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Alaska Communications Systems Group, Inc. (NASDAQ:ALSK)

Q3 2013 Earnings Call

November 6, 2013, 5:00 PM ET

Executives

Leonard Steinberg - General Counsel

Anand Vadapalli - President and Chief Executive Officer

Wayne Graham - Chief Financial Officer

Laurie Butcher - Vice President, Finance

Analysts

Barry Sine - Drexel Hamilton

Julia Senior - Bank of America Merrill Lynch

Operator

Good afternoon, ladies and gentlemen. Welcome to the Alaska Communications Systems third quarter 2013 earnings conference call. (Operator Instructions) I would now like to turn the conference over to Leonard Steinberg. Please go ahead, Sir.

Leonard Steinberg

Good afternoon, and welcome to the Alaska Communications third quarter 2013 conference call. I am Leonard Steinberg, General Counsel. And with me today are Anand Vadapalli, President and Chief Executive Officer; Wayne Graham, Chief Financial Officer; and Laurie Butcher, Vice President of Finance.

Before we get started, I'd like to remind everyone that during this call, company participants will make forward-looking statements as defined under U.S. Security laws. Forward-looking statements are statements that are not historical facts and may include financial projections, estimates of shareholder returns, or other descriptions of the company's business plans, objectives, expectations or intentions. You are cautioned not to put undue reliance on forward-looking statements as actual results could differ materially from expectations as a result of a variety of factors, many of which are outside the company's control.

Additionally any non-GAAP measurements referred to during this call have been reconciled to their nearest GAAP measure. You can find these reconciliations in today's press release. Following our remarks, we will open the line up for questions.

With that, I would like to turn the call over to Anand. Anand?

Anand Vadapalli

Thank you, Leonard. And welcome to everyone joining us on the call today. I am pleased with the progress we've made in the quarter towards the business plan objective of growing the business and paying down debt. We've done well, but I know we can do better, as we had built a few operational constraints, I'll discuss later in the call.

First, let me cover the progress made in this quarter. I am pleased with broadband revenue performance, which experienced strong year-over-year growth of 19.4%. Growth in broadband drives growth in total wireline revenues, which also experienced 1.2% growth in the quarter.

This overall wireline growth is unique to our sector and even more impressive, given that we moved all our existing backhaul contracts to AWN at close. This growth in wireline, driven by broadband is central to our plan and will continue to be a focus for our investments over the foreseeable future.

Our expectations of driving this growth come from several factors, including; one, our product funnel, which is strong. We recently launched managed security services for business, in partnership with NANA Management Services, a subsidiary of one of the largest Alaska native corporation.

We've upgraded our small business bundles to include standard IT support using our partner TekMate. Ahead of launching higher speeds on our new fiber-to-the-node network, leave upgraded our business internet with bonded pairs, and are now offering speeds of up to 25 megabits per second.

We are launching a new customer portal that provides performance management capability for our business customers. On the wireless front, we launched share data plans and the new iPhones in October. We expect to deploy a new prepaid system before the end of the year to maintain performance in that customer segment.

Two, our fiber-to-the-node program represents our first programmatic investment in our access network. The investment we will have made in 2013 of about $8 million, enables about 7,000 business locations and about 4,500 residential locations with broadband speeds of up to 50 megabits per second.

We expect services to be commercially available on this new network some time in Q1 2014. To provide some context, using a consumer and business ARPU numbers as a starting point, we estimate conservatively that this build has opened at least a $20 million market opportunity for us to pursue.

Last, but not least, we made an investment in a senior leader reporting to me to lead our growth in the managed services segment. We see an opportunity to grow our revenues from managed services, given a fragmented competitive environment and the challenge for small businesses to find technical talent. Focused management attention will lead to a structured and consistent development of capabilities and accelerate our performance. We look forward to reporting more on this in upcoming quarters.

Let me now address the operational constraints I mentioned earlier. The most obvious area is wireless. AWN represents a new operating model for our wireless business. We stretch our resources as we dedicate a significant attention over the last year to close the transaction and for various integration activity.

Further, we are selling into two networks, the CDMA network and the LTE/HSPA network. This causes some complexity, particularly when there is a different customer experience on different networks. We are working with AWN as we improve the quality of the LTE/HSPA network.

So how do we think about these issues related to wireless? First, by the end of the year, we expect to improve many of the processes and systems related to AWN. Concurrently, AWN continues its investment in the network and we expect to see significant coverage in network quality improvements in 2014.

Further, as I previously noted, we are implementing certain shifts in our retail strategies in anticipation of the arrival of a new competitor. While all these show us a pact for stabilized wireless performance, we do expect to see pressure on wireless metrics for several quarters.

On the wireline front, first, let me begin by commending our sales team for how they have stepped up in the market and the opportunities they opened up for us. Our primary issue has been supporting the sales team and translating sales activity into revenue. Put simply, our backlog for service delivery is high.

I suppose we can console ourselves by calling this a good problem to have, but that's just not how we look at things. We have a sense of urgency since extended backlog is not good for customer experience and certainly not good for revenue. A part of our backlog is from certain large revenue opportunities that's requires a built and involve longer lead times. Some of the backlog is attributable to certain rural healthcare orders that have latest delivery dates.

And lastly, we did not do a good job of matching our resources to our demand. We are working to address these issues. Part of the answer is in resourcing. Some of this is better internal alignment of resources to simplify how we do business, some additional work and improving monitoring and oversight, and lastly, a longer-term program of lean initiative to eliminate risk in our process. As we improve our back office performance, we expect to see improvements in our revenue performance.

With this, let me hand the call over to Wayne, to report our financial results for the quarter, and provide guidance for the rest of the year. Wayne?

Wayne Graham

Thank you, Anand. We will be taking more time in this call to walk investors through each schedule to our press release to discuss certain disclosures for the quarter. These disclosures are important to understand how to view our business, now that we are a one-third owner of AWN.

Let's start first with schedule one, the consolidated schedule of operation. As you can see, net income was $77.6 million. There are three significant categories worth mentioning in our results. First, a $132.1 million in income on disposable assets, this was primarily the gain from the AWN transaction and represents our contribution of wireless assets in exchange for $100 million in cash and a one-third interest in AWN.

Second, $8.1 million of earnings on equity method investments, representing our proportional GAAP earnings from AWN during the period. Third, $2.9 million associated with our disproportionate distribution received from AWN. We'll talk more about this disproportionate distribution later in the call.

Also you'll notice a parenthetical in the cost of services and sales category, representing the amount of wholesale cost and CETC pass-through to AWN. The wholesale cost net of subsidy support was $6.1 million and a CETC pass-through was $5.1 million.

Now turning the page to schedule two, our consolidated balance sheet, where we'd like to point several changes. First, our equity method investments have grown from $2 million at the end of last year to $207.6 million at the end of this quarter. The higher amount represents the value of our interest in AWN.

Second, you'll also note that deferred income taxes have decreased from $77.4 million at the end of last year to $49.8 million at the end of the quarter. This lower balance was due to a utilization of portion of our NOLs on AWN gain. After this gain, we have over $190 million of outstanding NOLs.

Third, you'll see changes in current assets and current liability categories. For instance, accounts receivable are lower than in the past, because we no longer have receivables related to our roaming business and accounts payable are higher, because we have moved to a monthly wholesale payment model with AWN.

Fourth, our long-term liabilities have increased by $65 million, primarily associated with $72 million of deferred AWN capacity revenue, which we'll talk more about later in the call. Most importantly, we pointed two strengths of position. Debt balances have declined by approximately $98 million. Funded debt decreased through $96 million of cash payment and the repurchase of $6 million of convertible notes with common stock. Partially offsetting these reductions were $4 million amortization of debt discount and a new lease arrangement.

Now, to schedule three. Our consolidated statement of cash flows, where you can see that our cash and cash equivalents have increased dramatically, and now stand at $53.3 million. The AWN transaction contributed approximately $22 million of additional liquidity. $100 million in proceeds in the quarter were used to pay down $65 million of our term loan, paid $4 million to unwind certain interest rate swap and pay approximately $9 million of transaction cost. While cash is strong, we expect to end the year with approximately $40 million, as our capital spending program is weighted to the back half of the year.

Now moving to schedule four. Our schedule of adjusted EBITDA and free cash flow, we have now changed our methodology in calculating adjusted EBITDA and free cash flow, but we do have some new line items that are important to understand.

First, you'll see that we are excluding our earnings and equity method investments, which is a non-cash item. We're then including our AWN distributions received during the quarter of $5.4 million and AWN distributions received within 14 business days following the end of the quarter of $4.2 million, including distributions this way is consistent with our debt, amendment definition of adjusted EBITDA.

Adjusted EBITDA was $24.8 million for the quarter and AWN distribution represents $9.6 million of that total. Free cash flow was $3.5 million for the quarter. Although, we benefited from lower cash interest expense on a year-over-year basis, we had a higher level of incurred CapEx for the quarter associated with timing for our summer build season. As mentioned earlier, CapEx for the year is weighted toward the back half of the year.

Now, let's review schedule five, our revenue growth schedule. This schedule has a few changes as follows. First, wireless backhaul revenue, which used to be included in wholesale and other revenue at the top of the schedule has moved down to the wireless and backhaul revenue category. We've done this because all backhaul contracts at closing of AWN move to this entity. Next quarter, we expect to have no backhaul revenue, but we intend on growing this revenue stream in the future.

Second, CETC revenue has been moved, net of access revenue and into wireless and backhaul revenue. CETC revenue is now a pass-through, which means it is a new cost of service for us and has no effect to adjusted EBITDA.

Third, we are emphasizing total wireline revenue, which as Anand previously discussed, represents our key area of focus. Performance of total wireline revenue for the quarter was solid. Business in wholesale increased 3.7% from $24.6 million last year to $25.5 million this year. Consumer increased by 5.3% from $9.7 million last year to $10.3 million this year. Access revenue, as expected declined, mainly due to lower switched, special and other access revenues.

Moving to wireless and backhaul revenue, which as we anticipated declined due to $13.3 million in lower roaming revenue, as the roaming business move to AWN, and $1 million of lower retail service revenue caused by weakness in the wireless business, Anand previously refer to.

While not significant, you'll see a new revenue category called amortization of deferred AWN capacity. At the closing of the AWN transaction, we contributed certain capacity rates to AWN to support their needs to carry traffic from contributed sell sites to switching and clearing site location. The value of these right has been recorded as a liability in our balance sheet, which I previously mentioned and will be amortized into revenue over the next 20 years.

Now let's move to schedule six, called key operating statistics, and walkthrough our core customer statistics sequentially, starting with business broadband connections, which increased by 0.6% to $19,216 and business broadband ARPU, which increased slightly to $175. Consumer broadband connections increased by 1.3%, while consumer broadband ARPU declined 1.2%. Consumer access lines continue to decline by 3.3% and business access lines decreased, but at a lower rate of 0.6%.

Wireless connection declined by 2,305 and the erosion was caused by the following. 782 fewer lifeline customers associated with continued compliance with certification standard. 2,453 pure postpaid connections, partially caused by 714 fewer non-revenue generating internal-use connections. These decreases were partially offset by 930 higher prepaid connections. Weakness in our postpaid subscriber base also contributed to a decline in wireless ARPU of 1.1%.

Finally, schedule seven, called summary AWN information, which provides a roadmap on how to understand the key element of AWN and their effect on our financial performance, both GAAP and non-GAAP. We start with AWN's free cash flow and how an investor should think of our preferred distribution as a percentage of AWN's free cash flow. As you can see, it start at 47.6% for the quarter. So our distribution is disproportionately better than our 33.3% ownership interest.

Now we show the summery balance sheet items associated with AWN, such as the equity method investment and the deferred AWN capacity revenue, which we've talked about previously.

Next, we present the GAAP earnings impact from AWN investment. You'll see the first item is the $8.1 million burnings on equity method investment in AWN and second is the excess AWN distribution value to $2.9 million. In total, the AWN investment represents $11 million of pre-tax GAAP net income.

Finally, we reconciled GAAP to non-GAAP. AWN cash distributions come from the free cash flow of AWN, which because of capital spending and other items is lower than AWN's GAAP income. We include this $9.6 million cash distribution generated by the AWN investment and adjusted EBITDA and free cash flow.

Before moving to guidance, I recognize we have covered a lot of ground. How do I step back and consider all of this information. It's really fairly simple. If we grow wireline revenue and manage our cost structure we can generate free cash flow. We are growing wireline revenue and we will manage our cost structure. If we make prudent capital investments in program like fiber-to-the-node, we add fuel for that growth.

Based on our return analysis, we believe that incremental growth on these type of investments will be profitable and will further benefit as if network gets operational. Finally, with debt balances coming down we create headroom for the business going forward. We are managing from a position of strength as we reduce our debt, build cash and invest for our future.

Now to wrap up this portion, I'll summarize with our guidance update. Total revenue guidance is unchanged and is expected to be between $340 million and $350 million. Adjusted EBITDA guidance is unchanged and is expected to be between $105 million and $110 million. Capital spending previously targeted to be around $50 million is now expected to be moderately lower. Free cash flow guidance of $20 million to $25 million is unchanged, but we expect to be towards the high-end of the range.

I'll now hand the call back to Anand.

Anand Vadapalli

Thank you, Wayne. As you have no doubted seen, AWN has introduced a certain degree of complexity through our financial statements. We believe our disclosers this quarter are responsive to the various questions we have received from investors over the last couple of months. However, it's important to remind ourselves that the fundamentals of how we view the business have not changed.

We've asked our investors to evaluate our performance in these categories. First, are we growing the business? The answer is, yes. Our record of consistently growing broadband revenues continues and we are expanding overall wireline revenues as a result.

Second are we deleveraging the balance sheet? The answer is again, yes. Overtime the way we continue to grow the business and pay down debt is by expanding free cash flow. Cleary that is our intent. You are investing in a company that has consistently delivered on what we said we would do. We've been transparent about our opportunities and our challenges. We have worked hard to earn the trust of our people, our customers and our investors. We look forward to reporting continued progress to our business plan.

Thank you for your time. Operator, please open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) And our first question comes from the line of Barry Sine with Drexel Hamilton.

Barry Sine - Drexel Hamilton

First of all and on, I guess for you, it sounds like from the script there is a systems issues on both the wireline and wireless business as it relates to essentially selling AWN services. Maybe you could walk us through what's actually going on at both of those businesses? What the resolution is, what the time line is?

Leonard Steinberg

So let's first start with wireless. As I noted in my prepared remarks, clearly this last year we've dedicated significant resource, attention, energy in closing AWN and doing all of the integration activities that you would expect with a transaction of this nature. And that has certainly attracted attention from what I would call the day-to-day operation of the business. That certainly impacted us.

The second part of it, as again I noted my prepared remarks, since the time we launch the 4G LTE HSPA network in December of 2012, we've been selling into two networks. The new network as well as the leafy CDMA network and just the virtue of selling into two networks, there is some complexity associated with that.

And clearly, the two networks also has a different experience associated with both of them, particularly as AWN is still feverishly building up the network across the state. So there is the transition that's associated with moving to the new network and we are seeing some results of that.

Add to that, we certainly need to do a better job of focusing on the specific segment where we can win and where we can play to our strength. And that's the transition that's underway as well. But some of it is just the work on the wireless side, some of it is just the work that's been going on with AWN, some of it is transition-related as we move from one better network technologies to the other, and some of it is improving our own retail strategy and there is work on all fronts.

As we look at where we are we've made substantial progress since the close of AWN on many of the underlying systems and process integration issues with AWN. In fact, as I noted in my remarks, we'll be launching a new prepared systems here in the next month or two and I would expect that by the end of this year, but as we move into the first quarter, many of these startup integration issues on the process and systems side or we would have worked through with AWN.

The second aspect of network quality, AWN, as you can imagine is making substantial investments across the state in building up its network, and 2014 will be in my mind, a really banner year for driving that investments. So we expect as a result of all of that to begin to stabilize performance.

Now keep in mind, when the new competitor comes into the market next year as we expect them to, all of the existing players in the market will take some of it on those five accounts, we expect that. But outside of that event, we certainly need to stabilize our performance and I think I'll walk you through the detail there.

Now, the second part of your question on wireline. Really the key, Barry, for us is we've been selling the heck out of wireline in the market and our sales team has been really successful. They've done well. We sold more this year so far than we have in prior years, and that's a direct reflection of the investment that we've made in the sales team over the last couple of years. The investments we've made in rolling our product.

The result of all of this is really increased backlog, which I would attribute to a couple of different things. One is, mostly what I would call the nature of payout that we've made. Some are high values payouts that are taking us long to deploy because of some bills associated with it. In fact, as we deliver on those sales, we expect improvements in business revenues. We expect improvements in business ARPU, as we do that.

Some are rural healthcare orders that just have a future delivery date and there is nothing we can do about it. It's just unfortunately adds to our backlog and there is not something that we can do anything to deliver them sooner.

The last one is on us, where we did not match internal resources just with the demand we were seeing in the marketplace. That I'll just put it bluntly straightly on us. And not something I'm happy about and not something that anyone of us are pleased and we are working to fix that. So these are things that have our attention and we are expeditiously working the backlog. And I fully expect the revenue performance to show the results.

Barry Sine - Drexel Hamilton

And then just a little more on wireless. I noticed at launch, if I looked at your website, they have pretty aggressive prices. I think it was zero on the 5S and the 5C, now you've gone up to 149 and 49, and now GCI has both handsets free. Is that the increasing pricing on your part somewhat related to the fact that you're having these systems introduced. You don't want to be as aggressive with pricing in the market or is that just normal fluctuation in what you're marketing? And then also on wireless, GCI in their press release after the close today talked about there Wi-Fi offering. Is that part of the AWN and available to you or not?

Anand Vadapalli

So at the two parts questions, Barry. In terms of the pricing in the marketplace and the shifts and fluctuations that you are seeing on our side, those are retails tactics that are playing out in the marketplace and we are working hard to keep any of the back office issues from impacting our retail strategies. So the changes that you see is part of how we have chosen to go to market in terms of the various devices and the plans that we have in offer. I won't read anything more into that than it's just retail tactics being played out.

The second part, the TurboZone Wi-Fi networks that is a supplement to the wireless macro cell network, and that is an AWN technology and product that is available equally to both parties and certainly we see great value in that and we will expect to see that plays well out even in our retail side all time.

Barry Sine - Drexel Hamilton

And then lastly, a question for Wayne, but fairly a detailed question. So Wayne, you must have been up all night I guess with all those schedules on the earnings release. But one more way, I'd like to kind of take a slice and dice and look at the financial numbers. Obviously, we had the AWN numbers in your results whether it was for the first 22 days of the quarter. And so I'm wondering if you could help us think about the third quarter results on a pro forma basis, what would have a standalone revenue and EBITDA and the respective growth rates for revenue and EBITDA have looked like consolidated wireless and wireline?

Wayne Graham

That's a really good question, Barry. But we haven't provided pro forma information. And as part of the approval process, we went to the SEC to get an exemption from pro forma, which helps us expedite a closing of the transaction, which we thought was the most appropriate thing.

So we're in a transition period with our reporting where it is not going to be clean pro forma year-over-year, which we recognized somewhat the challenge of that. And we offer supplemental information and the focus on the key areas that we think will drive our results going forward. It's imperfect, but it's really where we are and we think there is a lot of good information to make good decisions with what we're planning today.

Barry Sine - Drexel Hamilton

So maybe if I ask the question another way, I understand you're not providing the actual number breakout. Could you walk us through if we wanted to do this exercise at home, on the back of the envelope, the puts and takes we should be thinking about to look at the business on apples-to-apples basis?

Wayne Graham

Yes. So the puts and takes are on the revenue side or in the wireless and backhaul revenue category on schedule side. So that's one of the reasons why we remap some things so there, that's where on the topline is where the changes are happening in the business. So investor should go into the categories of foreign roaming, CETC, wireless backhaul and amortization deferred AWN catastrophe and that would allow them to get a pretty good cut at pro forma revenue.

On the cost side, it's a bit more challenging. What we offer is on schedule one, we've got our parenthetical and our cost of service and sales that will allow investors to understand what the new charges are from AWN. But we haven't presented historically what are avoided cost would have been if would have done AWN this time last year. So there's pieces of the equation and I think it helped people if they worked for their model.

Operator

Our next question comes from the line of Julia Senior with Bank of America Merrill Lynch.

Julia Senior - Bank of America Merrill Lynch

A couple if I could. Just to follow-up on that question about the pro forma financials, the guidance is not pro forma, right. So if we just strip out your reported year-to-date numbers, we'd get a true fourth quarter guidance, I just want to make sure if that's true. And then secondly if you could elaborate on the back office issues a little bit and just kind of what specifically you might be doing to address some of those issues? And if there are benchmarks that we could use to evaluate your progress there, that would be helpful? And then I have a follow-up on wireless.

Laurie Butcher

I could answer the exciting numbers question and then Anand could talk about those. So guidance, we've taken out really straightforward approach for the guidance where we're largely affirming the numbers we previously provided. We recognized this is a mix year or a transition year where pre-AWNs included in that guidance and post-AWN is included in that guidance. And we're not beyond that levels were keeping it simple.

We're not trying to provide a directional to you for the fourth quarter or how you should extrapolate that as to a run rate for the business. It's kind of in the same tune what Barry was trying to provide good information for this year and walk investors through the transition period. But for right now, we're not offering up Q4 guidance as a way to look at the business after AWN.

Anand Vadapalli

Going to the second part of your question, again on some of the wireline back office issues, really I have to go back to the color that I previously provided. And in terms of addressing it, we are certainly as you can imagine intensely focused on it. There's a fair bit of realignment of resources that's happened inside the company to make sure that we begin to align resources appropriate to the demand and that will continue.

In terms of monitoring it oversight, clearly as you can imagine that has a lot of attention up and down in the organization. And that will only have a beneficial impact as we work our way though the backhaul, at least the portions that are within our control. And last but no least, clearly we are going to embark on a series of longer-term lean initiatives, which frankly is the best way to eliminate waste when we have our frontline people address the issues, there are important event that are coming in their way.

The main message that I would take that from all of this is that the constraint is not in the market, the constraint is us and we are fixing it and we will. The opportunity in the market is high and we're going after it. And our sales team is doing a great job and we need to do a better job of supporting them at the backend. So to me that's the positive from it.

And clearly in terms of the markers, I guess the main marker for anyone would be how we are improving the growth in our broadband business revenues, at the end of day that's the marker. We will continue to provide qualitative color on how we are improving some of our back office issues. And the results are going to be in the revenue numbers that we will show it to you in the future quarters.

Julia Senior - Bank of America Merrill Lynch

Are you disproportionately affected on wireline side in the consumer versus the business market? Are some of these issues or is it one area that could really improve dramatically more than the other or is it spread across all of the low-end?

Wayne Graham

Business is where we've backed up in service delivery and obviously that has been our heavy focus for growth and sales and that's where the demand outstrips on resource allocation at the backend. So as we fix these issues, we certainly expect to see an improvement in our business to revenue results.

Julia Senior - Bank of America Merrill Lynch

Lastly, just a follow-up on wireless. I know you've got like that a 117,000, I think it's a number of subscribers threshold for you to get your full distribution from AW. So what exactly in a dollar figure, if you can, to what extent are you negatively impacted by not being there? And is it a goal of company to get to that level or not really?

Anand Vadapalli

So we are negatively impacted with that 117,000 threshold, if we stay where we are. There is somewhat complicated math, because it has to be with pull-ins and pull-outs, if that get affected. But essentially the impact is negative. It would begin to affect this in 2015. We'll have some calculations in our Q, it's not a significant number and consistent with what we disclosed in the past.

Last time, we did the calculation it was about a $200,000 impact to our free cash flow in 2015. I don't expect in the Q get [indiscernible], it will be a significant impact. And what's also important too is the overall exposure as a cap. We have the exposure for a certain number of years, during our preferred distribution period. The cap on the exposure is $21.8 million during that entire team period. So we think we can manage through that with that preferred distribution over that same time period of a $195.

Operator

There are no further questions in the queue, I'd like to hand the call back Anand Vadapalli for closing remarks.

Anand Vadapalli

Thank you all for joining the call and we look forward to talking to you early next year. Thank you.

Operator

Ladies and gentlemen, this concludes the Alaska Communication System third quarter 2013 earnings conference call. If you would like to listen to a replay of today's conference, please dial 303-590-3030 or 1800-406-7325 with the access code 464-5116. We thank you for your participation. And at this time you may now disconnect.

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