has been really strong.
On the enterprise side, I do not know if I could do too much more than what we have told you. I think the pricing is what we expected at this point. We have not seen any acceleration of the discounting of in the legacy or core services, which I think is good. We think the sales of the next-gen, which are obviously much more profitable, are doing well. We are seeing some more increased competition on what I call the next generation, but I think we would say, I would use the word encouraged by the stabilization of the pricing in total.
I think you have seen over the past that where MCI competed with AT&T obviously did well, and think we will continue to do well from a pricing perspective next to those competitors.
Thanks, David. Operator, next question, please.
Thank you. Your next question is from Simon Flannery of Morgan Stanley. Please go ahead with your question.
Simon Flannery - Morgan Stanley Dean Witter
Good morning. Thanks for the additional FiOS disclosure this quarter. It is very helpful.
You said that our speed wins in the broadband wars. It looks like you are out about 10% of your homes have FiOS data available to them now. Can you talk about the rest of the homes, the ones that have DSL or will be getting FiOS two, three, four years from now? Where are we in terms of the speeds that are available? How do you bridge the gap from today to when they get the FiOS product?
Can you also, just on the directories, come back to your thoughts on spin versus sale and on timing of that? Thank you.
Ivan G. Seidenberg
Simon, on the issue of FiOS, I remember that our longer term plan on FiOS is to perhaps cover between 60% and 70% of the lines, and we do that over a several year period. We are also obviously putting more fiber in the plant, so we are able to squeeze a little bit more capacity out of DSL.
The way I see it from an operating standpoint is over the course of the next three or four or five years, technologically we will see some improvements that will probably let us, for the same spend, cover more of our lines with respect to our FiOS coverage, because there is going to be technological improvements over the course of the next three, four, five years.
So the short answer to your question is that we will improve DSL plants, so we will get speeds close to 3-meg and 6-meg, and then we will be able to further penetrate with technological improvements the FiOS build. To me, there is not a big gap here. The real trick is that the speed -- customers will be demanding the speed and I believe we will see really big uptakes in FiOS. If we can actually accelerate beyond what our business model metrics are for FiOS because there is a chance to accelerate that where it would be appropriate to do that.
On the spin versus sale on VIS, there really is not anything to report. I think Doreen and her team and John Diercksen and his team are working through this. Our assumptions all along was that we believe, at least as it has been explained to me, and what we tell the board, is that a spin is probably the more financially prudent move for us to make, but we have not stopped looking at whether or not a sale would be appropriate.
If there is some transaction that somebody can invent that would make it worthwhile for us to reconsider that, we would, but we started down the path of a spin. We expect to finish it by the end of the year, but we will always keep an open mind as to other forms. Our bias is that we think the spin is probably going to be the format that we move ahead with this transaction.
Thanks, Simon. Operator, I would like to turn the call over now to Ivan Seidenberg for some concluding remarks.
Ivan G. Seidenberg
I thank everyone for taking the time this morning. I just have a few points. Hopefully when you remember the first quarter conference call that we had, we talked about a changing perspective for our company, which was one of really focusing on organic growth, improving revenues, expanding margins and generating cash flow. It has always been an issue for us as people look at our company as to whether or not the broadband build-out was chewing up so much capital that it was distracting from generating significant value long-term.
We see this quarter as kind of a little pivot. What we see is contributions in different ways from all three of our network-based businesses, clearly superior performance in wireless, which builds off of all of the investments and distribution and culture and product innovations that they have, but also really shows the power of the EBDO network and all of the innovation that comes from all of the new handsets. More than half the handsets out there are data-equipped at this point. You just saw all the significant announcements we made in the last couple of days with the new chocolate phone, which is the hottest selling item in Europe, which we are clear will be a very hot seller here in the next several months for us.
If you look at the business, as Doreen said, we are very encouraged by the fact that we are able to see some sequential growth. We are taking all the cost out, extracting the synergies, improving the systems, but at the same time, in the merger transaction, we watch people really focused on generating new growth for the business, which I expect to continue on the track and continue to do better as we go into the end of this year and into ’07.
In the telco, if there was one point on the call I probably would have like to have spent another second or two on it would be the fact that yes, we had year over year revenue decline and yes, we saw continued substitution of access lines for new technology, but the two counters to that is we had probably the strongest expense control we have had in a while. If you basically take away the dilution that comes from FiOS, we had very good performance in terms of maintaining EBITDA margins in the rest of the business. So our business model now begins to look clear, that we will take the cost out to keep the margins flat, and as FiOS continues to get healthy, you can see that we return the telco portion of the business to a business model that when you extrapolate out all the trends that we begin to see here, that we feel comfortable that we are in a position over the next several months to show good value creation.
I think Doreen mentioned this, that over the course of the next four to six weeks or so, we will invite several of you in for briefings and we will have discussions about FiOS and give you an even more color about how the project is going.
I think we are a point, second quarter ’06, where both our experience set and our confidence level is such that we are in a position to share a lot more of the historical information about it, which will give you a chance to understand how the business scales as we go forward.
On the corporate side, we are buying back shares. We exceeded our annual target. We will continue the program. We are working on the VIS spin and the international sales, so we feel we are in a really good position as we head into the second-half of the year and into 2007 to figure out really clever ways and very innovative ways to drive value for the shareholder.
So for us, this is not the usual quarter because we see this as a pivot and we can look ahead and see a lot more daylight than we have seen in the past couple of quarters, so thank you very much.
Thanks, Ivan, and thank you everybody for joining our call today. That concludes our second quarter earnings release call. Thank you.
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