Intelsat's CEO Discusses Q4 2013 Results - Earnings Call Transcript

Feb.20.14 | About: Intelsat SA (I)

Intelsat SA (NYSE:I)

Q4 2013 Earnings Conference Call

February 20, 2014, 11:00 AM ET

Executives

Dianne VanBeber - Vice President, Investor Relations and Communications

David McGlade - Chairman and Chief Executive Officer

Michael McDonnell - Executive Vice President and Chief Financial Officer

Analysts

Michael Funk - Bank of America Merrill Lynch

Simon Flannery - Morgan Stanley

Batya Levi - UBS

Brian Russo - Deutsche Bank

Jason Kim - Goldman Sachs

Joseph Mastrogiovanni - Credit Suisse

Anthony Klarman - Deutsche Bank

Kannan Venkateshwar - Barclays

Chris Qulity - Raymond James

Amy Stepnowski - Hartford Investment Management

Adam Spielman - PPM America

Preeti Doshi - Evercore

Romeo Reyes - Jefferies Company

Operator

Good day, ladies and gentlemen. Welcome to the fourth quarter 2013 Intelsat earnings conference call. My name is Dave, I'll be your operator for today. (Operator Instructions) I'd now like to turn the call over to Ms. Dianne VanBeber, Vice President, Investor Relations and Corporate Communications. Please proceed, ma'am.

Dianne VanBeber

Welcome, everyone, and thank you for joining Intelsat's fourth quarter 2013 earnings conference call. Earlier this morning, we issued our earnings release and published a quarterly commentary, both of which are available at intelsat.com. This is the first time we issued a quarterly commentary, we hope that by publishing the commentary ahead of the call we will provide the investment community with the information in context that you need to analyze our results well in advance of our discussion.

We made this change to make you time with us more efficient and to allow more time for discussion in Q&A with our management team. This is our first quarter to introduce this concept and we welcome your feedback, so that we can make it as useful as possible going forward.

Now, just some housekeeping matters. During today's call, we will discuss adjusted EBITDA and other financial metrics not prepared in accordance with U.S. Generally Accepted Accounting Principles, including EBITDA related margins, adjusted net income per share and free cash flow from operations. We provide reconciliations of these metrics to the most directly comparable GAAP measures in the earnings release and on our website. Later today, we'll be filing the Annual Report of Intelsat SA on Form 20-F with the SEC. You can find the link to the filing on our website.

Additionally, our conversation today will include forward-looking statements reflecting our current expectations for future industry conditions as well as our business strategy, market trends and positioning and expected future financial performance. These forward-looking statements are subject to risks and uncertainties many of which are outside of our control.

Please refer to the Safe Harbor statement included in our IPO perspectives of April 2013, for information regarding some of the factors that could cause our actual results to differ materially from our expectations. Finally, please be aware that our conference call today is opened to the investment community and media, with the media invited to participate in listen-only mode. Members of the media are not authorized to quote, either directly or in substance any participant in the call who is not a representative of Intelsat.

With that, I'd like to turn the call over to Dave McGlade, our Chairman and CEO; and Executive Vice President and CFO, Michael McDonnell, who are here to offer you additional detail on Intelsat's business and financial performance. Following brief opening remarks by, Dave, they'll be happy to take your questions.

David McGlade

Thanks, Dianne. At $643 million and $2.6 billion, our fourth quarter and full year 2013 revenues are in line with the guidance we provided during the third quarter call. Our adjusted EBITDA performance is strong at $510 million or 79% of fourth quarter revenue.

Adjusted EBITDA for full year 2013 was over $2 billion or 78% of revenue. Backlog, which provides visibility for future revenues ended the year at $10.1 billion. We entered 2014 with current year backlog of $2.1 billion.

The fourth quarter kept the year with many business and financial accomplishments. The completion of our IPO combined with successful refinancing activities has enabled us to significantly reduce our bad debt, improve our maturity profile and initiate our delevering plans to create equity value.

With respect to our operations in 2013, we charted a solid course for a steady longer-term growth. This includes continuing to invest in our video neighborhoods, for instance, at 304.5 degrees East, certainly Latin America. We are also building the operational enhancements needed to fully realize the benefits of the Intelsat Epic satellites, as they begin to enter service in 2016.

Earlier in 2013, our near-to-mid term outlook was based on a flattish growth scenario, tending the launch of our next series of satellites. However, as we've communicated over the last several months, two trends have emerged that are affecting our revenue performance.

First, our government business is challenged by the effects of reduced U.S. government spending. We believe that this will result in a reduction of 15% to 20% for our government business as compared to 2013 results.

Second, an oversupply environment, including terrestrial, microwave and traditional satellite capacity is disrupting the Africa market. This has pressured our service provider customers and has resulted in price reductions, as we renew business on a network services applications in that region.

We believe this will result in a modest decline in year-on-year overall performance for our network services business. At present, we believe these two factors will persist in 2014, and as a result we are guiding to a total company annual revenue for 2014 of $2.45 billion to $2.5 billion, roughly a 4.5% decline from 2013.

As we work through these challenges, we remind our investors of our commitment to a two-phase investment model. The first several years of this plan is not dependent upon revenue growth, but instead on the use of increasing cash flows to reduce our debt.

We are sharply focused on delevering to create equity value. With continued solid adjusted EBITDA margin performance, reduced interest expenses and in-line capital expenses, our guidance also includes an expected debt reduction of approximately $400 million in 2014.

With respect to lifecycle capital expenditures, we are incorporating the efficiencies at the high throughput Epic technology. As we look at the fleet planned over the next 15 years, we believe average annual CapEx will range from $650 million to $700 million, contributing to better cash flows over the long-term.

The 2014 operational plan includes many elements that will contribute to reaching our business and delevering goals. But the most important task is to ensure that new inventory is launched successfully, on budget and on time. Our satellites launching later this year and in 2015 are tracking according to schedule.

So we are headed into 2014 with a clear line of sight, on what needs to be accomplished, as we position for organic revenue growth over the long run. And the forefront of our plan is our near-term goal to generate cash flow to delever and create equity value.

With that, we are ready to answer your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Please standby for your first question, which comes from the line of Michael Funk.

Michael Funk - Bank of America Merrill Lynch

First just on the government business, I think you're pretty clear with your guidance there. But I wanted to get a better understanding, maybe where you see support in terms of government revenue? Second, on government revenue, is this just canceled contracts or the government pulling back or are you losing some of these contracts to competitors?

David McGlade

We don't believe we're losing contracts to competitors. It's been a combination of some price reductions, some capacity reductions and then the majority has really been around cancellations of contracts in the fourth quarter. So that is certainly the driver of what's happening.

Going forward, we see some reduction from the pullout in Afghanistan, but the question will be of course, what extent that will be, will it be an abrupt pullout as we saw in Iraq or will it be gradual or even allow some capacity and troops to remain there. So that's still a question mark going forward. We think we've taken a very prudent approach when we look at the overall plan that we've offered here. We have a good feeling in terms of existing business of what's happening, but the pipeline for new businesses is rather limited.

On the positive side, we hope that the budget deal could create some opportunity later in the year, but today we haven't seen that. And in fact, part of the issue also is that our customers have consolidated some of their capacity. And as they have learned to live with less and to be more efficient, we do not see that coming back anytime sooner at all.

So for us it really is about building a long-term plan to be cost effective with our government customers. We believe we can do that. We also believe that the government programs that we've seen in the past that were over-budget and behind schedule will not continue with new programs going forward. And that instead they will leverage the efficiency of commercial operators to provide capacity. So short-term, it rather varies, but long-term we're very positive about this sector.

Operator

Your next question comes from the line of Simon Flannery at Morgan Stanley.

Simon Flannery - Morgan Stanley

Your guidance was, obviously, the revenue pressures were clear, but your margin guidance was surprisingly good, given the topline pressure. Can you just talk through some of the steps that you're taking? I think we thought there would be more on that business that you might be losing this year. So how are you going to be able to deliver on the cost side to make sure that you deliver that margin guidance? And then Dave, a lot of speculation around M&A in the industry, can you just talk about how you balance leverage and stock price and looking at strategic opportunities?

Michael McDonnell

I think I'll speak to the first question, and then we can jump into the second one. I think as it relates to margins, when you look at 2013, as we've talked about one of the key drivers of mix in the past, one of the key drivers of margin I should say in the past, has been our mix in our government business.

And the majority of the business that we lost in 2013, it was disproportionate to be off-net side and so that did help our margins. But there were some other things that came through, in particular bad debts in 2013 that we are hopeful that we are moving toward the end of that. And the bad debt expense that we had in the fourth quarter was a bit lower than what we had in the third quarter and we're hopeful that we're closer to be end and the beginning there.

We've always been very, very focused on operating efficiencies. And I think that when you look at the mix, having less off-net in 2014 in the mix than we've had in the past, which we logically will, given the events of 2013 that actually helps our margins. And to the extent that we continue to control our cost and we'll stay focused on and get some upside in areas like potentially bad debts and others. We feel confident that we can preserve our margins at somewhere in the zip code of the 78%.

I think on the M&A, what we look for is just as you said, it's the right transaction at the right time. I think it is a balance between the amount of leverage, and the structure obviously matters and anything that we look at. But we do feel that given the events of 2013 with the IPL and the leverage levels that we sit at that we are in a good position to act on M&A, if it makes sense at the right price. And we'll look to strike the right balance and structure if something avails itself.

David McGlade

And just to add to that, when we look at M&A opportunities besides the ability to have an accretive deal from a free cash flow standpoint, we will look to enhance revenue growth to serve certain regions or customer sets. So it has to fit strategically with what we're doing. And that is the other paramount area to look at. So it really is about short-term doing what we can to delever the company.

Operator

Your next question comes from the line of Batya Levi at UBS.

Batya Levi - UBS

Can you talk about the fibers of the sequential decline we saw in media revenues? And you mentioned that Africa was one of the drivers of the weakness, if you adjust for that, how were the media trends on a sequential basis? And your outlook suggests a relatively stable revenues in this segment, is that off of the 4Q level or '13 full year level?

David McGlade

So we had a little pressure with media in the fourth quarter because of one-offs, which are isolated bad debts, some minor pressures with occasional use, and then a customer issue in the Middle-East, the media customer issue there. So in terms of trends, that depressed our overall results a bit in Q4. We are looking for stable performance in 2014 and the next catalyst for growth will be IS-30 and that's a DirecTV Latin America satellite that launches later this year. So that will create a growth opportunity, but until then it's rather stable.

Michael McDonnell

And overall the stable concept that we're throwing out is really when you compare what we expect in the full year 2014 to what we had in full year 2013.

Operator

Next question is from Doug Mitchelson at Deutsche Bank.

Brian Russo - Deutsche Bank

This is Brian Russo for Doug. Just a follow-up on the previous question on the media trends. I read about the bad debt, I think there was also a comment about, I don't know if it was decline or pressure in Europe, so I was hoping you could you give us a little color on that? And then with regard to the occasional use, do you think you'd see any benefits from the Olympics coming up on this?

Michael McDonnell

Brian, its Mike McDonnell, speaking. I think, when you look at Europe, as Dave mentioned, we had a few isolated instances and what can happen is when you have isolated credit instances, it can show up in a variety of different places, it can be in bad debt expenses, other times it can hit in revenue when you have to move somebody to a cash basis on accounting or move either to a slightly altered and more conservative revenue recognition level.

So we did have some small headwinds in the fourth quarter that we think are isolated to two or three customers that did occur in the media space. And as we've said, we think that the business overall is very stable. I think as it relates to the Olympics, certainly that's something that we've been proud to support for many years running now, but in terms of the aggregate revenue impacts or uplifts from that, they are typically very modest.

Operator

The next question is from the line of Jason Kim at Goldman Sachs.

Jason Kim - Goldman Sachs

If I can follow-up on the topic of M&A. And I'm hoping, if you could talk about your philosophy with respect to the balance sheet parameters in a bit more detail? And coming off from the credit side of things, bond investors are pretty comfortable with the fair amount of leverage in the business like this to give stability in the revenue EBITDA.

So frankly, the company being levered at 7.3x, 7.4x already means that any acquisition you make, can be made with decent amount of that component at the same time. In the past, you mentioned your desire to reduce leverage to create equity value. So given these dynamics what are some of your parameters and leverage as you look for M&A opportunities in the context of the current leverage ratio?

Michael McDonnell

Jason, I'll give you a three reference points on that. I think as it relates to M&A, there is obviously a number of key metrics that we would look at in terms of whether or not something is accretive. I think one of the key ones that we would certainly look at would be free cash flow per share.

And we would look at things, and say based on where we sit today. How do we think that that would impact our free cash flow per share and to the extent that that it was accretive and could accelerate our leverage return models, certainly that would be something that would be more attractive. I think on balance sheet parameters, I think our focus is a little bit perhaps less on multiple of EBITDA and a little bit more on metrics, like interest cover and a maturity profile.

As we said back at the time, that we went public, one of the key catalysts for our IPO was the favorable interest rate environment that we were able to lock in favorable rates for the long-term. And we're down at just under 6.5% across the entire complex right now.

And so I think when we look at an M&A opportunity and we look at what it would do for our balance sheet, I think that we would focus on a variety of things, but certainly our interest cover and our ability to service our debt service obligations would be first and foremost. And we'd certainly look at the maturity profile very carefully. And I think we would look those two perhaps a little bit more than we might look at debt-to-EBITDA multiple as an example.

Jason Kim - Goldman Sachs

And just a quick clarification on your guidance. In the press release, you talked about $400 million or thereabouts in debt repayments during 2014. Is that essentially the same as what you'd expect for free cash flow? Or does that $400 million of debt reduction assume the company using a bit other cash on the balance sheet as well?

Michael McDonnell

It's the latter. If you look at our balance sheet as of the end of 2013, we had about $248 million of cash. And we've said before, that we can pretty comfortably run at $100 million, maybe $150 million at the high-end. So it does contemplate a bit of a use of that cash balance that was a bit on the heavy side at the end of 2013.

Operator

The next question comes from the line of Joseph Mastrogiovanni at Credit Suisse.

Joseph Mastrogiovanni - Credit Suisse

Can you give us an update on the backlog for Epic? Has there been any new contract signing that maybe you can talk about? And then, when should we expect to see the sales activity ramp for the Epic satellites?

David McGlade

That's a great question. We have seen some additional contracts related to Epic. Harris CapRock did an additional agreement that transition from existing capacity to a future Epic satellite. Panasonic Avionics also did a follow-on deal to expand their capacity in Europe and Asia. We also had standard capacity sold on IS-35 Epic, which is our next satellite for [indiscernible]. So that's one where we customize the bean for their needs, but it is not pure Epic high-throughput capacity.

As we get closer to the time of launch, we're going to be in a position to get more deals into the pipeline. That's a natural function of getting closer to the time of launch, where we'll transition existing customers. That being said, we still have a pre-sales campaign underway. And we feel confident that we'll be able to expand another customers and customer applications on Epic. So we feel good about where we are today.

Operator

The next question is from the line of Anthony Klarman at Deutsche Bank.

Anthony Klarman - Deutsche Bank

Few questions. First on the media side, the guidance implied sort of a flattish outlook with the launch that's coming up. How much is DTV expected to contribute to the media business in 2014 with the late launch in the year?

David McGlade

It's pretty modest, Anthony, as you know, you don't get a full year effect in instances where launches occur. So to the extent that that launch occurs as currently scheduled in the back half of the year, you have to go through an orbit testing. And by the time it becomes operational, it would be a fairly modest contribution for 2014, but then you'll get the full year effect in 2015.

Anthony Klarman - Deutsche Bank

And then, if I recall correctly, they obviously had made pretty significant prepayments on these satellites. Can you remind us of how the accounting will work? You have deferred revenue on your balance sheet, which I would imagine, when the satellite goes up, and as in commercial service you start recognizing revenue from them, a portion of which sounds like it will be non-cash revenue that has already come in, and is that a impact or is that accounted for in the guidance, or is that all just sort of reported revenue versus cash revenue?

David McGlade

Yes. So you have it right in terms of how the accounting works. The guidance that we provided is all-in revenue, which would include both cash as well as the cashless piece that we're amortizing. But I would just add to that, that we have typically -- and we'll always continue to manage that cashless level at a very manageable level. While the prepayments are pretty substantial, they amortize over a very extended period of time. And the percentage as cashless we manage to a very, very small percentage in the overall revenue base.

Anthony Klarman - Deutsche Bank

And what is the total period over which the DTV prepayments or similar prepayments are amortized?

David McGlade

Typically, it's life of satellite, so 15, 16 years long time.

Anthony Klarman - Deutsche Bank

And then a question on the bad debt. I guess, I'm trying to get a handle on exactly what controls you're putting in place to help account for the bad debt. I think when we talked last quarter, you sort of felt like these were kind of one-time events, but there seem to be some sort of additional things that have transpired in the quarter. What exactly do you think is driving the bad debt episodes in Africa? And then what controls are you putting in place to sort of account for that going forward and will that be part of what creates a headwind for you on the revenue front, if you're using tighter credit standards before you sign contracts?

Michael McDonnell

Yes, I think at the end of the day what you had is you had a market that move very quickly. And what we had to do is go through and reset a lot of those contracts and work through them. I think that we're closer to the end and the beginning on that. And it's the kind of thing where when the pricing unlocked in that region and started to move, the first place you saw it, was really in bad debt expense where you just saw some change in behaviors in terms of payment patterns.

And we've largely worked through those accounts and we put in controls and we try to price some things at the current market, such that what you end up getting is exactly, as you articulated, you end up with less bad debt going forward. And as I mentioned before, we're hopeful that we're through the worse of that, but because you put entire controls and you have some pricing differentials you end up with softer revenue going forward in that region.

David McGlade

I would put it in three buckets. Really some of our service providers were uncompetitive. So in some instances we had to write-off part of their obligations to us. Others in a very small percentage might have been gaming us and getting our attention. And then others just went out of business. So we feel now that, as Mike said, we worked through a lot these deals and hopefully we can get to a point of stabilization sooner than later.

Anthony Klarman - Deutsche Bank

And then final question from me on the capital structure. Today you've largely --well, in the fourth quarter you've made a pre-payment obviously on the credit facility, which you announced back in October, that's your lowest cost of capital piece of debt. As you think about how to apply the $400 million, is that more likely to be towards the 8.5, which are called later this year and represent your highest cost of capital right now in the structure?

Michael McDonnell

I think the 8.5, certainly that is our highest cost of capital, and I think what it comes down to is timing. We don't have anything callable today. As you said, this do become callable later in the year, certainly we would consider that. I think the other thing that would come into the mix is that while the secured facility is at much lower rate, there is a significant portion of it that is unhedged and is at a floating rate. So we would factor that into the mix and we would look to delever in a spot that gets us to further biggest and most accretive return.

Anthony Klarman - Deutsche Bank

And, Mike, maybe one last one. How do you think about the mix between secured and unsecured debt in the structure going forward? I guess particularly as you think about things like M&A and how you weigh the total. You mentioned one of the things that would have to be free cash flow per share. And one of the ways obviously to do that is to give capital structure around a certain balance of secured versus unsecured, given that you're currently much more heavily weighted to unsecured debt?

Michael McDonnell

I think that's a good observation Anthony. I would say currently I would view us as being significantly under-levered as it relates to secured debt. We certainly can have more in the structure. We have assets that are very actively suited for secured debt. We do have some ratings considerations around increasing the current secured level just in our current complex. But to the extent that we moved into an M&A spot and we were looking to add incremental debt against incremental EBITDA, certainly we would look to maximize secured debt if it made sense.

Operator

The next question comes from the line of Kannan Venkateshwar at Barclays.

Kannan Venkateshwar - Barclays

Just a couple of questions for me. The first is on the pricing trend. In the context of capacity throughout the industry, does that mix trend is expected to go up post '14? If you could just give us some sense of how pricing and spending that would be great? And the second question is on working capital. This particular quarter there seems to be a big jump in the use of cash on the working capital front. So just wanted to understand that a little bit better?

David McGlade

So why don't I start with pricing. And outside of Africa and the Middle-East we're seeing general stability. There are areas of pockets of pressure. Certainly, for our older assets, we're unable to get a higher pricing that we are enjoying with the newer satellites. But as we've talked about before, it's been more of a pricing pressure in Africa rather than just a volume pressure, so that that in a nutshell is where we are.

Michael McDonnell

If the working capital is really tied to interest, we have interest payments that are very much heavier in the second and fourth quarters of the year. And so you have that dynamic happening in the fourth quarter, which is your big driver working capital.

And I would add that, in addition, as a result of some of the refinancing activities that we did with altered payment timing, it was something in the order about $60 million to $70 million of incremental interest expense that moved out of the third quarter and into the fourth quarter from strictly as paid or cash paid standpoint. So the fourth quarter had all in about $467 million of interest paid, not including amounts capitalized. So that was a significant driver of working capital, and my guess would be that's where you're seeing.

Operator

Your next question comes from the line of Chris Qulity of Raymond James.

Chris Qulity - Raymond James

I just wanted to follow-up on the government question. And if you can perhaps give some insights on how you're positioning for some of the new strategic planning by the military to perhaps move towards more disaggregated systems or hosted payloads? And secondarily, have you been able to engage with the government on Epic capacity?

David McGlade

We certainly are working as strategically as possible with our military and government customers. In fact, on the hosted payloads side, I'd say we were really the pioneer in that, have been working that for years and have enjoyed some success, but we look for more. In terms of long-term procurements and being strategic and looking how we can augment the MilSat programs. That's one where we also have done some good early work. And that has led to some RFPs that are now available that we're bidding on.

So I will just say from a personal standpoint, I spent a lot of time lobbying Congress to ensure that we can allow longer-term procurements just as our commercial customers are enjoying. This way we can be strategic, we can customize capacity as need and we ultimately can offer better pricing, which is good for the American tax payer. And actually better for us, because then we can plan long-term and have the visibility that we are seeking.

So I think we have done a great deal as a company. We're working of course as an industry to do everything possible to change the dynamics for our military customer. So in this disaggregated systems, we are well-positioned to take advantage of that. And on the Epic side, we think we have much better performance for them to enjoy on our assets with the 10 times better throughput and up to three to five times better capacity, we offer on the Epic satellite. So we absolutely are engaged with them on Epic as well.

Chris Qulity - Raymond James

And for a military integration capability, they tend to have proprietary stuff in terms of ground equipment. Are there any limitations on their ability to uptake that capacity, given the existing hardware to have feel good?

David McGlade

As you know, there has been a lack of coordination on the satellite assets and the ground assets for MilSatCom. And often the satellites will be ready, but the terminals will not be. We've seen that with [ph] NEOS. So what we're trying to do is just leverage our open architecture and that's what Epic is all about. So it has backward compatibility, its open architecture and it allows us to work with any wave from or terminal that our customers would have, so that they can leverage the investments they've already made. And then as time goes on and they implement new technologies and approaches, we'll make sure that we're compatible for that too.

Chris Qulity - Raymond James

And one final question, Latin America there has been some increased capacity with Hispasat and announcement with Eutelsat. And I guess this morning SES announced a new satellite for that market. Are we running the risk of repeating what happened in Africa over the past five to seven years or do you see different dynamics at play?

David McGlade

There is certainly a possibility of supply and demand imbalance. However, I think we're more insulated in Latin America than we were in Africa and are in Africa today. First of all, the percentage of our business as media is much larger, including DTH, which is a big percentage of our media business. That means we're locking in contracts for the long-term.

Latin America is also at a different stage in its development, so the alternative technologies like fiber are already well-understood, mature and well expanding, not immature to the level we've seen in Africa where prices drop very quickly and created disruption in the marketplace. And that means very quickly pricings dropping, that's for the fiber capacity.

So the other thing I would mention is that IS-30 we've launched later this year totally sold out, IS-31 backup satellites sold out, IS-34 we think by the time it launches will be largely sold out, IS-29 Epic we already have three anchored customers on it and we are well position to have differentiated capacity in the market vis-à-vis our competitors, which today they've been launching standard flat beam technology, which in efficient compared to Epic.

So we feel well-positioned at the same time. Some times this industry rushes into bring capacity, unfortunately it take years to do it and by the time they see the opportunity versus when they can implement it, time has passed and we see pressures. So hopefully that won't be the case in Latin America, but we're doing everything possible to insulate ourselves from it.

Operator

The next question is from Amy Stepnowski at Hartford Investment Management.

Amy Stepnowski - Hartford Investment Management

I was wondering if I could just follow-up on the cancelled contracts that you were seeing in December. As you're looking forward with your guidance for 2014, are you taking into account further cancellations? And are the cancellation contracts that aren't being renewed or contracts that are being broken within the term, if you could just give a little bit more color on what assumptions you're you using, when you think about your revenue going down 4%?

David McGlade

So first of all, we isolate the cancellations to the government business, I was referring to. I believe you're talking about government?

Amy Stepnowski - Hartford Investment Management

Correct?

David McGlade

So on government it's the majority of the pressures that we saw in the fourth quarter that then have a full year effect into 2014. There absolutely could be further cancellations, but that is something that we think we took a very close look at customer-by-customer mapped it out, and have a good feel that within the 15% to 20% reduction year-on-year that we've accommodated those cancellations.

So we feel that we understand what's happening to the best degree possible, but certainly there is not all the visibility that we used to see in the business. And probably other problem of course is that cancellations always occur and by the way they're within the normal terms of the agreements. So are often within the option years, not being renewed. But we usually enjoy a pipeline of activity that has been materialized at this time at the end of the budget year for our government customers, at the end of September.

So we're hoping that the end-to-end services, where we've had great success, by the way we've bid for five contracts, we won all of them. We hopefully can win some more of those as they develop. And we hope certainly with some potential budget later in the year that can be an upside. But with all that being said, our renewal rate is still rather healthy in the government side, even with some of those pressures we've seen. But that was really accounting for the majority of the pressures that we saw that are reducing revenues this year and last year.

Operator

Your next question is from the line of Adam Spielman at PPM America.

Adam Spielman - PPM America

Just a clarification on the guidance. When you talk about the government business being down 15% and 20%, would you be able to provide any general indication of what the mix on that off-net is? Is off-net down certain amount and on-net would be on, down less. Can you help us out on that area?

Michael McDonnell

I think at the end of the day, Adam, as you know what we saw in 2013, the majority of the decline that we saw there was in the off-net. The on-net was pretty solid. We do expect to see a higher proportion of on-net in the decline in 2014 than we saw in 2013, so I think it will be a mix.

But a lot of the off-net business that we saw or that we had up to 2012 that really dried up in 2013, things like hardware purchases and other mobile-on-demand services and that sort of thing, those services have really kind of slowed to a trickle and so there is not a lot of differential that we would expect in 2014. So we think at the end of the day, it will be a mix, but more heavily weighted to on-net than what we saw in 2013.

Adam Spielman - PPM America

Again, second question. Just on bad debt, would you be able to just quickly summarize. What was the amount of bad debt that went against your adjusted EBITDA in '13 that's not recurring in '14?

Michael McDonnell

Well, 2014 is still early, obviously. But the bad debt expense for the full year of 2013 was about $30 million. And in terms of 2014, certainly we would be hopeful that we would be materially below that amount, that $30 million is materially higher than we've ever had before. I think that as we mentioned before, we're through a lot of the reworks and contracts, and so hopefully that stems the bad debt, the softness in revenue will be with us for a while.

I think if you look back at historical, this is another point of reference, that $30 million in 2013 was $8 million in 2012 and it was probably closer to the $8 million than to $30 million from many, many years running prior to that. Where we'll land in 2014 remains to be seen, but we're hopeful that we would move back toward our much more normalized low levels, and not seeing anything like we had in 2013, now that we've worked through the situation in Africa on a lot of these contracts.

Adam Spielman - PPM America

And then just a final, when we read again on the guidance, more softness in network driven by Africa, where are we in cycling through that. I mean I just can't remember exactly when that started and which quarter in '13? Is it just a simple arithmetic of getting through those customers that you have lost or is it more complicated than that?

David McGlade

Well, we first started seeing those pressures, I would say in early second quarter and late first quarter of last year. And we have cycled through a great deal of the reworks. There is still some more to be done in 2014. Of course, other surprises could happen, we don't anticipate them, but we feel that we now have a run rate that we projected in the business. I'd say on top of that you have the pressures of the secular declines within our trunking business including ITS, IPO and managed services.

And we have characterized that around $30 million of headwind a year. So what we've seen is the pricing pressures in Africa. The decline of legacy services swapping the growth that we saw through new services by broadband and mobility. And because we don't have new capacity coming online until Epic, we're unable to get revenue growth from network services until that happens. So we have the demand, but we don't have the capacity right now to service those customers.

Adam Spielman - PPM America

And trunking is completely separate from channel?

David McGlade

So channel is a different category. That largely runs off by the end of 2015 and then it's almost all gone. So that is a headwind as well.

Michael McDonnell

But just to be clear, the $30 million that Dave quoted is inclusive of both channel as well as the trunking.

Operator

Your next question comes from the line of Bryan Kraft at Evercore.

Preeti Doshi - Evercore

This is Preeti Doshi for Brian. I just have one question on the 2014 government revenue. I know the guidance is down 15% to 20% compared to 2013, but the appropriation still imply the flat DOD budget, so I was wondering how you're thinking about the DOD budget and the revenue guidance?

Michael McDonnell

So in our guidance, we have a portion of the reduction, it's for the troop withdrawal in Afghanistan. Another percentage is for the consolidation of capacity that we've seen our customers implement over the last year. The other is around the terminations I discussed, the pricing reductions, and the capacity consolidations that have a full year effect within the run rate.

We have not projected an increase in revenue as a result of the budget deal, and they certainly have to appropriate those funds, which if you think about it, there is supposed to be another $22 billion decline in the 2014 government budget, on top of the $22 billion last year. And all that did with the deal is bring us back to last year's levels. So we started to see those pressures pretty significantly in quarter three of last year and then culminating in the 14% reduction of revenue in Q4.

So we think that, we again, have a pretty prudent approach for this. We thought about all the pressures and upsides within the business, and we've mapped it to every single customer that we have. We obviously cannot see customer task orders come through until they do, so we won't not know future pipeline, until it develops. We hope it grows, but right now it's minimal.

Operator

The next question comes from the line of Romeo Reyes at Jefferies & Company.

Romeo Reyes - Jefferies Company

Just a couple of follow-ups on the government contracts. Can you give us a sense of what's coming up for renewal in the next, I don't know, two years or so? I know you've talked about that, I guess $30 million. But can you give us a sense of that average kind of renewal pricing pressure or re-contracting pressure that you're seeing in contracts?

And of the revenue that you're going to have at the end of 2014, how much of that would you expect to come up for renewal in 2015? And then the second question related again through the government, is there a way to redeploy that capacity for other services, so you can replace that revenue that you're losing from governments with other services?

And the last question for, Mike, it seems like over the next three years given all the reasonable expectations on EBITDA growth from new capacity and Epic, plus the CapEx that you've laid out and the interest expense, and the prepayments that you're going to get, you should be getting about a $1 billion of free cash flow over the next three years. And on top of that you have $250 million of cash. It looks like you have about $1 million or $2 billion to pay down debt. Would you say that you'll use all of the cash flow, and I guess whatever excess cash you have to pay down the debt over the next couple of years?

Michael McDonnell

So Romeo, I will try to take those in order. I think on the first question, typically a standard structure of a government contract might be a five-year contract with one year renewal. So a lot of the renewals come up in the September, October timeframe, some of them come up in the February, March timeframe. I think that as we've laid out our guidance, we've been respectful of the renewals that have occurred and have not occurred.

But typically, we continue to operate in one year budget cycles in that business, although as Dave mentioned before, and as we've said in our commentary, we've seen significant amount of progress on the prospect of the government contracting for longer period of time into this long-term that could be a significant benefit for our model. In terms of redeploying capacity that is not renewed, in some instances we can. For the most part, those redeployments would occur in our network services business, but there is typically a reduction in price as a result of that redeployment.

On the third question, I think that we are committed as we've said to deleveraging. When you look at our business model, we've taken our interest expense down now inside of 6.5%, which across $15 billion gives you about $950 million of debt service a year. And our CapEx in 2014, net of prepayments, if you go to the midpoint of the guidance that we provided is about $525 million. So those two combined against the EBITDA levels that we've guided to, gives you a significant amount of free cash flow.

Obviously there are some working capital things that we have to factor in, the minimal amount of non-cash revenue, and that sort of thing that add up to maybe $75 million to $100 million a year. But even with that, and the modest cash taxes that we pay, there is a significant amount of free cash flow.

And as we've said, our investment pieces, is to retire debt in front of equity using the organic free cash flow on the business. So we're going to use our cash wherever we get the best return in terms of growth versus deleveraging. But we are committed to taking our leverage levels down. That's how we provide returns over the near term until our Epic comes online, when we would expect an enhance growth profile.

Romeo Reyes - Jefferies Company

One quick follow-up if I may, when you talk about your CapEx cycle going down to $650 million to $700 million. Obviously you spent a fair amount of money in '09, '10, '11 and '12, and so you have a bunch of brand-new satellites. Are you looking at over the next eight to 10 years is that going to be to $650 million to $700 million of CapEx, is that kind of like the normal annual CapEx that we should be expecting?

Michael McDonnell

The $650 million to $700 million is intended to be a normalized CapEx number. It does not include any prepayments that we might have under contract. Our prepayment guidance will be separate from that and we only guide to what's actually under contract. But the $650 million $700 million is a normalized to our average level. And we're going to vary from year-to-year, some years we'll be higher, some years we'll be lower. But we think for the long-term as we see it today that that's a reasonable estimate of where we would be on a normalized basis.

Operator

Gentlemen, there are no further questions. So I would now like to turn the call back to Mr. David McGlade for closing remarks.

David McGlade

Thanks, Dave. Our goals for this year are quite clear, keep our planned satellites on schedule and maintain our focus on delevering to create equity value. So thank you for joining us today. The team plans to attend a number of conferences over the next few weeks. And we look forward to seeing you there. Thank you very much. Goodbye.

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Good day.

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