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Qwest Communications International, Inc. (NYSE:Q)

Q2 2006 Earnings Conference Call

August 1, 2006 9:00 am ET

Executives

Stephanie Comfort - SVP Investor Relations

Dick Notebaert – Chairman, CEO

Oren Shaffer - Vice Chairman, CFO

Analysts

Jonathan Chaplin – J.P. Morgan

David Barden – Banc of America Securities

Simon Flannery – Morgan Stanley

Frank Louthan – Raymond James

Ana Goshko – Banc of America Securities

David Janazzo – Merrill Lynch

Mike McCormack – Bear Sterns

Operator

Good morning. My name is Letricia and I will be your conference operator today. At this time, I would like to welcome everyone to the Qwest second quarter earnings conference call. (Operator Instructions) I would now like to turn the conference over to Ms. Stephanie Comfort, Senior Vice President of Investor Relations. Please go ahead, ma’am.

Stephanie Comfort

Thank you. Good morning everyone, and welcome to our call. We’re here to discuss our second quarter results. With us on the call this morning are Dick Notebaert, our Chairman and CEO and Oren Shaffer, our Vice Chairman and CFO.

Before I turn the call over to Dick, I want to remind everyone that we will be making forward-looking statements. These statements contain risks and uncertainties which could cause actual results to differ materially from those expressed or implied here on the call. The risks and uncertainties are on file with the SEC. In addition, we do not adopt analysts’ estimates nor do we necessarily commit to updating the forward-looking statements that we make here.

Let me add that in order to supplement the reporting of Qwest consolidated financial information, the company will discuss certain non GAAP financial measures, EBITDA, free cash flow and net debt. We have a full reconciliation of non-GAAP measures included in the quarter earnings section of the web site.

With that, I’d like to turn the call over to Dick.

Dick Notebaert

Thank you, Stephanie. Good morning, everybody. Glad to have you with us. Today Qwest reported its second sequential quarter of net income equal to $0.06 per share. In addition, we continued to improve our EBITDA margin and delivered strong free cash flow all in line with our goals for this year.

Our performance demonstrates that our strategies are working. We continue to divest in our diverse portfolio of growth products. We also continue to increase ARPU and bundle penetration, improve our customer service, leverage our asset base and reduce costs.

As a result, we are steadily driving achievement of our long-term goals of sustainable growth in revenue, profitability and especially free cash flow.

As I have said before, this process requires discipline and perseverance to be successful and I hope you agree that we have demonstrated both of these qualities, as well as a commitment to deliver performance and value to all constituents.

Here are the highlights of the quarter:

First, we remain focused on driving revenue growth. While overall revenue held flat year over year, we saw positive trends for our high-value, high ARPU growth products across all of our business units, offsetting continuing retail access line lost trends which held steady.

In addition, mass market revenue grew both sequentially and year over year for the fifth consecutive quarter. This was due to continuing strong volume increases from strategic growth products such as high-speed Internet, long distance and increased bundle penetration.

Wireless revenues grew again this quarter. We achieved positive segment income in the second quarter. Let me say that again. In wireless, we achieved positive segment income in the second quarter which is also, for us, an important milestone.

We also have seen some positive trends in enterprise. Demand for emerging data products such as metro Ethernet, Voiceover Internet Protocol and iQ are driving strong volumes on our MPLS backbone.

The good news is that customers are migrating to these higher-value products, which are becoming a more significant part of the revenue mix.

Finally, wholesale continues to be a good story for Qwest. Though overall wholesale revenue was flat sequentially, we achieved profitable long distance growth in the quarter as we continue to successfully implement our strategy of driving more profitable minutes of use, resulting in higher margin revenue and improved profitability.

Second, our second quarter EBITDA margins were solidly in line with our projections. They were in the low 30% range and we have made steady improvement towards our longer-term goal in the mid-30% range. Our EBITDA margin was nearly 32%, continuing the improving sequential trend and up significantly from a year ago. These increases were driven by continuing significant progress on cost reduction and productivity improvement.

Contributing to that improvement was $188 million in operating expense savings in the second quarter and over $300 million in savings in the first half of 2006 compared to the same periods in 2005.

Specifically, our wireline facilities costs continued to improve toward benchmark levels, reflecting the ongoing benefits of settlements and network optimization efforts. We continue to work down facility costs, and we believe there’s still a significant cost reduction opportunity in this area.

Also, our productivity initiatives continued to gain traction. Through our continuing efforts to balance workforce and load, we have been able to improve our customer service metrics to record levels while reducing headcount through attrition.

Third, I especially want to talk about our improved customer service as a highlight of the quarter. J.D. Power announced that our rankings improved two levels this year, to third from fifth a year ago. This is our fourth consecutive year of improvement and we are very proud of this achievement. In particular, satisfaction with Qwest technicians ranked highest across all providers in this study. That demonstrates Qwest’s unwavering commitment to the spirit of service. We’re still on a mission to be No. 1 in customer service because we believe this is ultimately how we will differentiate our value proposition and win in our industry.

Fourth, we delivered strong free cash flow in the second quarter, in line with our goal of $1.35 to $1.5 billion in 06. You’ll remember, we said there could be some variableness within that and that’s before onetime items, compared to $904 million in 2005.

Free cash flow totalled a strong $595 million in the second quarter, while we continue to invest in Capex in a disciplined manner with a focus on driving revenue growth and maintaining the highest level of service. I will have more to say about how we plan to use free cash flow in a moment.

The important point here is that our outlook for both free cash flow and Capex remains unchanged for 2006. We continue to expect Capex to be approximately equal to our 2005 level of $1.6 billion, with approximately one third allocated to broadband and upgrading broadband speed.

The fifth and final highlight of the quarter is that we announced the acquisition of OnFiber, which is a good example of our disciplined approach to acquisitions that must fit strategically, operationally and financially. This acquisition, though small, builds on Qwest’s critical mass in an attractive, high-growth area of expertise. OnFiber’s facilities-based bolt-on metro assets extend Qwest’s already significant national and metro network even deeper into key markets, while its metro Ethernet, Wavelength and SONET products augment Qwest’s portfolio of high-growth, high-bandwidth solutions I talked about earlier. The anticipated synergies, estimated to total approximately $25 million primarily in network and facility cost reductions, are meaningful, easily attainable and should ramp quickly. We expect this acquisition to close in the third quarter and be accretive to EDBITDA, free cash flow and EPS in Year 1.

Now, Oren will review the second quarter details with you but first, my remaining comments will focus on how we believe we are creating and have plans to return sustainable value for all of our constituents.

We recognize that long-term value creation is based on delivering sustainable competitive and predictable growth in revenue, earnings and cash flow and this is our ongoing focus. Our strategy continues to be to drive higher penetration and ARPU on our growth products, to increase their contribution to our revenue while at the same time we continue to implement programs to stem access line loss trends. This strategy requires selective and disciplined investment in terms of both Capex and marketing support, and we continue to carefully review and adjust our pricing as appropriate.

Our growth products are increasing ARPU and market penetration. For example, in the second quarter, our broadband penetration reached 14.2% compared to a year ago, when we were at 9% and the industry average of 17%. Currently, 80% of Qwest households are eligible for broadband service, up from 67% at the end of 2004. About 98% of qualified households are able to purchase broadband speeds of 1.5 megabits or greater. More than 50% are able to purchase service at speeds in excess of 3 megabits, while 25% can access speeds of 7 megabits or more.

We also increased retention by devoting attention to the customer service and support experience. For example, during the quarter Qwest teamed with Microsoft to become the first communications company in the United States to offer co branded Windows Live Services. This platform compliments our high-speed Internet offering by providing customers with enhanced communications flexibility and security features.

Bundle penetration increased to 54% in the second quarter, from 53% in the first quarter and 48% a year ago, a continuing result of last year’s bundle launch and promotional initiatives. Sales of voice packages plus three and four products continue to experience significant growth. Net connections, which include mass market access lines, high-speed Internet, wireless and video subscribers grew over 318,000 or 2.6%, marking the third consecutive quarter of year over year increases.

Overall demand for value-added services has contributed to average consumer wireline ARPU increasing to $49 in the second quarter, and that’s up from $46 a year ago. We also continue to work on access line trends. We have expanded initiatives to protect our local franchise in Arizona to five more metro areas and we are increasing marketing and promotional support. Our strategy is to improve customer service and our diverse portfolio of products and bundle programs are also integral to this campaign.

We have demonstrated success in achieving our goal of reducing costs and of improving productivity, with more than $1.5 billion in cost reductions since 2003. The good news, the really good news, is that we believe we have the opportunity to still have significant, significant cost structure and productivity improvements, especially on our long-haul network. At the same time, we continue to drive volume on our network while improving the profitability.

We are also meeting our goal of improving EBITDA and EBITDA margins. Our long-term target is an EBITDA margin in the mid 30% range. We are currently at approximately 32% and we have the opportunity for continued improvement.

As I mentioned at the outset, we booked our second consecutive quarter of profitability and we have the opportunity for continued improvement through the course of the year. This is a good start to achieving sustainable and predictable profitability, which we believe is fundamental to value creation.

Also, with sustainable profitability, we have the opportunity to begin utilizing our significant tax loss carryforward, which we estimate to be in the range of $6 billion.

The net effect of all of this and our disciplined focus on Capex has been a significant improvement in free cash flow.

We’ve achieved these results through a great extent through debt reduction and restructuring, but to an increasing degree through operating improvements which we believe will drive free cash flow in the future.

To summarize, I believe we are making good progress on the components of value creation and we are heartened that this progress has translated into a total equity return of 43% over the first six months of 2006, on the heels of a 27% return in 2005.

Now the question on the front burner is returning capital to shareholders, a subject I know is on some people’s minds. Let me start by stating again that Qwest is committed to creating value in a disciplined way that rewards all constituents. We believe that now is the appropriate time, given our improved operations, including what we believe to be sustainable profitability in 2006, to evaluate strategies for rewarding our equity holders.

Until now, we have been focused on increasing cash flow, which we believe has benefited both bond and equity holders as well as other constituents. The example is our use of cash and debt to accomplish a low cost and cash flow friendly deleveraging last fall. We will continue to opportunistically reduce debt over time with the objective of maximizing cash flow generation and we expect to continue our disciplined approach to capital deployment to support growth and service improvements.

We believe we have budgeted an adequate, sustainable level of Capex to achieve this and return capital to shareholders. Return of capital is a near term priority and the process is underway. The Board is about to begin its review of the obvious value-creation strategies that include dividends or share repurchase or further debt reduction, and possibly in combination. We intend to present what we believe will best reward shareholders as soon as possible once the process is completed.

So now let me turn the call over to Oren for more details on the quarter.

Oren Shaffer

Thanks Dick, and good morning, everyone. We are very pleased with the progress we’ve made in the second quarter. The momentum in our growth products, coupled with ongoing cost containment efforts, is driving further and significant margin expansion and improved profitability.

EBITDA margins are now solidly in the low 30% range. We are generating significant free cash flow. We posted another quarter of net income. All in all, we’re on track to meet our objectives for the year.

Revenues total approximately $3.5 billion in the quarter, bringing year-to-date revenues to $6.9 billion, up 0.4%. We are seeing improved trends across key growth offerings in all our channels, offsetting the impact of retail access line losses, which continued to hold steady.

We benefited from strong trends in data and IP services in all channels, mass markets, business and wholesale.

An increasing portion of our revenue is coming from higher growth data products such as high-speed Internet, VoIP, VPN, data integration and hosting.

Investment continues to be focused on revenue growth.

In aggregate, data IP revenues grew more than 8% year over year, and 1.6% sequentially and data now accounts for 32% of our revenues, up from about 29% a year ago.

In the mass market channel, revenue growth accelerated in the second quarter to 3.4% year over year, on top of already strong growth in the first quarter. The success in our bundles, the rapid growth of DirecTV in the bundle, and the migration to higher-priced offerings in wireless and Internet services is driving higher consumer ARPU, which has been steadily climbing each quarter.

In the second quarter, ARPU increased to $49, a 7% increase year over year. We expect our ARPU and revenue to continue to improve as more and more of our customers take bundles and higher-value, higher-ARPU offerings. This has been our strategy and we are pleased with the progress we’re making.

Mass market data and Internet revenues grew 40% year over year and 8% sequentially, driven by continued strong growth in high-speed Internet. High-speed Internet subscribers grew 7% sequentially and for the second consecutive quarter, generated over 50% year over year subscriber growth.

We see strong migration from dial-up to broadband and still have a significant opportunity to capture dial-up users, with an estimated 4 million dial customers in our territory.

The mix of our customers continues to improve as well. We are just beginning to benefit from increased take rates of higher-priced, higher-speed offerings. Approximately 90% of our new subscribers are signing on 1.5 megabit service or higher in the second quarter and more than half of our DSL customers are now on higher-speed offerings.

We continue to benefit from increases in our network availability, both in terms of network enabled and higher speeds. We will continue to advance our broadband network capabilities in 2006 with a focus on increasing speeds as well as some additional network enablement.

Mass market’s long-distance revenue grew 21% year over year as we benefit from pricing increases implemented in the first quarter, although these increases did contribute to a slowing of adds in the quarter. Long-distance remains an important area of focus and significant opportunity for us in 2006, as we continue to drive ARPU growth and increase penetration. We saw long-distance ARPU increase over 3% sequentially and 22% year over year and we have the opportunity to reaccelerate adds in the next several quarters as we recently launched Digital Voice, an integrated, local, long-distance offer.

As anticipated, retail line decline continues at a pace similar to what we experienced a year ago, due in large part to seasonality. Beyond the seasonal factors, wireless substitution continues to be the main driver of loss in residential lines.

Our DirecTV alliance has been a strong contributor to the bundling success. We now have over 210,000 customers on DirecTV, adding over 40,000 in the quarter and 150,000 more than last year. This quarter, we launched a Qwest football bundle, the exclusive football option, on DirecTV.

The business channel held stead year over year, as our data products continue to gain traction and offset pressures from access line trends in the business market. Data and IP revenue grew 4% year over year, driven by emerging data and integration products such as metro Ethernet and our iQ suite of services.

We are seeing impressive growth in our advanced data and hosting services while in aggregate, data revenues still reflect migration from products like Frame and ATM onto our IP platform.

Revenue from our business growth products, including products such as iQ, VPN and hosting now comprise more than 20% of our business revenue, up from less than 17% a year ago, and we continue growing at a healthy clip.

Finally, in wholesale, our focus on profitable growth continues to pay off as strength in wholesale long distance more than offsets the impact of ongoing attrition of UNI customers.

Wholesale long distance revenue grew 3.7% year over year on a growth in minutes of 3%.

We grew our activity with customers such as cable, wireless and VoIP. Our success more than offset the anticipated impact from minutes leaving our network as a result of industry consolidation.

In addition, demand for wholesale services from rebillers, resellers, continues to grow as we benefit from growth and share in this higher-value area of the wholesale market.

In sum, we saw the wholesale channel improve margins again this quarter as our pricing diligence continues to translate into higher quality, higher margin revenue.

Wireless revenue grew 8% year over year and as a result of our ongoing focus on high-value customers, we generated our first quarter of positive wireless segment income. Wireless subscribers declined slightly in the quarter due to the replacement of legacy wireless customers on low-margin plans to the higher-value contracts. We have the opportunity to return to subscriber growth in the third and fourth quarters.

ARPU reached $52, an increase of $2 from a year ago, benefiting from improved take rates in our higher-end offerings, including an increase in the take up of our data offerings. Nearly 50% of our new subscribers are taking a data service and we expect this to continue to improve as we introduce several new enhanced data phones in the third and fourth quarter. We would anticipate the benefit of further subscriber revenue and margin expansion as we progress through the year.

On the EBITDA, EBITDA was $1.1 billion for the quarter. This advanced our margin to the 31.9%, call it 32% level, an improvement of 330 basis points year over year and it continues toward our target of mid-30% margin. Margin should continue to benefit from traction in revenue growth as we increase penetration of key products and improve our average revenue per customer while diligently controlling costs.

Productivity improvement continues to be a key part of our strategy in driving further improvements in EBITDA and sustaining profitability for Qwest overall. We are seeing evidence that profitability initiatives are contributing to our improving profitability.

We reduced operating expenses by 6% in the quarter compared to a year ago.

Cost of sales and SA&G were down $116 million in the same period.

Our overall headcount declined 3.3% year over year as we continued to utilize the 5% to 8% natural attrition in our business to optimize our workforce levels. We did see an increase in headcount levels sequentially as we in sourced over 540 employees during the quarter.

At the same time we are benefiting from our wireline facilities cost optimization initiatives. We reduced wireline facilities costs by another $11 million in the quarter, and over $60 million year over year. Importantly, both our fixed and variable unit costs are coming down, reflecting the progress and the ongoing sustainability of our efforts. We believe there are still opportunities to reduce and improve efficiency with a focus on our long-haul facilities. We are encouraged by the progress we are making in many of our grooming and hubbing initiatives and believe they will translate into further facilities cost improvements.

We posted our second consecutive quarter of earnings per share. Reported EPS of $0.06 reflected the continued emphasis on sustaining profitability through improvement in productivity, operating efficiencies, network optimization initiatives as well as lower interest expense and depreciation.

Capex in the quarter totalled $442 million and was consistent with our expectations. We continue to expect Capex to be approximately equal to our 2005 level of $1.6 billion. Importantly, we continue to focus on the proportion we are spending on broadband, increasing speed and additional enablement.

We generated strong free cash flow in the quarter of $595 million while we benefited from improved operating results and lower seasonal payments. We continue to expect free cash flow in the range of $1.3 to $1.5 billion in 2006. This is a $450 to $600 million increase from the $904 million we generated in 2005. It’s resulting from improved operations and reduced interest expense. We expect the balance sheet to be neutral or a modest user of cash for the year.

We ended the second quarter with total debt of $15.4 billion, a decline of $2.2 billion from a year ago and taking into account a near doubling of cash and short-term investments to $1.4 billion during the quarter, our total debt less cash and short-term investments is now less than $14 billion.

Because of the past initiatives on debt, near-term maturities are relatively modest and manageable and in any new initiatives will be opportunistic and dealt with in a most value-creative manner.

For example, we plan to pay down our $485 million maturity at QCF in August, while reducing both interest expense as well as leverage. We will also maintain adequate liquidity as part of our forward planning.

In closing, we are very pleased with our second quarter results. We increased the penetration of our key growth products while driving higher ARPU. We strategically raised prices on selected products, we made substantial progress in our EBITDA margins, bringing us closer to our goal of mid-30%, and EPS continued to grow. We continue to see an opportunity to sustain profitability and are well on-track for our free cash flow objectives for the remainder of 2006.

With that, let me turn the call back to Dick.

Dick Notebaert

Thanks, Oren. For 2006, we continue to believe we have the opportunity to drive modest organic revenue growth and improve EBITDA margins, especially as our growth products become a more significant part of our business and as we continue to improve our cost structure and our productivity.

In closing I believe, my personal opinion, that our strategies are working. Our progress is demonstrable, conceived and plotted over a period of quarters the direction we are going, and that shows some momentum that is tangible. That causes us to have a positive outlook for the future.

Now, Letricia, we’d be happy to take questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Jonathan Chaplin with J.P. Morgan.

Dick Notebaert

Good morning, Jonathan.

Jonathan Chaplin – J.P. Morgan

On the facility cost savings, I think you said it was about $11 million in savings sequentially. That seems roughly the same as the savings you got in the first quarter and I’m just wondering if you expect to be able to repeat those kinds of savings in the next few quarters, or whether maybe they can even accelerate from here?

Dick Notebaert

Well, Jonathan, I don’t think we want to get exact on $11 million or $10, but let me just say in general, we believe we still have lots of opportunity on facilities costs of our network. We talked before about hubbing and we’ve talked before about what we can do as far as aggregating traffic versus having things homerun all the way out on long facility runs, so we believe we still have lots of opportunity and we’ve got a great guy in Dan Willis working it and we think we can still make a heck of a difference there.

Jonathan Chaplin – J.P. Morgan

Excellent. Thank you very much.

Dick Notebaert

Yeah, thank you. Thanks for the question.

Operator

Our next question comes from David Barden with Banc of America Securities.

David Barden – Banc of America Securities

Hey, guys. A couple of questions if I could. First was, it sounds like after you make this debt pay down in August, I guess, being opportunistic on the debt fund would kind of suggest that you’re reasonably happy with the leverage that you’re going to be at, which would look like it’s going to be around the three times level. I was wondering if you could just comment if that’s a level that’s going to be comfortable enough to just be opportunistic around, that’d be great.

Second, Dick, I guess I think you guys have been talking about the plan to go ahead and return capital to stockholders for awhile. I think that the, you know, a lot of the run up in the stock has been, you know, the market’s debate with itself about, you know, how aggressive, how comfortable you plan, you know, to be with this. I guess if you could comment on, if you give your feedback and thoughts to the Board about what you’d be comfortable doing in terms of magnitude of cash flow, that’d be helpful.

The last, the share count just obviously moved up a little bit. If you could talk about the moving parts in that. Thanks.

Dick Notebaert

Oren, you want to go first?

Oren Shaffer

Sure. David, how you doing this morning?

David Barden – Banc of America Securities

Great. Thanks, Oren.

Oren Shaffer

The leverage thing, as we’ve said in the comments and then I probably said on a number of other occasions, we’ve done a fairly decent job of scheduling out our maturities and I think if you looked at the whole maturity table between now and 2009, you’ll see it’s rather modest so, when we’re going to, for example, take out the maturity in all of this, the future, if you will, on any opportunistic dealing with the debt can go one of two ways. It can say, you just deal with the maturities as they occur, which would be modest, as I said, out through 09. Or, if there was some attractive way to restructure the whole maturity outlook again we would probably take that up. But basically, we are pretty comfortable with the leverage of where we are and dealing with it as it comes due over the next few years.

Dick, I’ll - you want to do the next one, or do you want me to do it?

Dick Notebaert

No, go ahead.

Oren Shaffer

Well, why don’t you go? You want me to try that third one, now?

Dick Notebaert

Yeah, go ahead. Do the third one.

Oren Shaffer

David, I didn’t quite understand the third question totally but it sounds like you were commenting on the slight increase in outstanding shares that we had quarter to quarter?

David Barden – Banc of America Securities

Right.

Oren Shaffer

I think what we, as we will say in the queue, we did a debt retirement on the basis of shares and I think the, I don’t recall the exact numbers, but I think the equivalent price of the shares, by the time we captured the discount in the debt, was between $7.90 and $8.60 or something like that and in all cases was well above the market. So we believe again that it was actually a value-creative way to reduce our interest expense while at the same time basically issuing modest amounts of equity at a very substantial premium to where it was trading.

David Barden – Banc of America Securities

So a 389 exchange?

Dick Notebaert

He said a 389 exchange, yes?

Oren Shaffer

Yeah.

David Barden – Banc of America Securities

Okay. Great. Thanks.

Dick Notebaert

Then on the reward for, you know, the return of capital or using that cash on the equity issue, I think, you know, we’ve got two good quarters as far as positive earnings and you’ve seen the second quarter cash flow which I think was strong. So now I think we are in a position to go to the Board and go through the process that one should go through, a very disciplined process, and make a recommendation on what we should do.

I think to have done it prior to that, even though we projected it in our forecast, we needed to have the actuals under your belt and so we’re comfortable with making it meaningful and I think that’s very important. It has to be meaningful, and there are only a couple of options. We all know what they are, and I think the Board will review this, again, very disciplined, diligently, and make their decision in short order. But I think, again, I think the timing is very important to us.

David Barden – Banc of America Securities

All right. Thanks for those comments, guys. Appreciate it.

Dick Notebaert

Thanks for the question.

Operator

Our next question comes from Simon Flannery with Morgan Stanley.

Simon Flannery – Morgan Stanley

Okay, thank you very much. Good morning.

Dick Notebaert

Good morning, Simon. How are you?

Simon Flannery – Morgan Stanley

How are you? Dick, could you talk about the M&A environment? You’ve obviously made an acquisition here. Are there other things of this nature or in other directions that are still something that you might consider over the next couple of quarters and then just a question on the employees? Can you just describe the in sourcing in a little bit more detail and is that sort of it for in sourcing and should we expect the attrition to sort of come through in the numbers in the second half? Thanks.

Dick Notebaert

Yeah. On the M&A I think I commented in my remarks, we continue, as we have, to scan the horizon, not just a traditional telco look but maybe over in the hosting or systems integration side but, as we said multiple times, it has to be very disciplined. It has to be strategically fit. Operationally, we have to be able to exercise it and make sure it works and meets expectations. And then we have to apply a financial test to it, the spreadsheet, and say, what’s the payback period? I mean, for example, the one we did, you know, it’s positive in the first year. So we have to be able to sit down with our owners with a pencil and paper and show the benefits and be assured that we can do it.

We’ll look. We don’t have to knee jerk into anything. We have organic growth opportunities in revenue that we can look at. So I think we’re doing this thing right. Over the last few years I think the testimonial is, our actions more than our words. And so that’s very important.

On the in sourcing what we did, with the help of the Communications Workers of Americas, the CWA, is we were able to renegotiate a wage scale that is significantly lower than what we had been paying. What the trade-off there was that if you can pay somebody $8 or $10 a hour versus $20 or $22 an hour then, in fact, you don’t need to outsource those jobs and we feel very good that, at that cost structure, having someone with Qwest, the Spirit of Service on their shirt really makes a difference when they answer the phone and when they talk to people. So this is call center work that we have brought back in and I think we’re very proud of what the CWA has done and I think it’s a model for other companies in our country to bring work home.

We will look at that. We just opened a center over in Logan and we will - we’re pretty close to wrapping that up. What we’ll do is, as more of those call center jobs attrition, they’ll be replaced by the lower pay scale and that’s what’s going on.

As far the overall headcount, with the exception of the call center work I think I’m pretty safe in saying that we have continued to take advantage of the natural attrition that our company experiences. So I would expect us to continue down that trajectory.

Simon Flannery – Morgan Stanley

Okay, thank you.

Dick Notebaert

Thank you. Thanks for the questions.

Operator

Our next question comes from Frank Louthan with Raymond James.

Frank Louthan – Raymond James

Good morning. Just a couple of questions. Can you go over what you’re seeing in the wholesale pricing trends in the quarter? I know you’ve driven some wholesale, a little bit of improvement in the wholesale last year, but can you tell us what those are? And as far as the acquisition goes, where do you sit as far as what you think you need to fill in on the long-haul side for some of the cost containment? Do you still think another acquisition – are you still being as aggressive looking for other acquisitions, or just let this one digest? Thanks.

Dick Notebaert

I think on the acquisition and I’d ask Oren when I get done, I think Ken Dunn, who runs our M&A group is being very aggressive in looking at it. But I do believe we’d have to stay with our discipline and, you know, if you could add some pops, those types of things, that’s good but again, if you could add some hosting capability or some systems integration capability as far as working with state and federal governments, that also would be positive. So I don’t think we should just look at facility costs alone. Again, it’s build it versus buy it and if you have to pay too much of a premium because of price points, then you’re better off building it. I mean, I just – that feels very comfortable with me. Oren, you want to add anything to the M&A?

Oren Shaffer

Absolutely the feeling.

Dick Notebaert

Yeah, and then the second part of your question was on –

Frank Louthan – Raymond James

The wholesale pricing.

Dick Notebaert

Oh, the wholesale pricing. What we have seen on the traditional wholesale minutes of use, you know, the thing that happens is that that pricing is competitive, especially on dial port business and, in fact, some of us might question similar pricing the competitors put out as far as their ability to have positive cash flow or earnings but, in our hosting wholesale business and in our reseller business and in our IDDD business, we’ve seen good solid performance and feel very good about what’s going on there. I mean, in spite of all of that, you know, the revenue is up, the volumes are up 1.6% sequentially and, you know, when you’ve done a couple of price increases and you strategically readjust your pricing in different laterals, that feels pretty good. As Oren said, that’s where that positive margin was so important to us and we have walked away from some business. Then the last thing I would say would be mergers by two other companies, you know, in the consolidation within our industry, those people took their traffic and put it on net as they should, as we would have done. So that traffic left ours and it was a sizeable amount, and yet we’ve been able to make it up and still grow a little. So that tells you the opportunity in the wholesale business is still pretty solid.

Frank Louthan – Raymond James

Okay, great, and just one follow up. You mentioned earlier this year about looking at the small-medium enterprise SME market and a couple of your peers had indicated some strength in that this quarter. What did you see in that part of the market and how do you view that going forward? Thanks.

Dick Notebaert

Yeah, you know, in the small and medium-size business it’s a great opportunity for us. If you said Dick, how are you doing? I would say not nearly as well as I should do. We talk about this constantly. There’s good opportunity there and yet, you know, at the low end we’ve got growth and we’re doing okay but at the middle, the mid-point, that key system area, I just don’t feel that we are performing as well as we should do and I think if you ask the team, and I’m not talking about just the people who report to me, I think you’d get pretty consistent feedback that we feel we can, we’ve got a lot of opportunity there to improve our performance.

Frank Louthan – Raymond James

Great. Thank you.

Operator

Our next question comes from Ana Goshko with Banc of America Securities.

Ana Goshko – Banc of America Securities

Hi. Thanks very much. Oren, I just wanted to clarify on your debt repayment plans. When you say that you’ll be dealing with maturities as they come due, do you mean that you’ll be paying them down with cash from the balance sheet or do you plan to refinance them?

As I look ahead over the next 12 months, I see about $1.1, $1.2 billion of debt maturities and if I think of your kind of cash flow generating ability at about, you know, $1.5 billion, if you were to repay all of the maturities from cash on the balance sheet I don’t think there’d be a whole lot left for other kinds of, you know, shareholder enhancement.

So again, you know, mainly wanting to know what your plans are for refinancing versus organic delevering?

Then secondly, when you talk about adequate liquidity, it that still about $1 billion of cash on the balance sheet in general?

Oren Shaffer

Yeah. No, I’m not suggesting that we would automatically pay down our maturities. I think what we’ve tended to do, if you look at the way Qwest has handled its right-hand side of the balance sheet, I think we’ve always tried to do something that was more elegant than simply paying down an existing maturity and this has served us very well. In fact, if we look back over the last four years I suppose there’s been an occasion where we’ve simply just paid down a maturity but it doesn’t come to my mind right off hand. Most of the time we’ve tried to roll things into a more value creative solution. The debt action we took at the end of last year was, as you know, a larger package put together that restructured debt that was not due and had not matured, but it seemed like an opportune thing to do.

So no, we will – I didn’t mean to indicate that we would simply just write checks each time the maturities came up. In fact, we probably will not.

But I think it’s important to clarify your thoughts about the cash flow. Yes, let’s suppose we do generate $1.5 billion of free cash flow this year, I think if you look at the report in the second quarter, we’ve managed to move cash in the second quarter to almost $1.5 billion, it’s $1.4 billion something, so we actually have a fairly good portion of cash going not only through 06 but also into 07.

As far as the liquidity discussion, I’ve emphasized the word liquidity because we included liquidity or undrawn, standby revolver in the credit line and that gives us even greater flexibility for the use of the actual cash on the balance sheet and we think that, you know, $750 to $1 billion of liquidity is sufficient to tide us over the lumpiness which sometimes occurs in our quarterly generation of cash flow. So maybe that will recalibrate some of your ideas.

Dick Notebaert

You might mention the size of that bank facility.

Oren Shaffer

Yeah, we mentioned – it’s an $800 million undrawn revolving credit line and so, in my thoughts about liquidity added to the $1.4 billion that we’ve got in cash on the balance sheet today that we would really be speaking about liquidity of $2.2.

Ana Goshko – Banc of America Securities

Okay, that’s great. Okay, thanks very much. I’m sorry you up.

Dick Notebaert

You’re very welcome.

Letricia, we’ll take two more questions, please.

Operator

Okay, sir. Your next question comes from David Janazzo with Merrill Lynch.

David Janazzo – Merrill Lynch

Good morning.

Dick Notebaert

Good morning, David.

David Janazzo – Merrill Lynch

The State of New Mexico is proposing a $265 million settlement for some unfulfilled obligations. Is this in your current planning, your current thought process and what time do you think that’ll take place?

Dick Notebaert

Well, first of all it has not been approved by the PRC so we have to be very respectful of their position. But we found that settlement to be very fair and very good for the people of New Mexico in the sense that we will push high-speed Internet and other capabilities further into the state. The timeframe that that occurs over – by the way, the number’s $265 million, $15 million of which goes to education over a three-year period – but the other part of the commitment, the $250 million, is composed of both capital and expense and it takes place over 42 months. So, 42 months into the future. So we await with anticipation the decision by the PRC. We were grateful to have the support of the governor and the attorney general and again, this is very good for our customers and provides us opportunity, at the same time opportunity for growth. Oren, you want to add something here? Go ahead.

Oren Shaffer

No, no. I just – to make sure that any of the amounts that needed to be reflected were reflected in our second quarter results. It was the correct entries and the books reflected the anticipated settlement.

David Janazzo – Merrill Lynch

Thank you.

Dick Notebaert

Thank you.

One more question, Letricia.

Operator

Your final question comes from Mike McCormack with Bear Sterns.

Mike McCormack – Bear Sterns

Hey, guys. Good morning.

Dick Notebaert

Good morning, Mike.

Mike McCormack – Bear Sterns

There are a couple questions on free cash flow. It looks like the guidance for the year might be a little conservative. If we look at your margin improvement this quarter and potentially, you know, additional strength in the back half of the year, as well as sort of Capex levels in the first half and second half being relatively equal, is there something I’m missing on working capital that would drive some pressure on free cash flow in the back half of the year?

Secondly, on free cash flow in the long-haul business, you know, where do we stand on that and maybe you could just weigh, you know, the pressures, perhaps, of carrier disconnects versus some of the commentary around pricing stability and enterprise growth opportunity. Thanks.

Dick Notebaert

First of all, I think we’ve been very consistent this year talking about working capital. I think we’ve been some very straightforward and very consistent in what we’ve said and I also would take you back to, I think it was the December quarter or maybe back in December when we talked about free cash flow and we said that we had $904 million before one-times and that we would increase that by, you know, 350 to – what was the number? 500 or 600?

Oren Shaffer

350 to 600.

Dick Notebaert

350 to 600? Or 450 to 600, and we said there would be variability within that range and variability possibly outside of that range, as there was last year. So again, I think we’ve been very consistent in what we’ve said so I don’t think you’re missing anything. We just want to make sure that we perform and we meet expectations.

Oren, do you want to – I mean, I think that’s – I don’t know what else –

Oren Shaffer

Yeah, that’s – you know, we do have this variability quarter to quarter and I know $595 million a quarter will come to a number greater than but we’ll keep our projections the way they are.

Dick Notebaert

Yeah and again, on the working capital, I want to go back to that, if you look at what we’ve said, we’ve been very consistent in our, you know, in the queues, with what we’ve said about our ranges of capital investment. We’ve also been very consistent in where that capital investment would go. We’ve said it’s 30% to 35% or so, you know, about a third, approximately, that goes into that broadband, pushing that bandwidth out and I would point out, we feel very good about the fact that 25% of the qualified high-speed Internet customers now get 7 megabits so we are pushing it out without a lot of fanfare, but you can see from our net adds on high-speed Internet that we continue to have opportunity there.

Mike McCormack – Bear Sterns

I guess I was looking at sort of the second half of last year, you know, if you have the same performance in free cash flow as last year, you’re almost to the guidance trench currently and that’s obviously with an OCF that’s probably quite a bit lower than we’d be looking for this year.

Dick Notebaert

I think we should stay consistent with what we’ve put out. Again, we have said variability within and without so, you know, we’ll just see how – we think we can continue to execute and expand the margin, or we have that opportunity, I should say, to grow that margin, that EBITDA margin a little better.

I appreciate the question.

I’d like to thank everybody for being on the call. We appreciate your interest and your support. Thank you very much.

Operator

Thank you for participating in today’s Qwest second quarter earnings conference call. You may now disconnect.

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Source: Qwest Communications Q2 2006 Earnings Conference Call Transcript (Q)

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