PAETEC Holding Corp. CEO Discusses Q3 2010 Results - Earnings Call Transcript

| About: PAETEC Holding (PAET)


Q3 2010 Earnings Call

November 04, 2010 09:00 am ET


Chris Muller - IR

Arunas Chesonis - Chairman & CEO

Keith Wilson - CFO


Colby Synesael - Cowen and Company

Donna Jaegers - D.A. Davidson

Edward Katz - Morgan Stanley

David Dixon - FBR Capital Markets

Mark Rose - RBC Capital Markets


Good day ladies and gentlemen and welcome to the third quarter 2010 PAETEC Holdings Corp. earnings conference call. My name is Ahmed, 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)

I would now like to turn the conference over to your host for today, Mr. Chris Mueller. Please proceed.

Chris Muller

Thanks, Ahmed. Good morning everyone and welcome to PAETEC's third quarter 2010 earnings call. With me on today's call are Chairman and CEO, Arunas Chesonis; Chief Financial Officer, Keith Wilson. Following our prepared remarks, we will then conduct the Q&A session.

Before we get started I need to remind everyone that in our remarks today we will be making some forward-looking statements about our expected operating results and financial position, our business strategies and other matters relating to our business. These statements involve known and unknown risks, uncertainties and other factors that may cause our actual operating results, financial position or performance to be materially different from those we express or imply in our forward-looking statements.

We have highlighted some of the more important risks and uncertainties in our earnings release. For a more detailed discussion, please refer to PAETEC'S 10-K for its 2009 fiscal year, and in other filings with the SEC. We disclaim any obligation to update any of our forward-looking statements. Please note that in today's call we'll be referring to certain non-GAAP financial measures. These measures are reconciled to the most comparable GAAP measures in our press release and supplemental information which have been posted on the Investor Relations portion of our website, at

Finally, please now that we have posted on the Investor Relations portion of our website a supplemental presentation that will be discussed on this call regarding PAETEC's operating metrics.

With that, I'd like to now turn the call over to PAETEC's Chairman and CEO, Arunas Chesonis.

Arunas Chesonis

Thank you, Chris. Good morning everyone. We are pleased to announce our third quarter 2010 results today. Revenue growth, continued free cash flow generation, and stability in our overall business were themes for this quarter. We were also encouraged by the performance of Cavalier Telephone during the same period.

On a pro forma basis assuming the Cavalier PAETEC acquisition had occurred on January 1, 2010, the pro forma third quarter 2010 results for the combined company would have been 500.4 million in revenues and adjusted EBITDA of 83.9 million. We expect to provide full year 2011 guidance during our next earnings call.

We have been very active with our colleagues from Cavalier since our acquisition announcement in September. Our dedicated PAETEC merger and acquisition team has almost completed its integration planning for our go-to-market sales strategy, product roadmap, network enhancements and fiber expansion opportunities. The regulatory approvals are also proceeding on schedule with the Cavalier closing expected to occur during the fourth quarter of 2010.

As we've introduced more PAETEC employees to the Cavalier team, we have become even more enthusiastic about the combination of the Cavalier network infrastructure with the PAETEC customer base and sales channels. Our customers have also become more aware of our large fiber footprint and now are actively engaging our sales force in new network conversations. I believe our quarterly on-net buildings additions will accelerate substantially over the next few years.

PAETEC's sales performance during the third quarter 2010 was one of our best with the biggest quarterly improvement coming from the west region. Net new additions totaled over 140,000 equivalent access lines compared to the second quarter of 2010 and we achieved our annual goal of net new sales professionals.

Early next year, we anticipate announcing the formal establishment of a small business division within PAETEC. We believe there is tremendous revenue opportunity for PAETEC's broad IP-based product portfolio for commercial customers billing less than $1,500 per month in network services. Adding products like data center and cloud services, equipment solutions, energy offerings, IP security and managed services to the more traditional voice and data services offered to these small business customers while leveraging our national fiber footprint we believe will enable us to minimize both the customer churn and the price compression typically experienced in this customer base and continue our ability to fight unfair with the competition. We expect that this small business division will become another sales channel for our company.

The majority of our new network sales each month are IP-related services. As a result, we continue to see overall IP traffic growth and we completed many network projects during the quarter. One notable example was the activation of a new high capacity Great Lakes Regional Fiber Ring connecting Detroit, Cleveland, Columbus, Dayton, Indianapolis, and Chicago. We also completed data network upgrades in 11 western markets with the latest Cisco core and edge equipment.

Additionally, we continue to aggressively migrate our existing customers to the next generation IP network services to ensure we maintain the long term customer relationship. In this evolution however we do experience a short term EBITDA reduction per customer until we can upsell them the additional products now available via the IP infrastructure.

As we mentioned during last quarter's conference call, we are extremely excited about data center expansion program. This quarter we have ribbon cutting ceremonies at our Andover, Massachusetts and Houston data centers. During, the next few months I will be attending similar ceremonies in our new data centers in Phoenix and Milwaukee. The end over site which opened in mid August had already sold approximately $1 million annualized and continues to generate strong interest in the marketplace.

We are currently planning our future data center expansion projects and expect to introduce four to six new facilities throughout the US next year. We believe that our customers will continue to become more comfortable at outsourcing their our internal IT functions and you should expect that during our annual May Investor Conference in New York City we will explain in greater detail PAETEC's overall cloud strategy.

Before Keith steps you through the financials, I would like to review our strategic acquisition program again. As we said at the end of last year, after our Board of Directors approved the company's five-year strategic plan we anticipated focusing on two or three tuck-in acquisitions in a larger regional telecom company each year to help drive scale, increase network assets and fiber infrastructure or to enhance the product portfolio. We have accomplished our 2010 goals with the pending Cavalier deal and the acquisitions completed earlier this year of US synergy and Quagga.

We see similar opportunities for 2011 with respect to potential acquisitions. We believe that two or three tuck-in deals and a larger regional telecom provider will provide the appropriate balance for creating value for shareholders while ensuring merger integration activities can be reasonably handled with our existing personnel resources. There are many interesting acquisitions targets in our industry but please be assured that we will always maintain our long term conservative business approach when reviewing potential opportunities.

And now I'll turn the call over to Keith to walk you through the financials.

Keith Wilson

Thanks Arunas and good morning everyone. We are pleased to share our Q3 2010 operating results which were marked by continued expansion in revenue growth. Before we get started with our financial discussion I would like to point out some of the third quarter highlights.

Continued growth both sequentially and year-over-year, primarily due to the inclusion of revenue from equipment solutions sold by Quagga and the strong contribution of PAETEC's energy resell solutions. Core network services revenue per customer increased to $188 or 8.9% to $2,292 in the third quarter 2010 over the third quarter of 2009.

For the past several quarters our business has been migrating to a larger customers that tend to be stickier long term relationships and allow PAETEC to generate better operating margins to broader upsell opportunities. Consistent with increased revenue per customer, average Ts per customer increased 25.7% to 4.4 in the third quarter 2010 versus 3.5 in the third quarter of 2009.

Continued strong growth in overall access line equivalents as Q3 2010 ALEs increased 5.8% to 6.2 million from 5.8 million at Q3 '09. Continued investment in our infrastructure as our metro fiber miles increased 3.5% to 5,950 miles on a year-over-year basis. Growth in our sales teams consistent with the stated goal to drive our sales teams to better position PAETEC for growth. Our direct sales force grew 24% to 451 at Q3 2010, up from 365 at Q3 '09; the 31 consecutive quarter of positive free cash flow. And now let's turn to the financial discussion.

We will first walk through our income statement results on a third quarter year-over-year basis followed by a sequential quarter-over-quarter basis. And finally we will follow-up with a pro forma analysis including Cavalier Telephone. So let's start with the third quarter year-over-year analysis.

Our third quarter 2010 total revenues of 408.4 million increased 3.2% or 12.8 million from the third quarter 2009. Primarily due to the inclusion of revenue from recently acquired companies more than offset a decline on usage-based revenue and a 3.4 million decline in non-core basic telephone service revenue or POTS.

Core network service revenue decreased 2.3% or 6.5 million to 280.6 million for third quarter 2010 from third quarter 2009 due to lower usage-based revenue and continued rate compression. Core carrier services revenue for the third quarter 2010 was relatively stable at 45 million compared to third quarter 2009.

The integrated solutions revenue at 37.5 million for the third quarter of 2010 increased 21.3 million over the third quarter 2009, primarily due to PAETEC's February 28, 2010 acquisition of US Energy Partners and the June 7, 2010 acquisition of Quagga Corporation.

Adjusted EBITDA for the third quarter in 2010 declined 3.2% to 62.2 million from adjusted EBITDA of 64.2 million for the third quarter in 2009. Adjusted EBITDA margin which represents adjusted EBITDA as a percentage of total revenue decreased to 15.2% for the third quarter in 2010 compared to 16.2 for the third quarter of 2009.

Overall margins were negatively impacted by higher cost of goods sold and SG&A expenses primarily related to the companies recently acquired by PAETEC. Cost of goods sold for the third quarter of 2010 was 206.3 million representing an increase of 11.8 million or 6.1% from the third quarter of 2009.

The increase in cost of goods sold for the third quarter of 2010 was a result of an approximate 3 million increase in special access rates and associated unbundled network element or UNE migration costs. Higher costs associated with the equipment sales from Quagga and substantially higher cost associated with the resale of energy services.

The increases in special access cost were detailed in our second quarter earnings and are expected to improve in 4Q 2010 to the UNE conversions that converted in the third quarter and ongoing during the fourth quarter. As a result of higher cost, gross margin for the third quarter 2010 decreased to 49.5 from 50.8 in the third quarter 2009.

SG&A expenses for the third quarter of 2010 were 142.5 million including stock-based compensation of 2.7 million, which represents an increase of 1.2% or 1.6 million from the third quarter of 2009. The increase in cost was primarily due to higher staffing levels and PAETEC's sales force and the additional headcount from the Quagga acquisition.

As a percentage of total revenue, SG&A expenses were 34.9% for the third quarter of 2010 compared to 35.6 for the third quarter in 2009.

Our net loss for the third quarter of 2010 was 14.8 million compared to net loss of 6.5 million for third quarter of 2009. The net loss for third quarter 2010 included 3.7 million of acquisition costs and 3.2 million of additional interest expense.

Interest expense for the third quarter of 2010 increased to 23 million from 19.8 million for the third quarter of 2009. The increase in interest expense was primarily due to higher weighted average interest rates following PAETEC's January 2010 issuance of 300 million of additional 8 7/8% senior secured notes due 2017.

Now let's turn to a sequential comparison of the third quarter revenue to the previous quarter. Total revenue of 408.4 million for the third quarter of 2010 increased 3.1% or 12.3 million from the second quarter 2010, primarily due to the full quarter inclusion of the results of Quagga and the strong contribution of the resale of energy services.

Core network services revenue declined by 1.5% or 4.2 million from the third quarter of 2010 from the second quarter 2010 primarily due to a decline in usage-based revenue and a continued compression associated with IP conversion. Core carrier services revenue of 45 million for the third quarter of 2010 was stable from the second quarter of 2010.

Integrated solutions revenue of 37.5 million for the third quarter of 2010 increased 64.8% or 14.8 million from the second quarter of 2010, primarily due to the inclusion of the fourth quarter results from Quagga and the growth and resale of energy services.

Adjusted EBITDA margins, adjusted EBITDA of 62.2 million for the third quarter of 2010 declined 4.5% or 2.9 million from the 65.1 million for the second quarter of 2010. Adjusted EBITDA margin was 15.2% for the third quarter of 2010 compared to 16.4 for the second quarter of 2010, primarily due to higher cost of goods sold in SG&A expenses. That

Third quarter 2010 cost of goods sold increased 4.9% or 9.6 million from the second quarter 2010. The sequential increase in costs were associated with the increase in special access rates and UNE migration cost and the full quarter impact of costs associated with Quagga equipment sales. As a result of higher costs gross margin decreased to 49.5% for the third quarter of 2010 from 50.3 in the second quarter of 2010.

SG&A expenses for the third quarter of 2010 were 142.5 million including stock-based compensation of 2.7 and increased 4.2% or 5.7 million from the second quarter of 2010. As a percentage of total revenue SG&A expenses were 34.9% for the third quarter of 2010 compared to 34.5% for the second quarter of 2010. Increases in SG&A were primarily attributable to the recent acquisition of Quagga and additional staffing levels.

Net loss for the third quarter of 2010 increased to 14.8 million from a net loss of 7.5 million for the second quarter. The net loss for third quarter 2010 primarily reflected higher SG&A expenses and the 3.7 million of acquisition costs.

Capital expenditures for the third quarter of 2010 were 34 million or 8.3% of total revenue compared to 27.7 million or 7% of total revenue for the third quarter of 2009. Capital expenditures for the third quarter of 2010 were largely applied to PAETEC's network including investments in our fiber infrastructure and network enhancements in specific markets to support growth, facility improvements and continued expansion of PAETEC's data center portfolio.

Capital expenditures for the third quarter of 2010 increased 2.6 million from 31.4 million for the second quarter of 2010, primarily due to the timing of certain network investments. Capital expenditures as a percentage in total revenue for its third quarter was 8.3% as compared to the second quarter of 2010 at 7.9% of total revenue.

PAETEC had cash, cash equivalents and short-term investments of 125.3 million on September 30, 2010 compared to a June 30, 2010 balance of cash, cash equivalents and short-term investments of 125.6 million. Cash flow provided by operations increased to 41.6 million in the third quarter of 2010 from 40.8 million in the third quarter of 2009.

Free cash flow for the third quarter of 2010 was 28.2 million, which represented a 5.5 million decrease from the second quarter of 2010 and was the company's 31 consecutive quarter of positive free cash flow generation.

At September 30, 2010, PAETEC had 950 million of debt outstanding under its senior notes, which was comprised of 650 million principal amount of 8 7/8% senior secured notes due 2017 and 300 million principal amount of 9.5% senior unsecured notes due 2015.

At September 30, 2010, PAETEC also had a senior secured revolving credit facility under which no revolving loans were outstanding and under which PAETEC could obtain from time-to-time revolving loans of up to an aggregate principal amount of $50 million.

PAETEC repurchased a total of 1.463 million 100 shares of common stock for an aggregate cost of 5.8 million or $3.97 average cost per share in the third quarter 2010. Till August of 2008, PAETEC has repurchased approximately 10.4 million share of common stock for an aggregate price of approximately $2.75 per share under its current and previous stock repurchase programs.

On the acquisition front, on September 13, 2010, we announced a definitive merger agreement to acquire Richmond-based Cavalier Telephone Corporation in an all-cash $460 million transaction. Cavalier is a privately held company with over 570 collocations and approximately 17,000 fiber route miles in PAETEC's existing service footprint. When completed, the transaction we will position PAETEC as one of the largest competitive communication providers in the US.

Highlights of the transaction include; the combined company will have over 37,000 fiber route miles, of which 10,600 are metro fiber route miles. The combined company will have nearly 1,178 collocations and have a presence in the 86 of the top 100 metropolitan statistical areas.

On a pro forma basis for PAETEC and Cavalier, assuming the acquisition had occurred on January 1, 2009, third quarter 2010 revenue would have been 500.4 million, an increase of 1.3% or 6.3 million over the third quarter of 2009 revenue of 494.2 million. Pro forma gross margin for the third quarter 2010 would have been 50.8% compared to 51.8% for the third quarter of 2009.

For the third quarter 2010 pro forma adjusted EBITDA would have been 83.9 million, a decrease of 3.6% from the third quarter of 2009 pro forma adjusted EBITDA of 87 million. Pro forma net loss for the third quarter 2010 would have been 19 million compared to third quarter 2009 pro forma net loss of 16.8 million; expected synergies which include expected annualized savings of 25 million in the first 12 months following the close of the acquisitions and expected annual cost savings of $30 million beginning the first 12 months thereafter.

That concludes our prepared remarks, and I would now like to ask the operator to open it up for questions.

Question-and-Answer Session


(Operators Instructions). And your first question comes from the line of Colby Synesael with Cowen and Company. You may proceed.

Colby Synesael - Cowen and Company

Thanks for taking the question. I have two of them. I guess one just relates to the quarter and one more strategic. As it relates to the quarter, third quarter seasonality, specifically within integrated services, whether it was the energy business or the resale business was higher than we were anticipating. Curious if that was in-line with your own assumptions, and then if you could talk about what we should see in terms of the fourth quarter because of that seasonality?

And then the second question has to do with additional acquisitions. If you read through the ITC DeltaCom filing associated with their acquisition with EarthLink, it looks pretty clear although they don't specify your name specifically, that you guys were involved in that process as well. So it does seem to be that you are looking at other acquisitions. Can you just give us a little bit of color on your thoughts there? Thanks.

Keith Wilson

Yes Colby, let's see, this is Keith. I will take your last question first on acquisitions. We don't comment on other peoples' SEC filings so I would just kind of go with no comment on that.

Colby Synesael - Cowen and Company

Well, maybe I could ask it in a different way which is, you obviously just made a meaningful acquisition with Cavalier. What's your appetite to take on additional acquisitions while you're integrating this one? Do you feel that you have that capacity? And for as it relates to your balance sheet, is there a specific amount that you'd be willing to take on in terms of additional debt, if you were to look at a different acquisition?

Arunas Chesonis

Yes Colby, its Arunas. I think its good you rephrased that question little bit. I think the way our management team looks at it right now, Caliver is not sort of a broken company. Danny and his team has done a really nice job driving some of the results for last several years and stabilize on the business and really growing the fiber side of the house. It's in our core footprint, so we have been very pleased with how we feel the integration is going to go, much quicker than some of the other mergers that were out of footprint for us. So we think just like we mentioned in our opening remarks, we could handle one other sort of regional telecom player sometime in 2011. And we don't see ourselves stretching the balance sheet too much. Again, the way we've always talked about it with everyone, going up to maybe four times leverage in the short term knowing that with synergies, very easy synergies on the network and SG&A side. You can drive that leverage back down below 3.5. That's sort of the some of the bumpers that we would be looking at. Again, there is a lot of opportunities out there and some companies are more difficult to integrate than others, and we'll see how it goes this year.

Keith Wilson

As it relates to the seasonality of ISG, Colby, as it relates to the energy piece, and again we'll give you anecdotally granularity but I'm not going to kind of, I will give you direction for fourth quarter not necessarily specificity there. It was on the energy side. It was a warm summer and our kilowatt hours were up during the summer time. That is a trend that we do expect to see in the energy business, strength based again on degree days that you will see both in the winter time and in the summer time. We would anticipate that you will have less degree day pressure or support rather for the usage of energy in the fourth quarter.

That being said, there was definitely a growth dynamic that happened within that, above and beyond, just kind of usage patterns that you will see. So spring fall, a little bit lighter; summer, winter, are going to be greater usage patterns.

On the equipment side, we actually saw very good quarter on the equipment side and again we've always said that that's a similar of a lumpy business but we do think the trajectory, both Quagga west and Quagga east was very good for the quarter and we look for, we expect that we will continue to see strong momentum out of that because it was broad based, it wasn't just through a singular sale or two.


Your next question comes from the line of Donna Jaegers with D.A. Davidson. Please proceed.

Donna Jaegers - D.A. Davidson

Hi guys, two quick questions on the UNE conversions. What sort of throughput are you getting from the Bells and converting that from special access to UNE? And then on traction in the McLeod regions, can you comment on what you're seeing in the mid-part of the country?

Arunas Chesonis

Sure Donna. On the UNE conversions, I think Verizon tends to be the most restricted of the carriers. We are pretty much allowed about 200 conversions per week with their rules of engagement. Its really not sort of a physical impediment, its just their own internal policy, which is something that we've been trying to raise as an issue with the SEC and other PUCs for a while now as well as our other carrier colleagues. AT&T is more flexible on those conversations and it just takes time.

As far as the west region, the sales were actually up probably, I want to say close to 50% in the third quarter for new bookings in the western region from the first quarter. It got some substantial improvement. I think Texas was one of our lower performing markets over the last year and with some fresh management the last three quarters and some new employees, they really gotten some momentum going as well as some other markets like in the Bay area and Portland. So, we feel very good about what progress the west has been making.


(Operator Instructions) And your next question comes from the line of Edward Katz with Morgan Stanley.

Edward Katz - Morgan Stanley

Hey guys. I just wanted to ask about typical book to bill cycles that you might be seeing as we look towards 4Q and into 2011. Looks like the access line equivalent ads were the strongest that we've seen in some time and I was wondering kind of how the revenue trajectory is going to shake out given those strong sales?

Keith Wilson

Thanks for the question. This is Keith. We have seen on the boarder more sophisticated solutions which has been a big propensity of what we've been selling is that that kind of install to cash cycle is a little bit longer than what we've seen, kind of in the sort of the classic 3 or 4T single location customer. Typically, that's running kind of 60 to 90 days depending on how the network gets built out. So it is a little bit of a drag from kind of classic solutions. But, again, we are expecting that there will be some support from previous quarters that will roll in through the fourth quarter.


Your next question comes from the line of David Dixon with FBR Capital Markets. You may proceed.

David Dixon - FBR Capital Markets

Jumping around a few calls here, so I apologize if you've answered this question in your prepared remarks, Keith. I wanted to just focus on the margin expansion opportunity going forward, if you could provide any additional insights from the Cavalier acquisition, to what extent there might be opportunities to exceed expectations going forward. I know we've talked about this in the past, but one of the things I see, particularly with the Cbeyond acquisition announced last evening, as they move further into the cloud. You know you're moving up in the managed services, to what extent you see that you can continue to scale this business model, is one of the things I would like to focus on this morning. And then, just wondering if you could lastly comment on the competitive dynamics you are seeing in the Ethernet space, where you're better positioned today relative to prior periods. Thanks very much.

Keith Wilson

Yes, thanks for the question David. We recognized that our EBITDA and gross margin had a step down this quarter and well not directly to your question, I think it is an important context to recognize that between the end of the merger considerations for AT&T and BellSouth as we had talked about on the second quarter call, we were going to take a short term hit in network cost as we recalibrated the company to address those issues. And those issues were really being driven by taking ourselves and restructuring our contracts with the Bells to allow us to do a more robust UNE conversion. So we do expect that we will pick up a good chunk of that pressure that we saw this quarter back in the fourth quarter. So we do expect that 15.2% is not really a jump up point from a margin standpoint that it will be back up into 16 ranges. Now, both Energy and Quagga are lower margin businesses but it should not have had that level of an impact.

As you think about the next piece which is Cavalier, the pieces behind Cavalier was really to be able to continue to drive the debt of that network to improve overall network cost. So we do think that there is some real scalability opportunities there, not only from the immediate middle mile and transport layer but on the last mile layer, which will take a longer cycle time; won't happen in the first three to six months of the transaction, will be over a period of 24 to 36 months of moving circuits and building out last mile loops to be able to leverage that piece.

And then really the final piece, I'll let Arunas talk about a little bit because he mentioned in some of his comments. We most certainly see opportunities in the Cloud and we do think that the balance of social acceptance of that platform versus being able to leverage the more sophisticated product set will provide extremely high margin opportunity for us, once we are able to get some leverage off to the customer base. But I'll let Arunas talk a little bit more about his expectations on the Cloud.

Arunas Chesonis

Sure. David, we've talked about this before in the past. I think, if you step back a few years, our average customer was three or four T1s billing $1,000 per circuit per month typically with all the usage components and port components. And that was a 3 or $4,000 a month, medium sized enterprise customer which was nice. But with the price compression, with the move to the IP networks, that average customer is doing 14, 1,500 a month. So all of a sudden you've got someone that was traditionally part of as a very small business client and they have got three or four circuits and maybe having two or locations on multi-side. It's just not a pure straight-up one side competitive situation against the cable provider; it's more complicated than that. And with the new products and services, with the opportunity with the Cloud technology, we think we can get that $1,500 a month network customer between IP security managed services, some other host of solutions and collocation. We've throw in a little bit equipment, with all works and IP simple, energy here and there, and before you know that account builds $4,000 a month again. And there is a lot of growth we still think its going to happen in the long run from the small business type of customers.

So I think it's a different dynamic than it was five years ago. We also have a different underlying cost structure as Keith said. We didn't think it made sense to invest billions of dollars in a nation-wide collocation UNE network with fiber to those central offices back to your own switch sites. But when you could acquire it for pennies on the dollar via some of these restructured companies, now you have an underlying structure that also allows you to make more money on those smaller customers as well on the network side. So I think it's a bunch of different areas sort of converging together around the same plant, and we think now is the right time to drive the whole brand new channel for PAETEC.

In many ways, we always have told you that we like the carrier business on the wholesale side, but keep it throttle somewhere between 15-20% of the business, and we think that the same thing is going to occur in the small business division. Keep it in sort of that 20-25% of the overall business but take advantage of it and really try to drive some revenue out of that, because as you acquire other companies there will be components of those acquired companies that will have small business clients and you don't want to walk away from that kind of stuff. So I think in a lot of different ways we are extremely excited about this new small business division and what it could do for us in the long run.

Keith Wilson

And I guess David I just finished up saying that we are not changing our long term view in terms of where we think the margins for this business could and should be. Mid 20s continues to be the target. We'll stand by that despite what we see as an accelerated pressure on rate reduction coming out of IP transition which we are aggressively pursuing and then we are really in the mid stuff. But we still believe that that margin target is appropriate and are working towards that.

Arunas Chesonis

And I don't want to miss sort of David your last question on Ethernet opportunities. I think we've been pretty aggressive rolling out at least 10 to 20 Ethernet NNIs with other carriers in markets every quarter for the last couple of years and we'll continue to do that. We'll participate in the Ethernet exchanges and make it just a much easier way for all the carriers to do business in a way that we can operate much more seamlessly than maybe some people realize we all do. But the Cavalier acquisition also gives us the opportunity immediately upon closing go after some of the facilities they have. They are driving a lot of Ethernet over their own copper and fiber infrastructure; they're using the headers equipment out there. We see ourselves not just taking advantage of that but also introduce in that throughout the McLeod footprint that we really haven't done in the past. And then you'll also continue as Keith said to see us drive those last miles, those on-net buildings, we'll have our own Ethernet connectivity on our own fiber as well.

So I think, you hit on one of the top three products that we're selling right now, which is the Ethernet, different services over Ethernet facilities. And sometimes I think we get ourselves warmed up and confused as an industry on MPLS Ethernet Dynamic IP and how all these play out together. They're not all apples and oranges. So I think we need to take a couple of hours in May when we're at the Investor Day and really step you through that.


(Operator Instructions). And your next question comes from the line of Mark Rose with RBC Capital Markets. Please proceed. Mark Rose, your line is open. Please proceed with your question.

Mark Rose - RBC Capital Markets

Thank you. Most of my questions have been answered. Just kind of one question to follow-up on your comment. In core network services, with the compression when you're going to the IP platform, can you put any metrics or quantify where we are in that process to give us a comfort? Obviously, revenue came down this quarter a little bigger than we expected. How can we look at that over the next 12 to 18 months?

Arunas Chesonis

Well Mark, that's a great question. I think it's a little difficult to give you specifics on that but the sense that we have is that we're about half way through a five or six-year transition from the traditional customer driving most of the revenues through a TDM network to driving most of the revenues through PAETEC on an IP network. But that gives you sort of a general sense.

Keith Wilson

And Mark on an apples-to-apples basis, what we are seeing today is a price reduction on like services. And again to Arunas' earlier point, the whole goal on the IP side is not to deliver like services but is to make that transition and then upsell for things that not only you can do or you should want to have as part of your IP solution set. You're looking at a 20-25% write-down over the contract cycle.

Arunas Chesonis

Mark, if you are not adding any new services on top of that IP infrastructure, if you are not doing the managed router, the network firewall, intrusion detection, prevention, all those types of services that you can't do it with an IP connection, then you are going to see that 20-25% hit. So as a target for us, we are trying to keep that somewhere between zero and 10% write-down off of kind of that core service.

Mark Rose - RBC Capital Markets

Right. Shouldn't margins at some point expand on this new platform I guess when you are collapsing the expenses related to the old?

Arunas Chesonis

Yes, you are absolutely right and that's the tricky part of the entire process, because most of us in the business have capped our TDM switches and we are driving all the new CapEx at a lower per unit basis on the IP network infrastructure. But you still have to operate that TDM network, because you're still adding traditional TDM services and PRIs and enhanced toll free services for customers that still haven't gone through the conversion process. So that tail will still be out there. So you really, you can minimize some of the other operations in two or three years but you still have to operate them.

Keith Wilson

Mark, to the point, and this sort of dovetails into earlier questions we've had over last couple calls on data centers, the big drive for us in data centers, not only because we think it's fundamentally a good business but we're sitting there with a significant infrastructure and every one of our markets with an average of five to 10-year leases left on these big physical facilities that are no longer necessary the long term because of the different size and scope of what the IP infrastructure is. And so what we're working to do is part of the data center initiative is to transition that into a leveragable use of that space. We've already got the HVAC, we've already got the fire suppression, the electrical, that stuff doesn't go away. So we are trying to do is leverage as building up these data centers as quickly as we can, using the space that we have and the existing infrastructure that can be leveraged on the backs of the transition IP.

Mark Rose - RBC Capital Markets

Interesting, that makes sense. Thank you.

Keith Wilson

Okay, thank you.

Arunas Chesonis

Well thanks everyone for joining us on a very, very busy earnings day. We'll let you all go and we'll see you next quarter. Bye-bye.


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

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