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CenturyLink (NYSE:CTL)

Q4 2013 Earnings Conference Call

February 12, 2014, 5:00 p.m. ET

Executives

Glen F. Post III – President & Chief Executive Officer

R. Stewart Ewing Jr. – Chief Financial Officer & Executive Vice President

Karen A. Puckett – Chief Operating Officer & Executive Vice President

William Cheek – President, Wholesale Operations

Jeff Von Deylen – President, Savvis

Tony Davis – Vice President, Investor Relations

Analysts

David Barden - Bank of America Merrill Lynch

Phil Cusick - JPMorgan

Mike McCormack - Jefferies

Simon Flannery - Morgan Stanley

Batya Levi - UBS

Frank Louthan - Raymond James

Kevin Smithen - Macquarie Research

Michael Rollins - Citi Investment Research

Sergey Dluzhevskiy - Gabelli & Company

Jonathan Epstein - Deutsche Bank

Adam Ilkowitz - Nomura Securities International

Operator

Good day, ladies and gentlemen, and welcome to CenturyLink's fourth quarter 2013 earnings conference call. [Operator instructions.] I would now like to turn the conference over to Mr. Tony Davis, Vice President of Investor Relations. Mr. Davis, you may begin.

Tony Davis

Thank you, operator. Good afternoon, everyone, and welcome to our call today to discuss CenturyLink's fourth quarter and full year 2013 results, released earlier this afternoon. Before we begin, let me apologize for the delay in the start of the call today. However, we had a pretty severe ice storm move through the area in the last 24 hours, closing a number of bridges, overpasses, and roadways.

As a result, we’re normally all in the room together doing this call from one location, but we are not today. So bear with us as the handoffs may not be quite as crisp as they normally are. And thank you for your patients as we get started today.

The slide presentation we will be reviewing during the prepared remarks portion of today's call is available in the Investor Relations section of our corporate website at ir.centurylink.com. At the conclusion of our prepared remarks today, we will open the call for Q&A.

On slide two, you will find our Safe Harbor language. We will be making certain forward-looking statements today, particularly as they pertain to guidance for first quarter 2014, full year 2014, and other outlooks in our business. We ask that you review our disclosure found on this slide as well as in our press release and in our SEC filings, which describe factors that could cause our actual results to differ materially from those projected by us and our forward-looking statements.

You’ll also note that our earnings release issued earlier this afternoon and the slide presentation and remarks made during this call contain certain non-GAAP financial measures. Reconciliation between the non-GAAP financial measures and the GAAP financial measures are available in our earnings release and on our website at www.centurylink.com.

Now turning to slide three, your host on today's call is Glen Post, Chief Executive Officer and President of CenturyLink. Joining Glen will be Stewart Ewing, CenturyLink's Chief Financial Officer; and also available during the question-and-answer period of today's call will be Karen Puckett, CenturyLink's Chief Operating Officer; Bill Cheek, President of our Wholesale Operations, and Jeff Von Deylen, President of CenturyLink Technology Solutions, formerly known as Savvis.

Our call today will be available for telephone replay through February 19, 2014, and the webcast replay through March 5, 2014. Anyone listening to a taped or webcast replay or reading a written transcript of this call should note that all information presented is current only as of February 12, 2014 and should be considered valid only as of this date, regardless of the date heard or viewed.

As we move to slide four, I’ll now turn the call over to your host today, Glen Post. Glen?

Glen Post

Thank you, Tony, and good afternoon everyone. Thank you for joining us today. I’m one of the ones who is iced in. Working from my home, so we’ll try to make this as smooth as we can, Stewart and Karen and Jeff.

If you will turn to slide five, I’d like to start off by recapping our performance for 2013. During the year, we continued to effectively execute our objectives and make investments that we believe will lead to revenue stability. For the full year 2013, total revenue declined by 1.5% compared to 2012.

In 2013, our core revenues trend continued to improve from a 2.3% annual decline in 2012 to 1.3% annual decline in 2013. This continued revenue improvement was driven by a nearly $400 million increase in strategic revenues, primarily due to growth in broadband, Prism TV, and high bandwidth data services and hosting services.

The annual strategic revenue growth was driven in part by a 13.4% growth in MPLS, Ethernet , and Wavelength revenues. Additionally, the decline of legacy revenues has slowed from 8.4% in 2012 to 7.3% in 2013.

We achieved solid growth in both high speed internet and Prism TV subscribers throughout the year, adding 140,00 HSI customers and 69,000 Prism TV subscribers. We’ve been pleased with the early growth of Prism TV subscribers in new legacy Qwest markets where we lost Prism in 2013.

Throughout the year, we invested to improve broadband speed availability across our footprint. We grew the number of enabled access lines receiving 20 Mbps and 40 Mbps each by approximately 25% over the prior year.

Also, we continue to focus on deploying more fiber to multitenant buildings and expanded the program by approximately 1,000 buildings during the year. We have continued to make excellent progress on our $2 billion stock repurchase program authorized by our board in mid-February of last year.

During the fourth quarter, we repurchased 10.5 million shares for a total investment of $331 million. From the inception of the program in February 2013 through February 11, 2014, we have completed 86% of the $2 billion program, having purchased a total of 50.8 million shares or $1.72 billion. We currently expect to complete the remainder of the current $2 billion stock repurchase program during the second quarter of 2014, well ahead of the original two-year timeframe.

Based on this anticipated early completion of our current stock repurchase program, the current level of our stock price, and the strong free cash flow we believe we will generate during 2014, management expects to recommend to our board that they approve a follow-on stock repurchase authorization at our regularly scheduled meeting later this month. This of course would position us to continue to opportunistically repurchase shares and return additional free cash to shareholders once our current stock repurchase plan is completed.

Over the last few weeks, our investor relations team has heard from the investment community that some investors are stating CenturyLink’s dividend is not sustainable. Obviously, that concerns us, so I want to clearly address the sustainability of our dividend before making further comments.

We remain confident that the investment in our key strategic initiatives continues to position us to reach revenue stability in 2015 and establish a revenue growth trend soon thereafter. Our strong fourth quarter and solid full year 2013 results, along with our full year 2014 revenue guidance show that we have made, and that we anticipate continuing to make, progress toward reaching our revenue objectives.

Additionally, we expect to successfully align our operating cost with our future revenue streams to continue to generate solid, predictable cash flows in the years ahead. We believe in our growth opportunities, and we also know that we must improve our operational efficiency to mitigate the impact of the revenue mix shift on our operational cash flow and free cash flow over time.

We believe this improving revenue trend, along with the strategic opportunities in the marketplace, position us well for future revenue growth and cash generation. These are the key reasons we believe that our dividend is sustainable and that our payout ratio will remain at a reasonable level, even as we begin to pay higher cash taxes in the future.

If you’ll turn to slide six, I’ll provide an update on our key strategic initiatives. Throughout the year, we have diligently executed in the four key strategic initiatives we initially laid out in third quarter 2011. We believe our investment in these strategies will continue to strengthen our overall product portfolio, which further positions CenturyLink as a leading integrated provider of global network, data hosting, and cloud solutions.

Starting with broadband expansion and enhancement, we continue to make significant investments in this area that we believe will better serve our business and consumer customers. We ended the quarter with approximately 6 million broadband customers. We had a strong fourth quarter, adding nearly 49,000 new subscribers, and we believe our fiber assets, including approximately 240,000 fiber miles across the U.S., position us well in the business market.

We continue to grow our advanced multitenant unit, or MTU, program. We had 200 fiber-fed buildings in the quarter, increasing the number of fiber-fed buildings by 17% in the third quarter. This program offers broadband capabilities of up to 1 gigabit of symmetrical service and it enhances cloud connectivity for these business customers.

We have made very good progress over the past few years in cost effectively deploying broadband services. We have enabled a total of nearly 8 million homes with fiber to node, and have passed a total of approximately 2 million homes with Prism TV capabilities.

We have utilized and continue to utilized a balanced capital investment approach, including gigabit fiber, VDSL2, and pair bonding deployments to efficiently enable higher speeds and enhance services to consumers and businesses in our markets. This balanced investment strategy has allowed us to deliver very competitive broadband speeds, including up to 1 gigabit service in a number of areas in an efficient manner, and to continue to drive broadband penetration.

Early results from our 1 gigabit pilots in Omaha and Las Vegas have met or exceeded our expectations, and are good indicators that by coupling GPON technology, gigabit enablement with expansion of fiber to the node, and Prism TV deployment, we can successfully compete and meet the broadband needs of both consumer and business customers.

Our announcement last week regarding the delivery of up to 1 gigabit service to more than 2,500 Salt Lake City businesses located in multitenant unit office buildings, or MTUs, is an example of how we’re leveraging our existing fiber to opportunistically expand speed and service capability to high value business and consumer customers.

Both the MTU and GPON programs offer upstream speeds and business service level agreements beyond what is normally available with the cable companies. These offerings are particularly compelling in the business market, where upstream capabilities are critical to enablement of cloud services.

In business areas where we do not offer our advanced MTU or GPON programs, we have extensively deployed Ethernet services. We currently cover over 2.3 million business locations with even that capability, with nearly half of this footprint capable of 20 megabits and higher symmetrical speeds.

In the months ahead, we expect to continue making the investments in our network enhanced speed capabilities required to deliver competitive broadband products and services across our markets.

Turning to slide seven, Prism TV service continues to perform well, and represents a very compelling entertainment alternative to cable TV service in the markets where we offer the service, and we added a record 26,000 Prism TV subscribers during the fourth quarter, ending with a total of 175,000 subscribers in service.

Over 50% of these added customers are new to CenturyLink, and they continue to have a very high rate of broadband attachment. This quarter we experienced an attachment rate of 98%. We continue to expand the footprint where Prism service is available, and in fourth quarter we added approximately 180,000 addressable homes of which just over half are in the newly launched markets of Phoenix, Colorado Springs, Omaha, and Denver. We are very pleased with the early Prism subscriber growth in these first Qwest markets to provide this video service.

We continue to see our churn rates improve with Prism Triple Play bundled customers, where the bundled customers are less likely to churn than the single play [unintelligible] customers. In addition, we continue to enhance our IPTV features by introducing new functionality and applications including expansion of our TV Everywhere capabilities, video-on-demand library, and our recent successful trial of wireless set top boxes.

Continuing on to slide eight, during the fourth quarter we completed approximately 930 fiber to tower builds for a total of 4,100 fiber builds in 2013, and over 18,800 total fiber connected towers across our footprint. In 2014, we expect to complete a total of 3,000 to 3,500 fiber builds.

As expected, we continue to experience some revenue compression as our wireless wholesale customers transition from copper based DS1 facilities to fiber-based Ethernet services. However, we anticipate that wireless data bandwidth growth will result in expansion of Ethernet consumption and thereby reverse the current revenue compression during 2014.

Moving to slide nine, managed hosting and cloud services, we continue to believe we are well-positioned to capitalize on the long term growth opportunities in this space will be developed and we’re expanding our strong product offerings. Cross sell or team selling opportunities for hosting products across our hosting and network sales teams continue to be strong, with sales of hosting services to business customers steadily growing.

Sales of hosting services to the network business customer base has grown significantly in the fourth quarter. We expect to maintain this momentum as customers seek IT solutions to streamline their operations, increase efficiency, and reduce cost. We are focused on growing hosting sales to our large base of business network customers, and expanding our hosting demand generation across target customer segments.

While we expect to have some churn of larger colocation clients, we expect the new initiatives to continue to drive growth. We continue to invest to increase our data center capacity as well as expand our product portfolio to meet customer needs and expand our market opportunity. In the fourth quarter, we opened a new data center in Hong Kong, and we announced late in November the acquisition of Tier 3, an innovative provider of public cloud services.

Tier 3’s products, roadmap, and vision are now the foundation of CenturyLink’s cloud development strategy. We believe Tier 3’s public multitenant cloud platform, combined with our global network and data center footprint and managed services team will greatly enhance our service capabilities to businesses of all sizes.

Additionally, in January this year Savvis began operating as CenturyLink Technology Solutions, aligning the brand with CenturyLink and demonstrating deeper ties to the broadband portfolio of IT solutions delivered to businesses.

Turning to slide 10, I’d like to shift briefly from 2013 achievement to looking ahead at our priorities for 2014. We were pleased with the strong consumer metrics generated in 2013, as we achieved high speed internet and Prism TV subscriber growth. As we enter 2014, we expect to continue to invest to enable higher broadband speeds and drive further broadband penetration across our markets.

During 2013, we enabled Prism TV service to approximately 800,000 incremental households, primarily driven by our launch of Phoenix, Colorado Springs, and Omaha during the year. We expect to continue to expand our Prism TV addressable market during 2014 and to drive subscriber growth during the year, driven by the expanded and addressable market, improvements in our programming packages, and the continued improvement in the customer experience.

We also will continue to monitor our success in all of our Prism TV markets, including Highlands Ranch, Colorado, a suburb of Denver. We launched service late last year and may consider further expansion of our Prism markets if our results continue to be strong.

With our customer retention programs, we continue to refine a series of programs targeting our highest-value customers, focused on high speed internet, voice, and Prism TV services. We also extended programs focused on new customer outreach, auto-pay take rates, and overall higher quality sales during the year.

In our business segment, we will continue to focus on driving growth in sales of high-bandwidth data services including MPLS, Ethernet, and Wavelength to meet strong customer demand. We believe our targeted marketing approach and sales programs, as well as continued enhancements in our product portfolio, continue to position us to drive revenue growth.

Based on early sales results associated with our recent launch of Managed Office, we will continue to grow and expand these by the seat solutions to meet market demand and gain market share. We also expect to continue to expand our GPON and fiber deployment to buildings, providing expanded addressable market opportunities to our business sales team.

In our wholesale segment, we continue to expand our fiber deployment to wireless towers, continue to drive revenue growth from the continued market demand, and from wireless carriers for wireless data backhaul. However, we expect our 2014 expansion pace to be below that of the last few years.

Utilizing the capabilities of CenturyLink technology solutions and the recent acquisition of Tier 3, we also expect to expand our marketing of white label cloud services on a wholesale basis, enabling us to drive further growth in cloud services in the coming year.

In the data hosting segment, we will migrate it to a single platform, that of Tier 3, for all cloud and managed services, which will enable new capabilities that further differentiate CenturyLink in the market and enhance customer experience.

Further, we will meet customer needs by selling a full portfolio of colocation, cloud, and managed hosting services, while retaining existing customers through exceptional service. Lastly, we expect to identify key partners that will help expand our capabilities beyond our direct sales force and drive additional revenues there as well.

Overall, I’m pleased with the solid results for the quarter and the full year. We continue to invest to drive growth, and we’re experiencing good traction in those key areas. With that, I’ll turn the call over to Stewart for an in-depth look at our financial results and guidance.

R. Stewart Ewing Jr.

Thank you, Glen. I’ll spend the next few minutes reviewing the financial highlights from the fourth quarter and then conclude my remarks with an overview of the first quarter and full year 2014 guidance we included in our earnings release issued earlier this afternoon.

Beginning on slide 12, I’d like to review some highlights from our strong fourth quarter results. I’ll be reviewing the results excluding special items, as outlined in the earnings release and associated financial schedules.

As you can see, we generated solid operating revenues and cash flows in the quarter. Operating revenues were $4.54 billion on a consolidated basis, a 0.9% decline from fourth quarter a year ago. Core revenues, defined as strategic revenues plus our legacy revenues, were $4.11 billion for fourth quarter, a decline of 0.4% from the year ago period. Strategic revenues grew 5.4% year over year, and represent 50% of our total revenues compared to 47% a year ago.

Strength in strategic products such as high speed internet, high bandwidth data services, Prism TV, and managed hosting services continues to drive this growth. As Glen mentioned earlier, subscriber growth was strong for both broadband and Prism TV.

From a business market perspective, we experienced strong new sales to business customers for network and hosting services in the fourth quarter. We generated strong operating cash flow of approximately $1.84 billion for the fourth quarter and achieved an operating cash flow margin of 40.4%.

As we’ve discussed on prior earnings calls, adjusted diluted EPS excludes special items and certain noncash purchase accounting adjustments as outlined in our press release and associated supplemental financial schedules. Adjusted diluted earnings per share for the fourth quarter was $0.68, well ahead of the midpoint of our guidance of $0.58. Results included the benefit of certain favorable year-end operating expense adjustments related to employee benefits, operating and income taxes.

Normalizing for these items, operating expenses would be approximately $60 million higher and adjusted diluted earnings per share would be $0.59 above the midpoint of our guidance range for both operating cash flow and adjusted diluted EPS. Additionally, we generated $601 million of free cash flow during the quarter, which is defined as operating cash flow less cash paid for taxes, interest, and capital expenditures and additional adjustments to other income.

Our strong cash flows continue to provide us the financial strength and flexibility to meet our business objectives and drive long term shareholder value. Also during the quarter, we made strong progress on the share repurchase program, buying 10.5 million shares for $331 million.

Now, turning to slide 13, the 0.9% decline in fourth quarter 2013 operating revenues compared to fourth quarter 2012 was primarily a result of growth in strategic revenues that was more than offset by lower legacy revenues due to access line losses and lower minutes of use. The growth in our strategic revenues was primarily driven by strength in high speed internet, high bandwidth business data services, Prism TV, and data hosting services.

Now, turning to slide 14, we’ll discuss each of our operating segments, beginning first with the consumer segment. Consumer generated nearly $1.5 billion in operating revenues, which represents a decrease of 1.7% over fourth quarter a year ago. Our strategic revenues in this segment grew 7.7% year over year, to $683 million, driven by growth in high speed internet and Prism subscribers and the full quarter impact of price increases.

The long term growth rate in high speed internet is likely to slow over time, due to our growth in penetration of households. Legacy services revenues for the segment declined 8.4% from fourth quarter 2012, due primarily to a continuing decline in access line and long distance revenues. Expenses were essentially flat compared to the same period a year ago, driven mainly by lower employee related costs, which were partially offset by higher Prism TV cost.

Moving to slide 15, our business segment generated $1.56 billion in operating revenues during the fourth quarter, which increased $16 million or 1% from the same period a year ago. On a sequential basis, total revenues grew $19 million from third quarter 2013, primarily driven by higher CPE revenue.

Fourth quarter strategic revenues for the segment increased by 7.5% to $643 million from fourth quarter 2012, driven primarily by strength in high bandwidth services such as MPLS, Ethernet, and Wavelength. We continue to generate solid growth across the enterprise customer segments, and we see an opportunity for further investment in the small and medium sized business space to improve market share and drive further growth.

Legacy services revenues for the segment declined 3.5% from fourth quarter a year ago, due primarily to a continuing decline in access line and long distance revenues. Total segment expenses increased $39 million or 4.1%, driven by higher facility costs associated with our MPLS product growth.

Now, turning to slide 16, our wholesale segment generated $884 million in operating revenues, a decline of 2.5% from fourth quarter a year ago. Strategic revenues for wholesale were $581 million, which grew 1.6% from fourth quarter 2012 as growth in Ethernet services and data bandwidth capacity expansion by wireless carriers and delays in TDM disconnects offset the decline in low speed transport services revenue.

Legacy revenues declined by 9.6% to $303 million, reflecting the continued decline in access and long distance minutes of use and the implementation of lower access rates under the CAF Order rate step-down.

Operating expenses for the quarter were $290 million, 3.7% below the same period in prior year, driven primarily by lower voice usage costs. Now, moving to slide 17, and our data hosting segment, which includes all colocation, managed hosting, cloud, and hosting related network services revenues.

This segment generated $353 million in operating revenues, representing an increase of 3.8% from fourth quarter 2012 revenues of $340 million. Year over year managed hosting revenues including cloud grew 14%. Colocation growth of 1.4% was weakened by customer churn and price erosion in previous quarters.

Data hosting and operating expenses were $283 million in fourth quarter, compared to $264 million in fourth quarter 2012. This 7.2% increase is primarily due to increased sales costs, the Tier 3 and [unintelligible] acquisitions and incremental expenses associated with them, and investments in marketing.

Over time, we expect long term improvement in both revenue and margin trends across the data hosting segment and continue to leverage these assets to drive additional revenue through cross selling opportunities in our other segments.

On slide 18, we provide our first quarter 2014 guidance. We expect for the first quarter 2014, operating revenues and operating cash flow to decrease compared to fourth quarter 2013, primarily due to a decline in legacy and data integration revenues along with favorable employee benefits and operating tax true-ups present in fourth quarter 2013 results that are not expected to reoccur in first quarter 2014.

Similar to last year, we also anticipate a decline in depreciation and amortization expense in the fourth quarter of 2014, driven primarily by the impact of declining amortization of acquisition related intangible assets and the annual review and update of depreciation rates.

For first quarter 2014, CenturyLink projects total operating revenues of $4.46 billion to $4.51 billion, our core revenues of $4.07 to $4.12 billion, and operating cash flow between $1.73 billion and $1.78 billion. Adjusted diluted EPS is expected to range from $0.58 to $0.63.

On slide 19, we provide our full year 2014 guidance. For the full year 2014, we expect total operating revenues of $17.9 billion to $18.1 billion, reflecting a year over year revenue change of flat to negative 1.2% and core revenues of $16.25 billion to $16.45 billion.

Operating cash flow is expected to be between $7.05 billion and $7.25 billion, and adjusted diluted EPS is expected to be between $2.40 to $2.60. Our capital expenditures are expected to be approximately $3 billion as we continue to make investments in key growth areas. So we anticipate free cash flow for full year 2014 to be between $2.6 billion and $2.8 billion.

We anticipate decline in operating cash flow and free cash flow, primarily driven by the decline in legacy revenue, investments to continue to grow strategic revenues, as well as a lower level of acquisition related synergies in 2014 compared to the level of incremental synergies that we achieved in 2013.

That concludes our prepared remarks for the day, so at this time I’ll ask the operator to provide instructions for the Q&A portion of the call.

Question-and-Answer Session

Operator

[Operator instructions.] Your final question comes from David Barden of Bank of America.

David Barden - Bank of America Merrill Lynch

I want to talk first a little bit about the guidance, Stewart, if I could. So first, the full year midpoint is looking for a margin of around 39.7%, which is a higher margin than you had in the fourth quarter, a higher margin than you’re guiding to in the first quarter. So if you could kind of step us through where that margin expansion and where the pivot starts to occur, that would be helpful.

I think the second thing that would be helpful is, you know, last year, around the middle of the year, there were challenges to the guidance numbers and hitting those numbers. Can you talk a little about the process that you went through for setting these expectations here now, and kind of some of the base case expectations that you made around the enterprise environment and other things?

And then lastly, if I could, you talk about, as we all know, the falling revenues in legacy have higher margins than the growing revenues in kind of strategic services do. You’ve also talked about the potential for a pivot in EBITDA about a year following the pivot in revenue growth. Could you put numbers around those margin numbers? If you were having a conversation with someone, and they say legacy revenues are X and strategic revenues are Y, at what margins could we have a conversation about that? And think about when the EBITDA pivot can occur.

R. Stewart Ewing Jr.

First of all, the full year guidance midpoint basically is 39.7%. The midpoint in the first quarter is 39.1%. So obviously we expect the latter three quarters of the year to be above that. We basically have expense reduction programs that we’re working to put in place, which will help reduce our expenses from the first quarter expected levels into second, third, and fourth quarter of the year.

Our guidance last year in 2013, if you’ll recall, we had a hockey stick, basically, in revenues. So where we really missed our guidance in ’13 and came back and tweaked it some was really associated with the revenue that we hope to get out of some of the products such as Savvis Direct, which is our cloud product, and another product that just didn’t materialize as we had hoped.

We feel like we have all that worked through in 2014, and feel much more comfortable with the revenue guidance in 2014, I think, looking back on the experience we had last year. So we feel much better about the guidance there. And again, on the expense side, we think we have the programs in place and about to put in place to get us to the point where we need to be to hit the guidance.

In terms of EBITDA pivot, basically we will continue to lose legacy revenues, but our strategic revenues grew very strong in the fourth quarter, and really full ’13. We expect continued growth in strategic revenues in 2014. What we’ve said is that we’re not ready really to put a peg in when we can stabilize the EBITDA, and turn to EBITDA growth, but as Glen indicated in his prepared remarks, we do expect to get to revenue stability in 2015.

David Barden - Bank of America Merrill Lynch

And Stewart, just to be clear, I think you have kind of talked about a 12-month lag between the revenue pivot and EBITDA stability. Are you saying something different now? Or am I missing it?

R. Stewart Ewing Jr.

Really pretty much the same. What we’ve said exactly, I think, is hopefully we would get to EBITDA stability shortly thereafter, or sometime reasonably thereafter. You know, a year or so. We’re not really saying anything different than we said before.

Operator

And our next question comes from Phil Cusick with JPMorgan.

Phil Cusick - JPMorgan

Can you talk about a couple of things? One is the 4Q employee cost savings, just help us out and help us understand what was there, and I understand it’s not going to be there in the first quarter. And then as you think about the buyback from here, what’s management thinking about in terms of the size of that recommendation? And how should we think about the max leverage on the business going forward?

R. Stewart Ewing Jr.

From a leverage standpoint, we said that we would like to stay in the 3x debt to EBITDA or so. We’re at 2.8x debt to EBITDA now. I’ll let Glen talk to the buyback for a moment, and then I’ll come back to the cost savings.

Glen F. Post III

You know, besides the buyback, we’ve really not discussed that with the board yet, so I’m not ready to put a number out there, but we realize it has to be significant enough to make a difference and give us an opportunity really to buy our stock back at attractive prices, which obviously we believe the current price is very attractive. But we’re not ready to give a number yet. We’ll announce that after the board meets.

R. Stewart Ewing Jr.

And the employee cost savings were really related to employee benefits, and it was really just making adjustments for really all the adjustments related to the full year 2013. They revolved around our medical, dental, and vision accruals, basically, for current year cost.

They also revolved around some of our post-retirement benefit costs as we made adjustments to adjust that to the liability that it needed to be at. We changed our paid time off policy and had fewer hours carried over from year to year. A lot of people took a lot of time off, both the last quarter of the year, so that drove our paid time off expense up.

That’s about $40 million of that. The remainder of the other $20 million or so is really related to a transaction tax reserve that we had on an acquired company that is no longer necessary, so we’re able to limit that reserve as well as our normal year-end ad valorem tax true ups for the most part.

Operator

And our next question comes from Mike McCormack from Jefferies.

Mike McCormack - Jefferies

Maybe just a quick comment, Stewart, regarding the view here. Obviously you’re discussing the potential for share repurchase. The competitive landscape for high speed, obviously, becomes tougher and tougher, I think, as cable gets more aggressive on pricing or functionality. What’s your thought regarding balance in the capital budget, when you look at 2014 versus thinking about a repo? And then if you can give us any color on what you’re thinking for cash taxes rolling into the ’14 guide, that would be great.

R. Stewart Ewing Jr.

Let me hit the last point first, and I’ll let Karen talk a little bit about competition. Cash tax is somewhere between $50 million and $100 million in 2014. The potential for share repurchase and balancing that with the capital budget, we think our capital budget will be about $3 billion this year, and we think that that will give us enough free cash flow to complete the share repurchase program that we have in place, which we have about $300 million remaining there, and implement another program that we would expect to get the board to approve at our February meeting in a couple of weeks.

Karen, you want to talk about where we are with regard to high speed internet?

Karen Puckett

Yeah, in terms of high speed internet, just great quarter, and congratulations to the CenturyLink whole team that made that happen. But I would say that we have ADSL2 fiber to the node capabilities, and we really do a great job with our local model using the capital and optimizing by market what capability, and how we can market the best capable speed with the cash available.

So it really is a balance of the cash, the technology capability on the economics, and then taking that and optimizing that message within each market. So it is very market specific. And we seem to win that way.

R. Stewart Ewing Jr.

And we consistently upgrade speeds. I think in the talking points that we have, I think there’s a 25% increase in the households that could receive a 20 megabits and higher and a 25% increase in the households that could get 40 megabits or higher at the end of ’13 versus the end of ’12. And we’ll continue to shorten the loop, to put fiber in the network to shorten loops to bond, and just to do whatever’s necessary in our markets to be able to compete with the cable companies.

Mike McCormack - Jefferies

And Stewart, when you look at 2014, does the available homes for sale for Prism, is that going to be expanding at the same rate we saw in ’13?

R. Stewart Ewing Jr.

It will not expand at the same rate. We added about 800,000 homes past in 2013. For 2014, we have the Phoenix market to complete, and we have, I think Glen mentioned, the area in Colorado, Highlands Ranch. And we’ll have incremental expansion in really most of the markets. We’ll cover potentially at least an additional 300,000, maybe 400,000 homes in 2014, really without going into any new markets. And we’ll evaluate new markets through the early part of the year.

Operator

And our next question comes from Simon Flannery of Morgan Stanley.

Simon Flannery - Morgan Stanley

Glen, you talked in your prepared remarks about the strategic opportunities in the marketplace. I wonder if you could just expand on that a little bit. Does that mean doing more things like Tier 3? And then just a clarification, Stewart. I think I’m right in saying that your Q1 and your ’14 guidance only includes the share count as of December 31, that the buybacks you’ve done year to date are not in that number? Just want to clarify that number. So, given what you’ve already completed in the last six weeks or so, that will help some of the earnings versus what you’ve printed here, is that right?

R. Stewart Ewing Jr.

Yes, Simon, that’s correct. Our guidance only includes this year’s purchases through the end of the year.

Glen F. Post III

Regarding my comments about strategic opportunities, I really wasn’t talking about a potential acquisition. I was talking more about the opportunity to expand our services, especially in the cloud hosting space, IT services space, where we’re seeing more and more demand in that space, with our Tier 3 acquisition and the other product expansion, product development we’re doing. We think there’s significant opportunity there the next couple of years to do something very meaningful.

Simon Flannery - Morgan Stanley

Is there timing on when the Tier 3 integration really kind of kicks into high gear and you can start benefitting from that acquisition?

Glen F. Post III

We’re thinking second quarter it kicks in really at a much higher level. We’re talking about midyear, our target. We’ve already begun selling it and integrating it in some ways, but a full integration, we’re thinking second quarter.

And regarding acquisitions, we’re focused on our key strategic initiatives, and we think there’s good growth of these, and bringing more MPLS, Ethernet, expanding our Prism opportunities, connect the home, the connected office work that we’re doing. So we think there’s significant opportunities there. At the same time, we will consider inorganic opportunities that will help drive growth, really. We’ll maintain our disciplined approach to these decisions, and we’ll just look for the right opportunities that can really grow shareholder value. That will be our goal.

Operator

And our next question comes from Batya Levi with UBS.

Batya Levi - UBS

Strategic wholesale revenues grew for the first time in a while, and you had mentioned before that you expect wireless backhaul to grow in ’14. Can you provide more color on the timing of that? Can we see that early on in the year? And then also, within your guidance for the year, for revenues, which is looking for an improvement in the rate of decline, can you talk about your assumption you have for strategic in there?

William Cheek

Let me just talk to you a little bit about the timing and the growth of backhaul revenues. We are continuing to build out our fiber to the tower initiative, and we’ll have completed [unintelligible] really about 18,800 or so towers next year with adding another 3,000 to 3,500. We are expecting to see revenue compression start to mitigate. It won’t happen earlier in the year. There’s a fairly major reduction in some DS1s when a large carrier turned down the push to talk network, and that affected everyone in the industry. So we’re having to live through that a little bit, but we do expect that we’ll mitigate towards the latter part of the year.

Batya Levi - UBS

And in terms of strategic services growth within your guidance?

R. Stewart Ewing Jr.

We are expecting our strategic revenue growth to improve in 2014, and think it will be led by our broadband, our Prism, and our data hosting areas and the success that we continue to have with business customers in the business segment.

Batya Levi - UBS

It’s about 50% of revenues going to now to [45%]. Should we expect that trend to continue?

R. Stewart Ewing Jr.

Yes.

Operator

And our next question comes from Frank Louthan with Raymond James.

Frank Louthan - Raymond James

Looking at some of the IP trials that are at the [unintelligible], do you see any value in pursuing that yourself? And then can you comment on the managed office platform that you recently launched? When do you start to get traction with that in the [unintelligible] segment?

R. Stewart Ewing Jr.

I’ll comment on the [unintelligible] trials and Karen will discuss managed office. But yes, we would expect to be involved in the [unintelligible] trials, alongside the other major carriers there, so that we’ll be in a position to move in that direction and get all the learnings that we would get from a trial.

Karen Puckett

In terms of managed office, we’ve really just begun to roll that out in late fourth quarter. But we are really encouraged by the traction and the funnel that we’re seeing. It is a different sell for our sales reps, but it’s very simple for the business owner, right? Because it allows them to have their information technology simply on a per-seat basis, and it bundles a business grade data network and a hosted VOIP service, with cloud based applications for EMLs and storage, really all in one package. And so we’re also enabling that with our MTU fiber to the building. And we’ll keep you posted, but we’re very encouraged. And the sales team has given us a lot of good feedback, and we think it’s going to change the dialogs they’re going to be able to have in front of the customer.

Operator

And our next question comes from Kevin Smithen with Macquarie.

Kevin Smithen - Macquarie Research

I just had a follow up on an earlier question. Given your sequential improvement over the past couple of quarters in broadband and Prism TV, I guess why wouldn’t you launch new markets and try to pass as many homes as possible this year? And given that interest rates have fallen, why not take up lever slightly to fund both the capex and a buyback to try to get to revenue and EBITDA breakeven as quickly as possible and retire shares?

R. Stewart Ewing Jr.

We’re certainly looking at new markets and evaluating new markets and the cost of going into them. And we really wanted to see a little bit more success. You know, we really just turned up the Omaha market in September or October on a commercial basis. And we’ve done really well there. We’ve done well in Las Vegas, where we have fiber to the home. We’ve done well in Colorado Springs. So I think we want to see a little bit more performance and just make sure it really lasts, which we certainly believe it will, and all indications are that it will. But rest assured that we’re looking at other potential markets that we could provide Prism service.

Glen F. Post III

When you look at revenue growth opportunity, look at Prism, it’s certainly one that, as Stewart just said, we’re looking hard at. That would involve some additional capex. I don’t think a whole lot for this 2014. But it also impacts our startup expenses, or EBITDA. So we would have to take a look at that. But if we did, we’d come back to investors and explain, that we’re doing this to accelerate revenue. We’re seeing significant success in these markets, and this is why we’re doing it. But that would be the issue we deal with if we decided to make a move to more aggressively invest in Prism TV in the coming months.

Kevin Smithen - Macquarie Research

And what would roughly the capex be per market and opex, for startup?

R. Stewart Ewing Jr.

It’s really hard to say. It varies by market, and it depends on the quality of the plant that’s there today, and how much work needs to be done. So it’s really very difficult to generalize. But again, if we continue to have good success in the markets that we’re in, we’ll keep evaluating in other markets, and come back to you guys like Glen indicated.

Kevin Smithen - Macquarie Research

What’s the max leverage ratios you feel comfortable with exiting 2014?

R. Stewart Ewing Jr.

What we’ve said is that basically three times is really our bogey.

Operator

And our next question comes from Michael Rollins of Citi.

Michael Rollins - Citi Investment Research

I guess the first question is, if you just look out three to five years, is there a sense of what broadband speed a home needs given the evolution of technology and over the top type of applications? And then if you have a view there, how the company is working backwards to try to get the portfolio in better shape in aggregate to get to that goal.

And then just secondly, on the consumer side as well, are you seeing any changes to the way customers are using bandwidth, using internet, that you could just give us a sense of whether it’s volume growth or usage per household, and maybe how it’s different in a fiber to node fed home versus a straight up copper home?

Karen Puckett

In terms of the broadband, everyone has an opinion. We’ve made good investment in our ADSL, VDSL, really VDSL, technology as well as our fiber to the [perim]. And you know, 33 meg to 53 meg, we believe we can be successful at. With bonding, we can get well beyond that. But really, what we’re focused on is the functionality and the capability, so Prism and the connect the home we’re pretty excited about. We continue to push the technology team in getting more efficient, and we’re encouraged by some work that we have going on that we’ll be talking about in future quarters. So I think from the standpoint of how we’re positioned, we feel good about where we’re positioned right now.

Glen F. Post III

If you look at it, you know, we have 65% of our households can get access to 10 meg or higher, on an unbonded basis, not bonded. Almost 40% can get access at 20 megs or higher on a nonbonded basis.

Michael Rollins - Citi Investment Research

And just to follow up, if you have some details also on usage for home and maybe growth in broadband traffic over the last year, that would be great.

Glen F. Post III

The growth, basically in the average monthly download, was 44 GB, which was an increase of 24% quarter to quarter. The median monthly download, however, was 16 GB, which is, again, about a 25% increase quarter to quarter. So the top 1% of our subscribers represented 11% of the total traffic, basically. And 20% represented 70% of the total traffic.

Michael Rollins - Citi Investment Research

And then just one final question, if I could. Is there a way to think about your capex in terms of what’s a general bucket of the network, you know, that supports all of the segments? And then maybe the capex specifically for consumer versus business. I know you’ve laid out some bogeys already on fiber to the tower, but is there a way to think about how you have this pool of broad capex, but then you could identify maybe some of the pieces for us, just think through where you’re [pacing] your dollars?

R. Stewart Ewing Jr.

You know, we’ll spend $400 million or so on broadband expansion enhancement this year, and another $150 million on our Prism TV products. We have a lot of success based capital with our business customers, but that’s all the detail we really want to give you now. It’s going to be slightly less for fiber to the tower in 2015. It will be more like into $200 million, depending upon the requirements there.

Operator

And our next question comes from Sergey Dluzhevskiy from Gabelli & Company.

Sergey Dluzhevskiy - Gabelli & Company

Two questions. One for Glen on M&A. Could you update us on your M&A philosophy and potential areas of interest. Obviously you guys have mentioned in the past that you have the right mix of assets to return to revenue stabilization, and eventually to grow, but to the extent that you would look to augment this growth through acquisitions, what areas would be of primary interest to you?

And also, one question for Karen, on 1 gigabit service offerings. Maybe if you could share with us some initial learnings from Omaha and Las Vegas, and what are your expectations for these markets and for 1 gigabit offerings in general, as you roll them out?

Glen F. Post III

Regarding the acquisition approach we’re taking, we don’t feel like we are compelled to make an acquisition, but to the extent we can find companies that can accelerate our growth, that we are interested, we’d expect it to be revenue growth accretive, also free cash flow accretive, I think we said within 12 months. And it has to drive long term shareholder value. So those are the three things we look for. And the recent acquisitions we’ve made, all those fit this criteria, basically. They all are especially poised to enhance our growth in the months ahead, and we’ll continue to look for those. These are all the small ones, but even larger ones we consider. But those are the primary criteria we’ll be looking for in acquisition target.

Karen Puckett

And regarding the gig learnings from Omaha and Vegas, still early, but again, we are really encouraged by the results there. We are seeing strong pull through, just overall, two to three times in terms of HSI, even outside the gate footprint as well as in impact on business customers. So we have landed some new business opportunities just because of what we would call a halo effect in these two markets.

Operator

And our next question comes from Jonathan Epstein from Deutsche Bank.

Jonathan Epstein - Deutsche Bank

First, on your comments about the dividend, you’ve previously expressed the desire to keep the 2015 dividend payout ratio under 60% of adjusted free cash flow. Is that still the foundation of the dividend policy? And if so, is it a litmus test? Or is there any wiggle room there, especially considering the forthcoming renewal of share repurchases? And then just a follow up on a previous question. Was the $60 million savings in the quarter originally contemplated in ’13 guidance? And can we expect savings of this magnitude in the fourth quarter of this year, of course baking in the tax savings that you already mentioned that you expect?

R. Stewart Ewing Jr.

Last question first. No, this was not in our guidance for the fourth quarter or full year, really. We always have a few adjustments during the fourth quarter, more related to property taxes and the true-up of our income tax rate for the year and things like that. You know, minor items. But it just turned out to be much more significant this year because we had a number of employee benefit items that have been much smaller in the past. So it was not baked into guidance, and we would not expect that to reoccur in 2014.

In terms of the dividend, we basically indicated that we thought we could keep the payout ratio around 60% in 2015 when we became a cash taxpayer. It’s not really a litmus test, and there is certainly wiggle room from there, so it’s just where we thought we would be at the time that we indicated that. And so it’s not set in stone, basically, that if we get above 60% we have to take action. So we’re good with the dividend. We’re comfortable with the dividend where it is, and we’re comfortable looking out a few years to the time when we become a [full cash] taxpayer, that, based on our business plans today, we would not have to change the dividend.

Operator

And our final question today comes from Adam Ilkowitz from Nomura.

Adam Ilkowitz - Nomura

Quick question on the data hosting segment. Can you give a little detail on how much Tier 3 added to the growth rate? I know we’re lapping Cyber a bit, but I was wondering how much the managed hosting growth was actually organic. And then a question on cash flow beyond ’14. I know it’s a little out there, but thinking about cash taxes going up and capital spending for some of these initiatives going down, given that you’re having success with GPON and with fiber on the business in consumer side, does this change how you’re thinking about capex and the speed requirements and moving more to fiber than VDSL and bonding in the future, and how that would impact the capex budget going forward?

Jeff Von Deylen

On the first question, for the quarter, the Tier 3 acquisition added about $1.6 million in revenue for the quarter. And then just full disclosure, we get about a $2 million benefit for exchange rate favorability. But the rest of the managed hosting cloud growth would have been organic. So we had a very strong quarter sequentially in terms of growth and new business customers that we added and got installed during the quarter.

R. Stewart Ewing Jr.

And on your second question, in terms of GPON and Prism impact, and how we might think about capital expenditures and leverage related to that, really we believe we have enough capital built into the budgets in the out years to be able to do what we need to do to adequately serve our customers and compete with the cable companies and other competitors. If we did get to the point where we felt like we needed to drive more fiber than we’re planning on today, and expand into many more Prism markets, we would certainly come back and talk with you about that and have the case associated with that to sell that.

But basically at this point, we plan on really using multiple technologies to provide higher speeds to our customers, and think we can continue to really have success there. Again, we’ll monitor Omaha and the gigabit fiber trial there, as well as where we’ve rolled it out in Las Vegas, and see what success we have and make decisions later. But for now, we believe that with other technologies, we can basically be competitive.

Operator

I would like to turn the conference back over to Mr. Glen Post for any closing remarks.

Glen F. Post III

Thank you, operator. Overall, we are well pleased with our strong fourth quarter and solid full year 2013 operating results and financial results. We believe the investments in our key strategic initiatives continue to position us to effectively compete in the marketplace and drive revenue growth from our strategic products and services into the future. Thank you for joining our call today, and we look forward to speaking with you in the weeks ahead.

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