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Executives

Liane Pelletier – Chief Executive Officer, President and Chair

David Wilson – Executive Vice President, Chief Financial Officer

Anand Vadapalli – Chief Operating Officer

Leonard Steinberg – Vice President, General Counsel and Corporate Secretary

Analysts

David Barden – Bank of America Merrill Lynch

David Coleman – RBC Capital Markets

Chris King – Stifel Nicolaus

Jason Frazier – Raymond James

Alaska Communications Systems Group Inc., (ALSK) Q2 2010 Earnings Call July 29, 2010 5:00 PM ET

Operator

Good afternoon, ladies and gentlemen. Thank you for standing by. Welcome to the Alaska Communications Systems Q2 2010 earnings conference call. (Operator instructions.) This conference is being recorded today, Thursday, July 29th, 2010. I would now like to turn the conference over to our host, Mr. David Wilson, Chief Financial Officer. Please go ahead, sir.

David Wilson

Thank you, Damian. Good afternoon and welcome to Alaskan Communications Systems Q2 conference call. With me today are Liane Pelletier, President, Chief Executive Officer, and Chairman of ACS; Anand Vadapalli – Chief Operating Officer; and Leonard Steinberg, General Counsel.

During this call, company statements may include forward looking statements as defined in the US Securities laws. Forward looking statements are such statements that are not historical facts and may include financial projections, estimates of shareholder returns, or other descriptions of the company’s plans, objectives, expectations, or intentions. You are cautioned not to put undue reliance on forward looking statements as actual results could differ materially from expectations as a result of a variety of factors, many of which are outside the company’s control. We discuss these factors in our SEC filings.

Lastly, any non-GAAP measurements referred to during this call have been reconciled to the nearest GAAP measure. You may find these reconciliations, today’s press release, and our SEC filings on our investor website at www.alsk.com.

We will begin the call with Liane providing an overview. Then Anand will discuss operating details; I will cover Q2 metrics and financial performance, and highlights of our strategic investments just announced. With that I would like to turn the call over to Liane. Liane?

Liane Pelletier

Thank you, David. The company delivered strong EBIDTA this quarter from both Wireline and Wireless lines of business. While total revenues fell about 1.5% compared to last year we’re growing where we want to, with Enterprise and Wireless revenues now at 55% of total company revenues. In every quarter we work to outrun secular declines in legacy products with growth in Wireless data and Enterprise data where our strengths lie and market demand is high. Our strategy to navigate the industry transformation consistently placed us well, as we shift the business model with solid execution. We build dominance in data and limit the impact from shrinking commodity voice. We invest behind growth, train our workforce, transform our local assets, shed non-strategic assets and manage costs in lower-value areas.

Within Enterprise we managed transformation as well and we closed Q2 with a revenue split of 88% data and 12% voice. We also announced a compelling investment and an exciting partnership with TekMate, a successful Alaskan IT professional service firm that will help extend the ACS business model in several ways. Immediately it will drive new customer relationships, bandwidth, and hosting sales – all key components of ACS Enterprise data revenue.

Within Wireless, while we lost subscribers again over 40% of post-paid disconnects came from low-value segments – Lifeline, non-pay, and one government contract. As we manage the Wireless business for the long run we focus on financial returns and not on subscriber metrics. Central to our Wireless performance is data growth, up 52% over last year. Anand and David will share some more details in a few minutes.

And since our target Wireless data users rely on our superior network performance we continue to deepen our 3G network. As we sit here today we’ve nearly completed our 2010 build program, an expansion program that covers 72% of Alaska population with EVDO Rev A. The network team performed exceptionally well, mastering both build and performance requirements in a high-traffic quarter.

We remain bullish about the Wireless business and we aim to stabilize it and define our market position more clearly for customers we serve best. Anand will now fill in some details on Enterprise sales translating to Enterprise revenue, and on Wireless operations that move us to a better second half. Anand?

Anand Vadapalli – Chief Operating Officer

Thank you, Liane. I’ll first begin with Enterprise. We closed a large number of contracts in the quarter, with an annual value of $5 million, all data. These wins are working their way through our service delivery pipeline, providing a healthy revenue backlog for the Enterprise segment, and giving us better visibility into future revenues than we had exiting the Q1. Given the mix of sales we closed we also benefit from lower exposure to price compression from carryover in voice, now only 12% of Enterprise revenue.

So, we are delighted with the dollar value of our data wins and we’re delighted with the sources of the growth spanning a range of carriers, commercial, and federal customers who understand and appreciate the creative solutions and network reliability we bring to the market. Several of our recent wins combine ACS’ professional services with our top notch Wireline and Wireless services. For some of our recently acquired customers we serve as their national representatives. These are Alaska-based companies that have business locations in the lower 48. And conversely, we also serve as the Alaska boot from the ground for some lower 48-based companies doing business in Alaska now through ACS.

It’s clear that providing more than connectivity is part of our strategy to drive quality Enterprise revenue. Recent wins and our investment in TekMate begin to demonstrate what sits at the heart of our Enterprise growth strategy. The ACS investment in TekMate is exciting for us. Our investment will allow TekMate to scale their professional services business and that in turn will drive demand for ACS products, since we have an operating agreement in place with TekMate to supply our services to them.

We are excited about the potential because TekMate has one, a large number of customer relationships – some new to ACS and some familiar to ACS – and their experience working together has been very positive. Two, their reputation for excellent customer service. Three, an innovative business model that helps businesses replace the headache of internal IT support with a cost-effective outsource service for all manner of devices, all delivered by TekMate professionals. Four, a model that can work in Alaska and extend into the lower 48 by leveraging the assets of ACS - our undersea cable system and data center in Oregon, for example. Five, a model that is equally compelling for mobile devices as it is for fixed.

We see a lot of legs to the partnership and are excited to build out this part of our Enterprise business strategy. Now I’ll discuss our Wireless operations.

As Liane briefly mentioned, our focus is on returns, mobile data, and the quality rather than the quantity of subscribers. As for returns, revenue and EBIDTA have held up well in the face of a large number of subscriber losses year over year. With 11% fewer subscribers we’ve had only a 1% decline in revenue, and we’ve managed EBIDTA to be in line with last year and at EBIDTA margins that lead the industry.

As for mobile data, we see steady expansion and the penetration of data center devices in our base, which in turn drives HLDI data ARPU growth and overall improved churn. To excel at serving these data users, we’re expanding by 50% the number of sites with 3G technology, including along the corridors heavily traveled by cruise ships. Customers of our principle roaming partner really get a superior data experience when they travel throughout Alaska.

As for Wireless churn, as Liane mentioned earlier, disconnects for the quarter were highly concentrated, with over 40% coming from three buckets. First, since we apply fairly stringent collection standards, churn was impacted by high levels of ACS-initiated disconnects for non-pay, an extra 30 basis points versus Q1. Second, since we do not focus on Lifeline voice customers we lose some of them to a competitor that invests in aggressive Lifeline product, advertising, and marketing offers. And lastly, we lost some users within a large government account to a competitor, a win for them at a price point that translated to a loss-making business for ACS.

We look at customer return ratio among postpaid non-Lifeline customers. This is our largest and most valuable subscriber segment and the segment where we invest most in marketing and customer management tactics. In this segment, churn improved sequentially, dropping 10 basis points for the quarter. Looking to the back half of 2010, we will see churn performance benefiting from improved store formats, more Android-powered devices, and more marketing and retention tactics developed from our competitor and customer research.

Now, to David for the financial review.

David Wilson

Thank you, Anand. I’ll begin with the review of our financial performance, with revenue and EBIDTA comfortably exceeding consensus expectations and cash flow from operations at a record level for the Q2. Success was underpinned by resiliency. Our data centric strategy continues to drive revenue gain and our operating discipline continues to drive healthy margins for a business in transition.

Revenues declined modestly to $84.5 million from $85.9 million in the prior period. We posted strong growth in Enterprise and Wireless Data revenues, $3.3 million more than last year. This growth in data was offset by a decline in voice and excess revenues of $4 million and the expiration of the capacity exchange valued at $750,000. The success of margin management overall ahead of the new revenues that will come from recently-sold Enterprise contracts is the story of our Q2 performance.

Translating our strategic focus and cost management actions into numbers, EBIDTA grew 1.6% to $31.5 million, up from $31 million in the prior year. Wireline EBIDTA was particularly impressive, up 3.2% to $15.3 million with margins expanding to 30.9% from 29.3%. Wireless EBIDTA of $16.2 million was right in line with the prior year, with a 52% gain in data revenue providing a significant offset to lower subscriber levels. Cost containment drove a modest expansion in already industry-leading EBIDTA margins to 46.4% from 46%.

Before looking at metrics, an update on the open tax matters that we covered in detail on our last call. As you will recall, we received a notice of proposed adjustment from the IRS in April that impacted the 2006, 2007, and 2008 tax full years of Crest Communications, a company that we acquired in October, 2008. Our review of the tax implications arising from the IRS audit is substantially complete, and this quarter we booked $29.7 million non-cash charge to potential losses we may incur from tax selections taken by the prior owners of Crest.

The stock purchase agreement provides us with indemnification rights from the selling stockholders to potential tax exposures such as those raised by the IRS audit. We are satisfied that through basic tax planning and our indemnification rights from the selling stockholder request we can ensure that there is no adverse impacts to ACS’ future cash flows arising from the IRS audit. Additionally, we continue to expect that ACS will not be a significant cash tax payer until after 2015.

Now on to metrics. Data device users in the base grew 26% from 23% in Q1, and 13% in Q2 2009. Data ARPU grew to $10.77, up 15% sequentially and 38% annually. Looking at retail access lines, trailing 12 month decline improved to 5.7% from 6.1% a year ago, as a result of continued business line strength and customer migrations from AT&T, who is exiting the residential business in Alaska.

Some quick thoughts on TekMate. From my perspective it is a smart enhancement to our Enterprise business and is a smart investment from day one. The company’s highly regarded in Alaska, it is familiar to ACS, and our 49% investment for $2 million is accreted even before the new business we will see as TekMate’s solutions drive sales for ACS Enterprise Services. The addressable market for TekMate when using ACS’ assets can expand in several ways: across customer segments, across service lines, and across geographic boundaries. We are pleased to see this part of the Enterprise strategy take hold.

And now as to 2010 financial guidance, where ACS is maintaining guidance for dividend payout ratio to be below the 70% to 75% target set by the Board, EBIDTA to modestly exceed 2009 levels, CAPEX to be approximately $36 million, and to pay $29 million in cash interest based on our current debt structure.

ACS is updating its directional guidance for revenue. With revenue from its recent Enterprise data wins working its way through the delivery pipeline, ACS now expects year-over-year growth in revenues to recommence in the Q4 of 2010. Year-over-year revenue growth in the Q4 is not however expected to upset revenue differences in the first three quarters of 2010. As a result, 2010 revenues are expected to be slightly below 2009 levels rather than in line.

Looking at our debt refi: As you recall, our term loan matures in 18 months and our revolver matures eight months from now. Given recent market turbulence and possible volatility over the near term, we are getting in position to execute a deal ahead of year end.

A final item: We’d like to communicate to ACS shareholders the effects of a possible end to the casual tax treatments of ACS dividends. Should that tax treatment shift to ordinary income tax, ACS shareholders will be largely shielded given the majority of our dividends are expected to be computed as a return of capital. Now, back to Liane.

Liane Pelletier

Thank you, David. As you can hear we are reporting familiar themes – we’re transforming the business, strengthening our data business, both Wireline and Wireless, and making the most of our vertical integration that comes with our legacy. For this quarter, two operating highlights emerged: our quality margin management overall and achievement of a meaningful revenue backlog in Enterprise; and outside of operations, a small and smart investment aimed at extending our Enterprise business model. We believe these are the best ways to deliver shareholder value.

As I wrap, let me share that Anand and I will be at the Oppenheimer Annual Technology Media and Telecommunications Conference in Boston on August 11th to share the ACS story. Damian, please now open the line for questions.

Question-and-Answer Session

Operator

Thank you, ma’am. We will now begin the question-and-answer session. (Operator instructions.) Our first question is from the line of David Barden with Bank of America. Go ahead, please.

David Barden – Bank of America Merrill Lynch

Hey, guys. Thanks for taking the question. Would love to kind of follow-up on a couple issues. First, I guess in the front text of the release it says that the government I guess sub-losses are expected to continue for several quarters, but that you mentioned that they were lower-value subs. If you can kind of elaborate a little on kind of the magnitude in terms of number but also in what ways are these lower-value subscribers than the installed base? I guess my second question would be you know, the Enterprise, I guess the lack of Enterprise momentum this quarter seems to be a contributor in having to kind of change the guidance this quarter. I guess last quarter, I was checking my notes, you know, we were talking about a strong funnel, 6% quarter-over-quarter, 19% year-over-year growth and things seemed to be good. And I wonder if you could talk about maybe why things slowed down in the Q2 and what’s changed to get them going again. And then I guess the last question if I could was just David, you touched on the maturity cliff in 2012. You’ve had some pretty attractive rates, cash interest rates on the borrowings that you have out there now. As you mentioned the market’s a little choppier, the rates that you're likely to get are probably not as good. I wonder if you could talk a little bit about the strategy you have. Is it convert? It would seem like the logical option. Thanks.

Liane Pelletier

Thanks, David. Let me start off with the government contracts. So the State of Alaska is the customer we’re referring to and the timeline for customer migrations away from ACS that has been a longstanding supplier to them is a two-quarter view that we have. So we took half of them probably this quarter and we anticipate the second half of those to leave in the Q3. And to put a little color on it, again, since it was a government procurement we do have complete transparency into what was the winning price point and the math doesn’t work for ACS. So the winning supplier offered $14 for nationwide 300 minutes with a free device at the offset and every 12 months a free device refresh. And those devices do include Blackberries. So we obviously tried to retain the business and we put together a good solution for it, but we didn’t come up with those sorts of economics for the state government.

So that’s the substance of the pricing that we referred to that would be loss-making for ACS and the timeline. On Enterprise momentum, why don’t I hand it to Anand and he can provide a little bit around that.

Anand Vadapalli

Yeah, sure. I can color that with three points. One, if you look behind the headline number for Enterprise revenues as a whole and we focus on Enterprise Data, we’ve grown consistently in that space with 12% annual growth reported this quarter in Enterprise Data. And as we said before in prior quarters, the growth in Data has been muted by price compression and commodity voice. Commodity voice revenues are now only 12% of the total Enterprise revenues so the mix is substantially again toward Enterprise Data.

And lastly in the Q2, in one quarter we built a book of business that represents over 10% of our total Enterprise revenues, and this new business is all data. So again, the funnel and outlook, funnel remains at levels similar to what we’ve seen so we expect to see this performance over the upcoming quarters as well. And I’m going to hand it back to David now for the last question.

David Wilson

Sure. So David, you are looking at that just in terms of the debt side we referred to in our prepared remarks. So we’re primarily focused on doing a refi for our existing term loans and we’re looking to do term debt to replace the existing term debt. We’ve had a lot of reverse inquiries coming in from our existing holders. They’ve been very satisfied with their investments and we’re expecting a significant portion of them to participate in a new offering, too.

In terms of price, it’s actually opportune from an accounting standpoint – Intelius is actually out in the market this week, obviously very similar to ACS in terms of a combined wireless, wireline business. Their price talk for that is much improved from I think where the markets were even a couple of weeks ago. So the thought is they’re liable plus 375 with a 2% liable floor and minimum OID. So I think that’s consistent with the deal they did this time last year. And from our standpoint, if we were to refi for those rates we’d be in a situation whereby by the time we maybe extinguish the added money costs that we have our payout ratio would still be comfortably below 75%.

David Barden – Bank of America Merrill Lynch

Thanks for that, David. So with the respect to the convert coming out in 2012, maybe you’re going to let that go and then deal with it in 2012?

David Wilson

Yes, absolutely. So it’s sort of 5.75 coupon, so it’s good debt to have out there and we can run way ahead of that maturity.

David Barden – Bank of America Merrill Lynch

And I apologize, to follow-up real quick with Anand: You said you’ve built a book of business that’s 10% of the exiting Enterprise business, which is kind of a $40 million run rate. Could you clarify that comment? I apologize.

Anand Vadapalli

Yeah. We signed Enterprise Data contracts worth an annual revenue of $5 million, which when you look at the annual value of that that’s a little over 10% of the annual Enterprise revenue we had coming out of last quarter.

Liane Pelletier

Those were the sales that happened April, May, June. And while we were with you all in April we thought some of them were going to happen closer in May, and it was a very busy June in the back half of June. And so it’s the effect of that that landed us a 3% sequential Enterprise growth rate, a 12 annual, a little different than what you had started off in your question in terms of running it. But those sales are in and they’re working their way through delivery, and then when they’re delivered we kick off billing.

David Barden – Bank of America Merrill Lynch

Got it, that’s clear. Okay. Thanks, guys.

Operator

Our next question is from the line of Dave Coleman with RBC Capital Markets. Please go had.

David Coleman – RBC Capital Markets

Thank you very much. I just want to get some clarification on the 2010 revenue guidance. Can you talk about revenue growth returning in the Q4, is that on a sequential basis or year-over-year basis? And then if you could talk about CAPEX plans and anything related to LTE at this point and how we should start thinking about you know, places to build out LTE if there are any. And then just as far as going to the Enterprise, the $5 million of Enterprise revenue bookings in this quarter - over what period of time should we anticipate that that gets layered into the Enterprise revenue growth? And then I guess, sorry for this, but the final I guess question is just on the government wireless subscribers that you lost. You mentioned that the winning bidder I believe was offering $14 per month for 300 minutes. I was wondering how that compares to what they were paying you before you lost the contract. Thanks.

Liane Pelletier

Okay. Dave, why don’t I hand three of those four off to David, but I’ll just kind of finish off really the last question you asked. So we were north of that and by a good amount, it was a very fair price because it’s a very large volume contract. But we did not compete for the new contract at $14, and our current ARPU on that is also north of $14 but below what our consumers spend with us. So that’s why we kind of characterize it in not the highest value subscriber base for us.

David Coleman – RBC Capital Markets

If I could just sort of ask a quick follow-on to that: Your ARPU is around $66 a month.

Liane Pelletier

Yes.

David Coleman – RBC Capital Markets

The new contract that the winning bidder had is $14. Are we looking at sort of the midpoint of the two or are we closer to the $66?

Liane Pelletier

Closer to the $14, actually.

David Coleman – RBC Capital Markets

Okay. Okay, great.

Liane Pelletier

So what our current earnings are from those customers that are moving over is closer to the $14 than the $66.

David Coleman – RBC Capital Markets

Gotcha, great.

Liane Pelletier

Okay, David, so I think David can pick up on the guidance CAPEX.

David Wilson

Yeah, and it may be helpful, David, to give an overview of our Enterprise revenue first cause that’ll kind of reflect on revenue guidance too. So in terms of the $5 million worth of data deals that Anand referred to, we’re working very hard to get them installed as quickly as we can. Some will turn up and we’ll get a nice pickup in the Q3, but I think the vast majority will be booked and up closer to the end of the quarter. So you’re really going to see the pickup in Q4 of this year. That just gives you a sense from a timing standpoint.

As we also said on the call, we still have a very strong sales volume of potentials out there. It’s not as if the cupboards are bare there so we will look to continue to sell and look to continue to build that, maintain that backlog of business to give us a great stepping stone to go into 2011.

In terms of guidance, the expectation is for increases in sales on a year-over-year basis. In terms of the profile of our revenue we continue to have our biggest single quarter being the Q3 and so we won’t be growing I don’t think between Q3 and Q4 on a sequential basis but certainly year-over-year growth in Q4 of this year. Just a small point on Q3 2009 – we did actually enjoy about $2.4 million in out-of-period network effect last year that won’t appear this year. That’s part of the reason why we’re not going to see a year-over-year growth as early as Q3 of this year.

David Coleman – RBC Capital Markets

Okay.

David Wilson

And CAPEX plans for LTE again, it remains a priority, we remain focused on it. And we’ll look to be at follows with everything that’s happening in the lower 48 and that would suggest that we start thinking about doing things and actions in 2011, 2012.

David Coleman – RBC Capital Markets

Just a follow-on to the LTE question: any estimate if you were to sort of you know, cover the same geography that your CDMA network covers, how much the spend would be if you were to build an LTE network?

David Wilson

What I will say is I think we can comfortably afford to do it with the excess cash on top of our dividends. That should substantially fund the build requirements in 2011, 2012.

David Coleman – RBC Capital Markets

Okay, great. Thank you very much.

Operator

Our next question is from the line of Chris King with Stifel Nicolaus. Please go ahead.

Chris King – Stifel Nicolaus

Hi, good afternoon. Just two quick questions for you. First of all, pretty impressive Wireline margin results. Just was wondering how we should think about that going forward, particularly over the next couple of quarters as presumably the Enterprise revenue stream will become a much larger part of the total Wireline revenue picture; how we should think about Wireline EBIDTA margins trending over the course of the next couple quarters. And then secondly, just wanted to ask I guess a bit of a 30,000 ft question with respect to your dividend payout policy and assumably under the knowledge that it remains a poor decision – we’ve seen several of your larger peers certainly lower their payout ratios over the course of the last several years, primarily through acquisitions and the like, but whereas to the point now where most of them are kind of in the call it 45% to 55% or so payout range. Is that something that you look at when making a determination regarding your payout ratio? Or is it just simply looking at your balance sheet and what you guys are comfortable with, and pay not attention to the peer group? Thanks.

Liane Pelletier

Thanks, Chris. I’ll make a comment on dividends, David can build on it and then address the EBIDTA question for Wireline, which we feel good about. So I think one of the things that distinguishes ACS from a lot of its peers is the growth profile of the business. So because we’ve got a big Enterprise growth engine within Wireline, and we’ve got Wireless – as we look at it as a Board obviously we have a lot of comfort with the payout ratios. We’ve got provisions. David, feel free to layer on any comments about that and if you will take up the other one.

David Wilson

Yeah, obviously the Board’s been very clear that a 70%, 75% payout ratio, that’s what we focus on. We’ve been comfortably below that, we’re comfortably below that this year and even with the debt refi we’re positioned to be within that range. So on a firm footing there.

In terms of expectations for Wireline EBIDTA margins, Chris, we don’t give sort of specific guidance on a segment-by-segment basis. But you’re right – as you look at the backlog of Enterprise business that we have it is data. Data is the segment we want to grow in, data is the high margin segment so that should play out very well for us.

Chris King – Stifel Nicolaus

Thank you.

Operator

(Operator instructions.) Our next question is from the line of Jason Frazier with Raymond James. Please go ahead.

Jason Frazier – Raymond James

Hi, good afternoon. Thanks for taking the question. Just starting off, just given your unique MPLS network up in Alaska, I was wondering if you could talk about in terms of Enterprise wins – how many of those are coming as a result of growing the pie versus stealing the pie? And given that kind of network are you attracting a lot more opportunities that may not have been there in the past? And number two, can you talk a little bit about what you’re seeing regarding the tourism industry in Alaska right now? You can also get the roaming revenue on top of that. And what is your expectation for tourism and roaming revenue in Q3? Thanks.

Liane Pelletier

Thank you, Jason, for the questions. Anand, do you want to handle the MPLS and the Enterprise piece?

Anand Vadapalli

Yeah. And you’re right, Jason – a lot of the wins are because customers recognize the quality of our network, and the wins are both new business and stealing share. So that’s healthy for us. So it’s a combination of both, but it’s exactly on the quality of the network and the services that we layer on top of it. So thank you for the question. Liane, do you want to take the question on tourism?

Liane Pelletier

Yeah. So tourism is not as strong as it has been for the last couple of years. What I would say, Jason, is the roamers that come up and use our network are using a lot of data, and we were very strategic in our placement of additional 3G sites including in the roaming corridors. So volume, I think, per tourist on data is a real landmark thing for this year in terms of total annual spend from roamers, it’s about $4.6 million up.

Jason Frazier – Raymond James

You said $4.6 million?

Liane Pelletier

Yeah, $4.6 million.

Jason Frazier – Raymond James

Thank you.

Liane Pelletier

So it’s a really good experience for their customers and we’re happy to put that together in Alaska this year.

Jason Frazier – Raymond James

Great, thank you very much.

Operator

At this time I would like to turn the conference back to Ms. Pelletier for any closing remarks.

Liane Pelletier

Thank you, Damian. Well, I thank you all for joining us today. We very much appreciate your interest and support of ACS. For those of you at Oppenheimer we’ll see you in a couple weeks, otherwise we look forward to reporting our progress to you next quarter.

Operator

Ladies and gentlemen, this concludes the Alaska Communications Systems Q2 2010 earnings conference call. Thank you for your participation. You may now disconnect.

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