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FairPoint Communications Inc (NASDAQ:FRP)

Q1 2014 Results Earnings Conference Call

May 06, 2014, 8:30 am ET

Executives

Paul Taaffe - Vice President of Corporate Communications and Development

Paul Sunu - Chief Executive Officer

Ajay Saberwal - Executive Vice President and Chief Financial Officer

Analysts

Matt Swope - Baird

Sean Brown - Teton Capital

Operator

Good day, ladies and gentlemen, and welcome to the first quarter 2014 FairPoint Communications Incorporated earnings conference call. My name is Janeta, and I will be your operator for today. At this time, all participants are in listen-only mode. Later, we will conduct a question-and-answer session. (Operator Instructions). As a reminder this conference is being recorded for replay purposes.

I will now like to turn the conference over to the Mr. Paul Taaffe, Vice President of Corporate Communications and Development. Please proceed.

Paul Taaffe

Good morning everyone. Our speakers today are Paul Sunu, Chief Executive Officer and Ajay Saberwal, Chief Financial Officer.

I would like to remind you that certain statements made during this call, which are not based on historical facts, including any statements relating to financial guidance may be deemed forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Because these forward-looking statements involve known and unknown risks and uncertainties, there are important factors that could cause actual results to differ materially from those expressed or implied by these forward-looking statements.

With that, I will turn the call over to our CEO, Paul Sunu.

Paul Sunu

Thank you, Paul. Good morning. Thank you for joining us. We have been working toward 2014 for some time now. Our four-pillar strategy provided our functional teams with purpose and an agenda.

Since 2011, we worked to improve operations and we achieved that objective and continue to make improvements. In 2012, we worked to change the regulatory environment. We achieved a level playing field in Maine and New Hampshire through legislation and an incentive regulatory plan in Vermont. In 2013, we set off to stabilize and transform our revenue and we announced that we entered into that period of revenue stabilization during our second quarter call last year. By working together to successfully execute the four-pillar strategy, we brought together a strong, collaborative, talented and experienced management team. And now in 2014, as you all know, we have our labor negotiation. I will be sharing some information on that topic later in this call.

First, let me give you a little color on the first quarter. Generally, I am pleased with our results as we posted strong first quarter adjusted EBITDA and unlevered free cash flow numbers and our business trends will keep moving strong. However, we did post lower-than-expected revenue numbers for the quarter. This was due to three reasons.

First, our fourth and first quarter numbers tend to be lower than our second and third quarter due to seasonality of our business. First quarter, as expected, showed the continuing impact of seasonal disconnects, but in recent weeks, we have seen those seasonal customers begin to return to our markets and reestablish service.

Second, we do small selective rate increases throughout the year designed to offset revenue decline from line losses, and we review these selective increases to make sure that our prices remain market competitive. Our first increase for 2014 was instituted in the latter part of the first quarter and so we did not realize much of the benefit from rate increases in the first quarter, but do expect to see its full impact in the second quarter numbers. Now we closely monitor customer responses to these increases and to-date, we have not seen any noticeable change to our churn numbers.

Finally, in the quarter, we discovered that a discount package designed for retention evolved to being used more extensively and beyond its initial scope. Rather than being used exclusively for retention, this package was being offered to a wide array of customers lowering revenue. We estimate the impact of this use to our first quarter revenue is about $1.9 million. We put a hard stop to this and quickly set a course for cure, including instituting new tracking mechanisms but we expect a quarter-over-quarter incremental residual effect into the second quarter of about $200,000.

Now looking at our revenue in the aggregate, we are just $2.5 million behind the 2013 first quarter revenue when we pro forma for the Idaho sale and exiting one of the NECA pools. And as we look forward to the balance of the year, we see continuing strength in many trends.

Our growth products such as Ethernet services and hosted voice continued their strong performance as we leverage our network to provide next-generation services. Growth related products are up 350 basis points versus last year as a percentage of total revenue. Retention efforts we started last year are starting to show positive signs.

Access lines declined 6.8% versus 7.8% a year ago and sequential quarterly residential line loss was under 11,800 lines compared to over 14,300 lines in each of the two previous quarters. Broadband subscriber adds returned as we complete the credit quality improvement initiative that we started last year. We added over 1,750 broadband subscribers in the quarter while we show a noticeable drop in our bad debt expense. Our revenue team continues the sales bookings momentum. Our government and education segment saw a strong E-Rate season, and we expect to see these sales convert to revenue during the balance of the year.

We continue to add more fiber-to-the-tower business. At the end of last year, we crossed the 1,000 tower and over 1,300 connection marks and now we have contracts in hand for over 125 more fiber-to-the-tower connections of which just 44 are new fiber-to-the-tower builds. In addition, we have over 200 more connections being finalized in the pipeline.

I have shared in the past, the accolades our team receives from wireless carriers for our outstanding ability to manage complex projects like fiber-to-the-tower builds. Recently I met one major carrier who relayed to me how impressed they are with our day-to-day operational effectiveness as we are clearly setting the bar higher for others. Only through operational effectiveness can you continue to bring in and retain new sources of revenue and only through operational effectiveness can you build a reputation of quality and service.

Now no area may have a greater level of operational scrutiny than 9-1-1 services. As you know, we are building the next generation 911 system for Maine. This new system updates and upgrades equipment and of course uses fiber connectivity but it also allows access through text messages. We are on schedule and have connected 11 of the 26 public service answering points or TSAPs and these TSAPs handle well over 50% of the emergency calls in the state of Maine.

We also continue to make progress on our New England Telehealth Consortium or NETC project. We have connected over 250 healthcare facilities on our high-speed fiber network to allow for fast and efficient communications. NG 911, NETC and fiber-to-the-tower are the types of businesses we seek as they utilized IP-based technology over our next-generation network and 16,000 miles of fiber.

However, when we convert from TDM to IP, there is revenue churn as Ethernet based services do come at a lower revenue than TDM. Our objective is to cover this churn with new revenues but we could see some upsized technology churn that could exceed the revenue generated from our regular sales bookings for a particular quarter. In fact, in the first quarter, we did see about $400,000 impact from this type of revenue churn from our government and education sector. We do expect to be able to cover this drop over time as we convert the strong E-Rate season into revenue and from our consistent sales bookings.

Now, as many of you know, two of our collective bargaining agreements that cover the majority of our represented employees in Northern New England expire in August. Let me first say, the law permits me to share, from a collective-bargaining standpoint, only what has been communicated between the company and the unions across the bargaining table and nothing more. On April 25, we held the first of our 36 scheduled bargaining sessions. We presented our opening proposals and our presentation was direct and open.

Our core proposals include freezing the defined-benefit pension plan, discontinuing post-retirement healthcare benefits for active employees, moving bargaining unit employees to the contributory benefit plans available to other employees, making changes to lay off and recall provisions and the elimination of the related costs and changes to various other work rules that will allow us to more effectively serve customers. We put forth that this is our opening proposal and we stated that we will bargain in good faith and will show flexibility and creativity in working towards acceptable solutions so long as they demonstrate at the bargaining table a sincere effort to reach satisfactorily restructured successor collective bargaining agreements.

Having said all that, let me reiterate that our driving party 2014 is our commitment to customer service. We have a great network. We have outstanding products and more in the pipeline and through great service, I believe, we can accelerate our momentum. So in summary, through our demonstrated ability to collaborate and coordinate our efforts and to execute on our operating times, we believe we have the components necessary to continue to create value in 2014 and thereafter. I look forward to sharing our progress with you again in August.

So with that, let me turn it over to Ajay to review the financial results.

Ajay Saberwal

Thank you, Paul, and good morning, everyone. I will discuss our first quarter results and focus my comments on the sequential comparison of the first quarter versus the fourth quarter of 2013. We had a good quarter with unlevered free cash flow of $28.1 million, adjusted EBITDA of $64.2 million.

While revenue was lower than we expected, we made up for in continuing cost control, resulting in reported EBITDA and unlevered free cash flow in line with our expectations. Now let me take you through the financial results for the quarter from revenue through unlevered free cash flow.

We reported revenues of $230.6 million in Q1 compared to $233.4 million in Q4. The decrease is due to the continued decline in voice services revenue, resulting from fewer lines in service, fourth quarter revenue assurance activities that did not recur to the same extent in Q1, the impact of promotional discounts and seasonality. Access line losses slowed in the quarter and the 6.8% year-over-year decline was the slowest rate of loss we have seen since 2008 but the use of promotional discounts did negatively impact revenue. Broadband subscribers increased from Q4.

While we continue to stay focused on customer credit quality, the impact from last year's credit quality initiative is beginning to lessen and we expect subscriber count to continue to grow. Ethernet circuits grew 56.6% year-over-year as we see continued strength and ongoing conversion from legacy access technologies. Lastly, other services revenue increased $3.3 million from Q4 of which $3.1 million is related to certain nonrecurring special purpose construction projects.

As Paul said, we are fine-tuning our retention efforts and have discontinued the use of certain promotions that were used too broadly. We are also expecting further rate increases and to be favorably impacted by seasonality and revenue assurance.

Operating expenses before depreciation, amortization and reorganization were flat at $166.4 million in Q1 versus $166.2 million in Q4. Lower legal, bad debt and employee expenses were offset by higher than anticipated contracted services expense, including for tree trimming and building-related expenses. Employee headcount declined by five from 3,171 in Q4 to 3,166 at the end of Q1.

Adjusted EBITDA was $64.2 million in the quarter versus $67.2 million in Q4. The decline in adjusted EBITDA was primarily driven by lower revenue in the quarter. We had approximately $1.4 million in expenses related to our ongoing labor negotiations that as provided in our credit agreement were an add back to adjusted EBITDA in the quarter. Adjusted EBITDA margin of 27.8% was up 70 basis points from Q1 of 2013.

Q1 CapEx of $28.1 million declined from Q4 of $37.2 million and was in line with our expectation. For the quarter, unlevered free cash flow of $28.1 million resulted from adjusted EBITDA of $64.2 million less CapEx of $28.1 million and $8 million of pension contributions and cash OPEB payments. Lower CapEx offset the sequential decline in revenue to yield a quarter-over-quarter increase in unlevered free cash flow.

Our financial guidance for 2014 remains unchanged. We expect to generate $930 million to $940 million in revenue, resulting in unlevered free cash flow of $100 million to $110 million. This results from adjusted EBITDA of $260 million to $270 million, capital expenditures of approximately $125 million and cash used for pension contributions and OPEB on a combined basis of approximately $35 million. For the year, we expect scheduled annual principal payments of $6.4 million and cash interest expense of $75 million to $80 million.

As of the end of Q1, our cash balance was $31.7 million as compared to $42.7 million at the end of Q4. This sequential decrease was driven by the scheduled semiannual interest payment towards the company's senior notes and the payment of 2013 annual bonuses in Q1. Our $75 million revolver remains undrawn at year-end with $15.9 million committed for letters of credit.

So before I turn it over for Q&A, let me reiterate some key themes. Cash balances, adjusted EBITDA and unlevered free cash flow are in line with our expectations, and we continue to show our ability to manage expenses and effectively deploy CapEx.

So with that, let me ask the operator to open the call up for Q&A.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of Matt Swope with Baird. Please proceed.

Matt Swope - Baird

Good morning, guys. Could you comment further, on the other services revenue and Ajay, how much of that you said was nonrecurring?

Ajay Saberwal

Matt, $3.1 million is nonrecurring and this is a special construction projects where there is a variety of these projects. For the most part, they relate to other companies, sometimes our competitors, connecting to our poles to build certain types of networks as well. Now, on an ongoing basis, we get some pole attachment fees but those are small relative to the upfront payment for work done related to connections to our networks.

Paul Sunu

I might add though that, I think one of the things that people need to recognize is that there usually is some sort of one-time things that run through our numbers each quarter. Typically, it's in the revenue assurance area. In the fourth quarter of last year, we had about $2.5 million in terms of a net revenue assurance that popped in and you would just see that in the access line. In this quarter, we ended up having this thing in our special purpose projects. So comparatively speaking, these things tend to stand out a little bit more on a quarter-over-quarter view, but in terms of the trends that we have in the business, we do see these one-time effects happen or usually pop-up on a quarterly basis.

Matt Swope - Baird

I see. So as we model that revenue lines going forward, should still be in the $12.5 million to $13 million range?

Paul Sunu

Yes.

Matt Swope - Baird

Okay. That's great, and then separately, Paul, with everything that's going on with Comcast and Time Warner, you potentially face a more unified competitor in New England. Is it right that or is your understanding that Comcast will now be fully across Maine, New Hampshire and Vermont, where obviously now you are competing against a combination of Comcast, Time Warner and Charter? And how do you think, that could be an opportunity or a threat?

Paul Sunu

Well, first of all, these are formidable competitors and really they are already large. They operate in a -- the fact that they come together doesn't make them any stronger because they operate in their particular designated area. And so if you are strong, and you have got a strong competitive entity, they are going to continue to be strong. I don't know that the relative sizing here is going to make a big deal of difference from our point of view. They are, I think, that in one sense, we now have one competitive product that we get to monitor instead of two. So that might be a little bit better. In the short run, though I think that this announcement is creating some basis for conversation for our sales and marketing side. And so we certainly have an opportunity to talk about the values that we bring and the consistency and the dedication and commitment that we have to the region.

Matt Swope - Baird

As you compare Time Warner to Comcast, as you compete against both of them there, I guess, my impression was always a Time Warner in particular used Maine as a testing ground for some of their new strategies. Have you found one or the other of them to be more aggressive as you compete with them?

Paul Sunu

I have got to tell you that as we look at them, they are both strong. They are strong because the fact that they have local avails available. And so they obviously can do advertising that is more broad-based. Our marketing program has been very local in nature. We will go ahead and target local businesses where we might, as you know, we done these things where we give free parking days in local business areas where we will cover up all the parking meters.

We might be doing things like coffee promotions where we do the, you know, the slips that you put on a coffee cup so that it's not as hot and things like that. So we have been doing things that are a lot more local in nature, and tried to pair it with local businesses. We think that that's been effective and it speaks to the localness of what it is that we do.

The distinction that we have been giving here is that you are competing with a very large national player and while they have resources, we are a regional player and therefore we can be much more dedicated to you. We are large enough to provide you with the latest services over a great network which is newer and we have 16,000 miles of fiber extending through Maine, New Hampshire and Vermont.

So if you are a business, in particular that might cross a state line, we are an ideal partner to work with. And so I do think that, our competitive advantages are there and we have been capitalizing on them and that's part of the reason that I think you see the buoyancy in our revenues.

Matt Swope - Baird

Great, and just last one, Paul. Can you comment just generally on the M&A environment and behind the scenes what transactions might be brewing and what you are thinking on multiples and that sort of thing?

Paul Sunu

Generally speaking, we don't comment on M&A. It certainly seems like, broadly speaking, it does appear that face of the palm that we are seeing with Comcast, Time Warner deal, a consolidation on the cable side may be something that is starting to percolate more. I do think that the telecommunications industry is a consolidating industry and I don't see that as being any different. But from our point of view, we know that we have a lot of work to do, and there is a lot of value creation that we can provide for shareholders by sticking to our four-pillar strategy.

Matt Swope - Baird

Great. Thanks for the questions, guys.

Paul Sunu

Thank you.

Operator

Your next question comes from the line of Sean Brown with Teton Capital. Please proceed.

Sean Brown - Teton Capital

Hi, guys. Thanks for taking my questions. First, just a quick housekeeping question on the nonrecurring part of the other revenues, the construction related. Just wondering what I should think about in terms of margin for those when I try to back into core EBITDA in my model?

Ajay Saberwal

We don't give margin by -- this is one line, one product line in many that we have. But broadly speaking, here is how you may want to think about it. We have a workforce that, we have a significant SG&A expenses. We have not fixed asset infrastructure of poles. From time to time, folks want to connect to this infrastructure and we charge appropriately for this and these are often times data services. But I wouldn't like to get into specifically what's the margin per job.

Sean Brown - Teton Capital

Got it. I understand. You leverage your existing workforce to that and obviously you did quite a good job managing that. Then my second question relates to cable potential consolidation. I don't know if you have run through what the new landscape will look like but in case you have, I am just curious. I know you have said on previous calls that total cable overlap of your footprint is something like 89% or 90%. I am wondering what portion of that would be Comcast and then what portion of that would be regional players or other cable players?

Paul Sunu

The bulk of our coverage is going to be the new Comcast.

Sean Brown - Teton Capital

Got it. Thank you very much for the color, guys. Congrats on the quarter.

Paul Sunu

Thank you very much.

Operator

(Operator Instructions). At this time, I am showing we have no further questions. I would now like to turn the call back over to Mr. Paul Taaffe for any closing remarks.

Paul Taaffe

Thank you again for your interest in FairPoint. We look forward to speaking to you in August when we report our second quarter results. Have a great day.

Operator

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. Have a great day.

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