PAETEC Holding (NASDAQ:PAET)
Q4 2010 Earnings Call
February 17, 2011 8:30 am ET
Keith Wilson - Chief Financial Officer, Executive Vice President, Treasurer and Director
Arunas Chesonis - Chairman, Chief Executive Officer, Chairman of PAETEC Communications Inc., Chief Executive Officer of PaeTec Communications Inc and President of PaeTec Communications Inc
Chris Muller - Investor Relations
Donna Jaegers - D.A. Davidson & Co.
Michael Funk - BofA Merrill Lynch
Barry McCarver - Stephens Inc.
Michael Rollins - Citigroup Inc
Brett Feldman - Deutsche Bank AG
Good day, ladies and gentlemen, and welcome to the Q4 2010 PAETEC Holding Corporation Earnings Conference call. My name is Michael, and I will be your coordinator for today. [Operator Instructions] I will now turn the presentation over to your host for today's conference, Mr. Chris Muller. You may proceed.
Thank you, Michael. Good morning, everyone, and welcome to PAETEC's Fourth Quarter and Full Year 2010 Earnings call. With me on today's call are Chairman and CEO, Arunas Chesonis; and Chief Financial Officer, Keith Wilson. Following our prepared remarks, we will then conduct a 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 strategy 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 our other filings with the SEC. We disclaim any obligation to update any of our forward-looking statements. Please note that on 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 paetec.com.
Finally, please note that we have posted on the Investor Relations portion of our website a supplemental presentation that'll 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.
Thank you, Chris. Good morning, everyone.
Today, we are pleased to announce our fourth quarter and full year 2010 financial and operating results. PAETEC met its full year 2010 revenue and EBITDA guidance, continued our record of generating positive free cash flow to 32 consecutive quarters and grew overall revenues by 2.8%. We completed our stock repurchase program in the fourth quarter by acquiring over 1.4 million shares of our common stock for an average price of $4.7 per share. Since we began the stock purchase initiative, we have acquired almost 12 million shares of common stock at an aggregate cost of approximately $2.90 per share. And although we still believe our stock to be undervalued, the board of directors has agreed to focus our future excess free cash flow to be utilized to reduce our debt.
During the fourth quarter, we continued to operate the business well and generated strong network sales bookings, reduced revenue and customer churn, improved gross margins and experienced solid organic growth in our Integrated Services group. We also completed the acquisition of Cavalier in December ahead of schedule and aggressively began our formal integration process. I can share with you that our integration plan is on schedule with respect to cost synergies, network projects and IT initiatives. The deep fiber and collocation network we acquired has already provided tremendous benefits by increasing our sales funnel and driving better sales force excitement.
But before I turn the call over to Keith Wilson, our CFO, to review the detailed financial results, I would like to share with you a new way of looking at PAETEC from an investment perspective. Although we started the company in 1998 as a traditional regional CLEC, the business has evolved into a fiber-based nationwide communication service provider, focused on enterprise customers. We also have several distinct growth businesses buried within PAETEC today that has typically been combined and labeled in our quarterly earnings addendums as integrated solutions. It is now time to describe to you how the four growth areas within PAETEC's Integrated Solutions group will drive incremental network services growth. Let's call these four growth engines Managed Services, Cloud and Data Center solutions, Software and Technology and Energy Services.
But first I would like to share some recent developments in our Network Services area. The leaders in our Network Services segment have developed five additional techniques that we'll be using this year to help reduce revenue turn, reduced price compression and drive future growth. First, the renewed focus on last mile and metro fiber construction has already begun. We currently have over 100 new customer builds being proposed and our internal goal is to turn up 300 new on-net buildings per quarter by the end of 2013. We have also accelerated the rollout of Ethernet-over-copper in 280 additional collocation sites this year throughout the national network.
Security will be another way we'll improve customer retention and profitability, utilizing our network firewall and intrusion detection and prevention services. This product set was the most talked about program at our annual sales leadership summit last month in Atlanta. Enhanced call center and toll-free routing and reporting offerings have also been well received by our customer base. It is being spearheaded by our software team in Salt Lake City.
And finally, we'll be launching this spring a new family of unified communications products to help our clients manage their businesses more efficiently. We believe that the Network Services segment will generate EBITDA margins in the low to mid-20s over the next several years, depending somewhat upon potential network acquisitions.
Now let's begin the review of our Integrated Solutions group. The first of our four double-digit growth areas for PAETEC is Managed Services. With the pending XETA acquisition, our combined Managed Services annual revenues will more than double in scale. The combination will create one of the largest nationwide managed services providers with deep technical expertise in the Avaya, Nortel and Mitel product lines. XETA's headquartered in Tulsa, Oklahoma where we already have 120 PAETEC employees primarily in the technical and engineering areas. XETA has strong vertical market focus as does PAETEC in the healthcare, hospitality, government, retail and financial services sectors. We expect to close the XETA transaction sometime during the second quarter.
The second area of phenomenal growth opportunities for PAETEC is the cloud and data center sector. We currently have over 90,000 square feet of usable data center space within our footprint, primarily comprised of larger standalone managed data centers in Andover, Massachusetts, and Bethlehem and Conshohocken. Pennsylvania, and smaller central office located data centers in Houston, Milwaukee and Phoenix. We plan to organically grow our cloud business, build four to six data centers per year and launch a series of new hosted services throughout 2011 and 2012.
As an example of how our network infrastructure allows cost-effective expansion of our cloud capabilities, let's examine the Phoenix case study. In our most recent data center launched few weeks ago, we invested less than $500,000 of capital to build out 4,400 square feet of usable data center space, which is approximately 120 cabinets, in our primary Phoenix central office. There is also ample capacity for expansion within the same central office when needed. There are dozens of existing PAETEC central offices that are capable of unlocking similar opportunities as our Phoenix data center. Our cloud strategy and data center rollout will be the focus of our annual May Investor Day at the NASDAQ MarketSite in Times Square.
The third area of growth for PAETEC in the future will be our proprietary Software and Technology Solutions. Currently we have several award-winning offerings, including PINNACLE Online, which is an enterprise software service; and the Allworx telephone system product set. In December, we added RevChain solutions, which is carrier-class software and professional services for both wireline and wireless carriers, international providers and large enterprises.
We now feel we have the foundation set for a technology group that can grow substantially while providing an unfair advantage to our sales forces and sales partners. Our upcoming product offerings this spring will also be focused on mobile apps and will be driven by this group.
The final area of future growth for PAETEC is in Energy Supply and Management services. We expect our Energy Supply business to significantly grow in 2011 as we begin to offer services in five more states in the U.S. We are finding more and more of our customer IT decision-makers becoming directly or indirectly involved in energy purchasing decisions due to backup power issues, data center energy consumption, green initiatives and simple cost-saving projects. We believe this part of PAETEC's business will be another differentiator for us in the marketplace, especially with the Asian channel.
Although from a distance it may seem that some of these areas are not core to our business, our customers are telling us that the opposite is true. Through our ongoing customer conversations, they have repeatedly told us that their trusted network vendor is the perfect partner to help them monitor their internal Avaya or Cisco network, host their enterprise software and data in one of our technology centers or even create new mobile apps for their customers.
We believe 2011 is truly an inflection point for the company as we leverage our nationwide fiber network and our enterprise customer base. Our broad sales and distribution system utilizing direct sales, agent partners, carrier sales and account management will help accelerate the penetration of our various integrated solutions offerings into our existing customer base as well as our partners' customer bases. More importantly, we expect to gain additional wallet share from our customers and partners as we demonstrate we have the capability to potentially provide all services to any client.
In the end, integrated solutions improves customer retention, reduces price compression and improves our sales productivity. We will also continue to generate free cash flow as we have for the past eight years and focus on reducing our debt leverage ratios to ensure maximum financial flexibility for the company.
I think you can sense how excited I am about the future opportunities we have to increase shareholder value. Growing organically, paying down debt and building our cash reserves always creates a recipe for long-term success in our business. But we will be simultaneously opportunistic and cautious as we choose to purchase other firms. I continue to believe that there has never been a better time to be a PAETEC employee, shareholder, partner or customer.
And thank you for your attention. And now it's time for Keith to step you through the financials. Keith?
Thanks, Arunas, and good morning, everyone.
We're pleased to share our full operating results, which again was marked by continued expansion of revenue growth. Before we get started with our financial discussion, I'd like to point out some of the highlights.
One, PAETEC generated 2.8% revenue growth in 2010 over 2009. Number two, we reported full year 2010 adjusted EBITDA growth of 3.1%. Three, Core Network Services revenue per customer increased 2.6% quarter-over-quarter or 10% year-over-year, largely due to our continued traction in the design and installation of multi-location MPLS Virtual Private Networks. Four, consistent with increased revenue per customer, our average T1s per customer also increased 6.2% in Q4 over Q3 or 25.9% year-over-year.
Continued strong growth in overall access line equivalents, excluding CavTel, as Q4 2010 ALEs increased 7.5% to $6.3 million from $5.9 million at Q4 '09. Growth in our infrastructure as our total fiber miles increased 82% to over 36,600 miles on a year-over-year basis, primarily due to the acquisition of Cavalier Telephone. And as Arunas indicated, we reported the 32nd consecutive quarter of positive free cash flow, something that we continue to be very proud of.
Now let's turn to the financial discussion. We'll first walk through our income statement results on a full year basis, Q4 and on a sequential basis. So let's start with the full year 2010 results.
Total revenue of $1,623,800,000 for 2010 increased 2.8% or $43.6 million over 2009, primarily due to the 2010 acquisitions of U.S. Energy Partners, Quagga Corporation and Cavalier Telephone Corporation.
Core Network Services revenue for 2010 was $1,140,500,000 a marginal decrease of $1.3 million from 2009, primarily due to the decline in usage-based revenue and continued price compression. Core carrier services revenue for 2010 was $184.9 million, a decrease of 1.3% or $2.5 million from 2009 due to a decline in usage-based revenues as well.
And finally, the Integrated Solutions group revenue of $115.9 million increased 87.9% or $54.2 million over 2009 due to the inclusion of U.S. Energy and Quagga, along with the growth in sales of our IP Simple VoIP bundle which focuses on our Allworx platform.
Adjusted EBITDA and margins for 2010 increased 3.1% or $8 million to $264.9 million over adjusted EBITDA of $256.9 million for 2009. Adjusted EBITDA margin, which represents adjusted EBITDA as a percentage of total revenue is stable 16.3% for 2010 compared to 2009.
Cost of goods sold for 2010 increased 3.4% or $26.5 million. The increase in cost of goods sold for 2010 was primarily the result of substantially higher costs associated with the resale of Energy Services and higher costs associated with equipment sales from Quagga. As a result of higher cost, gross margin for 2010 decreased to 50.2% from 50.5% for 2009.
Selling, general and administrative expenses for 2010 were $559.7 million including stock based compensation of $9.7 million, and remained relatively consistent with 2009 due to initiatives instituted by management over the past several quarters to align cost more closely with revenue performance and expectations. As a percentage of total revenue, SG&A expenses were 34.5% for the full year 2010 compared to 35.4% for the full year in 2009.
Net loss for 2010 was $57.7 million compared to a 2009 net loss of $28.7 million. The increase in net loss was primarily due to a 29.9% or $22.2 million increase in interest expense. For the full year 2010, interest expense was $96.3 million compared to $74.1 million for 2009. The increase in interest expense was due to higher debt balances and a higher average interest rate, primarily due to PAETEC's January 2010 issuance of $300 million aggregate principal amount of additional 8 7/8% senior secured notes due 2017.
Now on to the quarterly results. Fourth quarter 2010 compared to fourth quarter 2009. Fourth quarter 2010 revenue of $429.2 million which represented a 10% increase from fourth quarter 2009 revenue of $390.1 million. Fourth quarter 2010 adjusted EBITDA of $72.1 million represented a 10.5% or $6.8 million increase over fourth quarter 2009 adjusted EBITDA of $65.2 million. Fourth quarter 2010 net loss of $25.9 million compared to fourth quarter 2009 net loss of $2.4 million. And fourth quarter 2010 net cash provided by operating activities of $39.4 million compared to fourth quarter 2009 net cash provided by operating activities of $62 million.
The total revenue of $429.2 million increased 10% for the fourth quarter 2010 from the fourth quarter 2009, primarily due to an increase in ISG revenue and the inclusion of Cavalier revenue.
Core Network Services revenue increased 2.8% or $7.9 million over the fourth quarter 2009, primarily due to the inclusion of Cavalier rev. Core Carrier Services increased 12.3% or $5.5 million over the fourth quarter 2009 to $50.1 million, primarily due to the inclusion of the Cavalier revenue. And finally, Integrated Solutions revenue of $39.1 million increased 136% or $22.5 million over the fourth quarter 2009 due to the acquisitions of U.S. Energy and Quagga.
Adjusted EBITDA for the fourth quarter 2010 increased 10.5% or $6.8 million to $72.1 million over adjusted EBITDA of $65.2 million for the fourth quarter of 2009. Adjusted EBITDA margin improved to 16.8% for the fourth quarter 2010 compared to 16.7% for the fourth quarter 2009.
Cost of goods sold for the fourth quarter 2010 increased 10.9% or $21 million over the fourth quarter of 2009 due to the addition of Cavalier.
Gross margin for the fourth quarter of 2010 decreased to 50.4% from 50.8% for the fourth quarter 2009 due to the acquisitions of U.S. Energy Partners and Quagga, which tend to carry lower gross margin revenue.
SG&A expenses for the fourth quarter 2010 were $146.1 million, including stock based compensation of $2 million, and increased 6.6% or $9 million from the fourth quarter of 2009, primarily due to the inclusion of costs associated with acquired businesses. As a percentage of total revenue, SG&A expenses were 34% for the fourth quarter of 2010 compared to 35.1% for the fourth quarter of 2009.
Net loss for the fourth quarter of 2010 was $25.9 million compared to net loss of $2.4 million for the fourth quarter of 2009. The increase in net loss was primarily a result of higher interest expense and $10.4 million in acquisition, integration and separation costs. Net loss for fourth quarter of 2009 reflected $7.5 million in debt extinguishment and a $6 million benefit from a sales and use tax settlement.
Sequential results for the fourth quarter 2010 compared to third quarter 2010. Total revenue for the fourth quarter of 2010 increased 5.1% or $20.8 million from the third quarter of 2010, largely due to the inclusion of Cavalier revenue. Core Network Service revenue for the fourth quarter 2010 increased 4% or $11.2 million from the third quarter due to the inclusion of Cavalier. Core Carrier Service revenue for the fourth quarter of 2010 increased 11.3% or $5.1 million from the third quarter of 2010, again due to the inclusion of Cavalier revenues. Then finally, Integrated Solutions revenue for the fourth quarter increased 4.2% or $1.6 million from the third quarter 2010 due to increased revenue generated from the equipment or Managed Services business of Quagga, both east and west.
Adjusted EBITDA of $72 million for the fourth quarter of 2010 represented an increase of 15.9% or $9.9 million over adjusted EBITDA of $62.2 million for the third quarter of 2010. Adjusted EBITDA margin was 16.8% for the fourth quarter 2010 compared to 15.2% for the third quarter of 2010.
Fourth quarter 2010 cost of goods sold increased 3.2% or $6.7 million from the third quarter 2010 due to the inclusion of Cavalier's results.
Gross margin for the fourth quarter 2010 was 50.4%, an increase from 49.5% for the third quarter of 2010. Gross margin improvement was driven by a combination of improved network costs associated with the transition of circuits from special access to UNEs [unbundled network element] beyond the addition of higher margin revenues associated with Cavalier.
SG&A expenses for the fourth quarter of 2010 were $146.1 million, including stock based compensation of $2 million, an increased 2.5% or $3.5 million from the third quarter of 2010. The increase in SG&A expenses was primarily attributable to the inclusion of Cavalier's results. As a percentage of total revenue, SG&A expenses decreased to 34% from 34.9% for the third quarter of 2010.
Net loss for the fourth quarter of 2010 was $25.9 million compared to net loss of $14.8 million for the third quarter of 2010. The increase in net loss was primarily the result of increased interest expense and higher transaction and debt extinguishment costs.
Interest expense for the fourth quarter of 2010 was $28.7 million, an increase of $5.7 million from the third quarter of 2010, primarily due to the $450 million principal amount of PAETEC's 9 7/8% senior notes due 2018 issued in connection with the Cavalier acquisition.
For the full year of 2010 capital expenditures were $125.1 million, an increase of $3.6 million from the full year of 2009. As a percentage of total revenue, capital expenditures were stable at 7.7% from the full year 2009.
Capital expenditures for the fourth quarter were $30.2 million or 7% of total revenue compared to $36.6 million or 9.4% of total revenue for the fourth quarter of 2009. The fourth quarter 2010 decrease in capital expenditures was largely due to timing of certain investments, reflecting projects related to network and IT enhancements and PAETEC's previously announced data center build-out.
PAETEC had year-end cash balance of $95.5 million compared to a year-end 2009 cash balance of $152.9 million, primarily as a result of cash used in acquisitions, associated acquisition and debt cost and continued purchases of PAETEC's common stock under the company's stock repurchase plan approved by its Board of Directors in September 2009.
Cash flow provided by operations decreased to $125.8 million in 2010 from $152.2 million in full year 2009. Free cash flow for 2010 was $139.9 million, a $4.4 million increase from $135.4 million for the full year 2009. Fourth quarter 2010 free cash flow was $41.9 million, representing the 32nd quarter of positive free cash flow generation. Due to the timing of capital expenditures, free cash flow for the fourth quarter 2010 increased 48.6% from the third quarter of 2010.
At December 31, 2010, PAETEC had $1.4 billion in debt outstanding under its senior notes, which was comprised of $650 million principal amount of senior secured notes and $750 million amount of senior unsecured notes. In support of our Cavalier acquisition, December 6, 2010, we raised $450 million in unsecured notes due 2018.
We continue to be very thankful for the support we receive from the debt investor community as this long-term junior capital enables us to maintain a thoughtful mix of secured and unsecured debt. PAETEC also had a senior secured revolver credit facility under which it could obtain from time to time revolving loans up to an aggregate principal amount of $50 million. At December 31, 2010, $25 million principal amount of loans was outstanding under the facility.
Under PAETEC's stock repurchase program in effect for the fourth quarter 2010, PAETEC repurchased over 1.44 million shares of its common stock for an aggregate cost of $5.8 million, or $4.07 average cost per share in the quarter. Since August 2008, pursuant to its two stock repurchase programs, PAETEC has repurchased in total approximately 11.9 million shares of common stock for an aggregate cost of approximately $34.5 million. PAETEC's second repurchase program expired on December 31, 2010.
For the second consecutive year, we are pleased to provide full year 2011 guidance. PAETEC's revenue and adjusted EBITDA expectations for the full year 2011 assume, among other matters, that there is no further significant decline in economic conditions and that there are no significant changes in the competitive or regulatory environments. Guidance for 2011 also assumes the second quarter close of the previously announced XETA Technologies acquisition. PAETEC's revenue and adjusted EBITDA expectations for the full year 2011 include revenue of $2.025 billion to $2,125,000,000 and adjusted EBITDA of $375 million to $395 million.
That concludes our prepared remarks. And I'd now like to ask the operator to open it up for questions.
[Operator Instructions] And your first question comes from the line of Barry McCarver of Stephens.
Barry McCarver - Stephens Inc.
Stepping back to that guidance just for a minute, pretty strong revenue and EBITDA guidance. I'm wondering if you could kind of break out on the revenue side Cavalier versus kind of organic growth for the existing the business, because you talked a little bit about organic growth in the past. And then second question would be using the midpoint for the EBITDA guidance, that suggests adjusted EBITDA margin of about 18.6%. That's stronger annual run rate than you put up in several years. Help us break that out between Cavalier as well.
Yes, Barry. I think we're going to defer on the Cavalier breakout because ultimately, Cavalier is part of PAETEC now. And as we report going forward, what we tried to do in this quarter was be very transparent between the contributions of Cavalier to the quarter, primarily because it was a stub component, as opposed to what we would expect in terms of going-forward reporting. Our goal is really to provide this as an integrated -- as it is with all of our acquisitions, just to integrate it into the core operations. And so we don't budget it on a breakout standpoint. And while in theory we have the ability to break it out on P&L standpoint, Cavalier's Richmond operation and PAETEC's Richmond operation are going to be the same operation -- they are already the same operation today. And so for us to be able to able to break it out for you guys, it would be not only difficult but unfortunately for your question, it's not something that we're going to do. I would say that the expectation on the margin is really driven by a couple of different things as opposed to breaking it out specifically. Cavalier was running higher margins due to the depth of the fiber network. And obviously, that's something that was attractive for us. And so we are going to show an improved margin profile from the company. I think you're just adding to see that with a little bit of lift that we saw in the fourth quarter and even in the pro forma. If you look at the pro forma information that we provided in the release, I think we're up in the high-17s on a pro forma basis, without any synergies yet. So if you include the synergies that we've articulated to folks externally, it provides a fairly fluid bridge for you.
Barry McCarver - Stephens Inc.
Well, let me ask my first question just a little bit differently then. Are you seeing any improvement on organic growth, certainly churn, both network and carrier improved, I'm just wondering kind of what you're seeing for all the business on organic basis.
Yes, I mean, there's a bunch of different moving pieces there, Barry. We have seen fantastic bookings and the biggest pressure point for us as that relates to organic growth, has been a combination of price compression churn and usage-based revenues. We are seeing improvement in all of those things. We continue to see technological shift, which is fundamentally a price compression event even though it improves or enhances your margins on both on the gross and typically on the EBITDA side. But if you look at our churn rates, both revenue line and customer this quarter all improved pretty significantly. I think revenue churn went from about 1.3% last quarter to 1% this quarter. Our line churn at 1.2% is the best that we've seen in a matter of six quarters. So we're definitely seeing some improvements. And there are definitely segments, both geographically and product-wise, where we're seeing very good growth. And we think we’re at the inflection point, which is why we essentially put the guidance out that we did. So we do expect to return to growth of this year.
Barry McCarver - Stephens Inc.
And when you talk about the kind of usage change, the technological change, I'm assuming you're talking about just the adoption of VoIP?
That's right, Barry. Yes, I mean, we're seeing more and more folks and really, we were seeing trending being driven by people seeking lower cost as they went through some of the challenging economic times over the last couple of years. But the adoption of VoIP or IP-based technologies has picked up significantly. It's something that we've talked about for quite some time and that continues to move along briskly.
Barry McCarver - Stephens Inc.
As a drag on organic growth for your business, do you think that, that is still accelerating or did you see the peak of that in maybe 2010 and start to move down a little bit?
Well, based on the volumes that we're seeing in bookings and productivity that we're seeing, we think that, that pressure point will be more flat than it was a negative driver over the last couple years.
Your next question comes from the line of Michael Funk of Bank of America Merrill Lynch.
Michael Funk - BofA Merrill Lynch
First, you gave us some more detail this morning on how you think about Integrated Solutions and the product sets there as growth drivers. Maybe some more color on how this is shifting your sales strategy, your go-to-market strategy with regard to products you're leading with, as well as potential target customers. And then just second, you’d talked earlier about some more potential acquisitions in 2011. I think you’d talked earlier about the opportunity for a larger bolt-on deal. Any kind of color here on assets that may be relatively attractive geographically products sets maybe where you could use some improvement as well, would help.
Michael, I'll address the last one first. We don't like to discuss any kind of acquisitions other than the ones we've announced. So love the question, appreciate the question, but I'm going to -- I think we're going to pass as a management team on identifying any names. And then I'll kick it over to Arunas to talk about the ISG.
And I think Michael, as we talked about in the past, sort of a network-based carrier, fiber-based and a handful of tuck-ins, one or two, very similar to what we did last year, sort of the types of companies we'd be looking at. So you shouldn't be surprised if you see a similar M&A program to what we did in 2010. But again, we'll be very cautious about how we go about valuing companies like that. I think on the Integrated Solutions side, it's a very interesting question you posed, because where the MPLS data offerings, the new VoIP offerings, they were very fresh and new the last three years, as far as a way to lead into a prospective customer to talk about how you can help them. That's changed now. That has become more and more of a commodity out there. And what you need to do is lead with other services, whether it's a cloud and data center services or discussions about helping them manage their internal infrastructure better. So we're leading with the other Integrated Solutions to get in the door, and then we pull through and drag along the voice and data network services because we've gotten to know what their pressure points are. We've gotten the ability to craft something that's unique for them. And then, you have a much better shot at getting those other network services at a reasonable price point, instead of just always having to compete for the lowest deal out there. So I think you asked a very good question. And it has modified our sales strategy. And part of what really helps us there is we have a very strong training organization. We just found out last week that we actually made it a fifth year in a row, we became the number 35 top training organization in the world by Training Magazine. And you have to train people to be more of a consultant out there if you're going to be successful in driving those kind of Integrated Solutions. So you definitely need the infrastructure behind you to teach the people how to go about that new sales technique.
Michael Funk - BofA Merrill Lynch
I didn't see it in the release, but do you have the customer data with Cavalier, as well you have x Cavalier for customer accounts and churn, for example, do you have that including Cavalier?
Michael, we have actually a lot of information. We specifically chose to leave some of the operating metrics out of this release just because of conforming nomenclature. We've had Cavalier in-house now for a couple of months but as you know, when we did our last significant acquisition in McLeod [McLeod USA Incorporated], we took a quarter to work to ensure conforming metrics. And so as we kind of go through that, we left that out specifically this quarter for that reason. We just want to make sure we have all the parent-child relationships and the methodologies consistent with PAETEC.
And Michael, one other sort of thought to your first question on how our sales strategies are changing. I mean, historically, we've thought and we've used fiber and last mile and metro infrastructure as a tool to save money as opposed to a sales and marketing weapon to attract new business. And that's changing very rapidly. With the folks that we got from Cavalier, combined with some of how they've been doing business in the last several years, we've got sort a new opportunity to lead customers to us by using that infrastructure as a weapon. As an example, we're going to be putting out a press release tomorrow with a company called QTS. They're one of the larger data center, cloud companies in the United States. They've just announced a new data center build in Virginia, which will be about 1.3 million square feet of space. We've just been awarded a multimillion contract for diverse fiber network and managed services agreement to build loops throughout Northern Virginia and Culpepper to connect it to other organizations and really build a site that's hardened for both our government agencies, large enterprise customers. And that's where we really use the fiber assets we have as a weapon to go get new business. So that's a somewhat new sales technique for us. And you'll see that release tomorrow. It's a fantastic relationship we're building with them.
Your next question comes from the line of Michael Rollins of Citi Investment Research.
Michael Rollins - Citigroup Inc
Really, two questions. The first of which, just looking at the pace of acquisitions that you've announced, completed and are still pending over the last 12 months, how do you think about the time that you need to integrate and make sure everything is running smoothly before possibly adding more layers on top of what you've done? I know you’ve had experience with this in the past in terms of managing a variety of different size deals. But I'm kind of curious for your latest thoughts on your approach to managing the process with a little more depth than what you shared so far. The second question is if you think of the guidance for 2011, there are a number of moving pieces in there between partial acquisitions in 2010, partial acquisitions for 2011. Can you give us a sense of if you sort of look at it all pro forma, what the base case performance looks like? And within that, what strategic is growing versus maybe what would be non-core and how investors should think about that mix?
I think we'll knock these off one at a time here. On the M&A side, you have to remember, we closed the MacLeod transaction back in early 2008. So it was really almost three full years before we closed the Cavalier deal. So we had a lot of time to really integrate. We have finished up late last year the final network integration and rechanging the network architecture throughout the entire McLeod footprint. So that's sort of one consistent network throughout the U.S. for us. We actually have set ourselves up by acquiring the RevChain solution assets and that billing company and professional services company so we can have the expertise in-house to really provide those billing conversions that much easier as we buy companies over the next several years. And they’re really, they’re different areas of different groups that you're almost flexing different muscles. The Cavalier footprint is primarily in the core sort of Mid-Atlantic, East Coast region, which is sort of the longest-tenured group of people at PAETEC, the most tenured management team. And it's very, I won’t say easy, but it's easy straightforward to integrate those groups. We actually have a dedicated M&A team that we established this past summer. And that group has been working very well, taking pressure off the day-to-day operational folks. But as you get bigger, you also get some extra management folks that free up to become real M&A integrators for you. So I think from many different viewpoints, we don't see sort of the pace of acquisitions that we've undertaken recently to be something that we can't easily handle. And you learn over time. We're much better at integrating small, medium, large businesses now than we were five or six years ago. And we're up to, I think this is going to be number 15th acquisition for us with XETA. So we've practiced a lot; we've learned a lot; we don't make the same mistakes. I'm sure we'll make some different mistakes in the future. But we've actually done really well by teaching the organization how to go about best practices for integration activity. On the other question, let's -- I'll go back to Keith.
Yes, I mean, I appreciate the question, Michael, which is that guidance is extremely complex versus what we've done historically because of all the M&A and the step-period analysis. I mean, I'll give you some high-level thoughts. We typically don't like to get overly granular because there are moving pieces in the business and sometimes things will perform better than you thought and vice versa. Look, as Arunas said in his introductory remarks, we anticipate the ISG or broadly the Managed Services group to be a growth area. You'll see that because we'll be breaking it out. But generally, we acquired a lot of these assets because we think there's real growth opportunity in those businesses. And we expect them to continue to do well. We expect continued pressure from our POTS segments, which we've talked about in the past. You've seen that trajectory. It's been a headwind for us; that's continued to be a pressure point. We expect that to be a counterbalance to the business. We won't have specific breakouts for Intellifiber, because part of Intellifiber is on the enterprise side and part of it is on wholesale side. We believe it's core to the overall business so we're not going to have a specific Intellifiber line item. But we do believe that Type One type bills, Type One type solutions going to both enterprise and carrier customers is clearly an area of growth. That was an area that we got very excited about. And we do believe that core network should be kind of a modest growth area for us this year, despite the fact that we anticipate some headwinds on the usage side. So generally, I hope that gives you some better color. To kind of breakout granular, non-officially reported SEC line items and guidance is just not something we're going to do. But I hope that gives you enough color to see where we're going with this.
But if we step back, Keith, and we try to normalize for everything out there. I mean we're still looking at guidance that is providing a 1% to 2% organic growth rate for the company overall this year, even with the headwinds with the POTS, access charges, usage compression, I mean that's we’re still hedging our bets a little bit about the timing of the XETA closing sometime during the second quarter. But we do see ourselves returning to positive organic growth, Michael, this year.
Yes. And if you look at -- I know we've got a lot of charts in the release. We have given pro forma breakout for everything while we didn't step through it in the comments. The information is available and we wanted to, again, try and be as transparent as possible, so that when you start to look at the guidance and what we put out there, you can see exactly what Arunas said, which is that we do unto anticipate organic growth out of the business next year.
Michael Rollins - Citigroup Inc
And just one other quick follow-up. You've highlighted -- am I getting the number right, is it 32 consecutive quarters of positive free cash flow? Is that the right number?
Michael Rollins - Citigroup Inc
So as you look forward and you talk about stepping up some investments in different areas, you talk about data centers, small deployments, you talked about more on that fiber building, how do you think about this goal of now having 32 consecutive? Or this historical record of 32 consecutive quarters of free cash flow, is that still a key part of your operating strategy, you'll continue to grow and invest but you still want to keep generating positive free cash flow each quarter?
Absolutely, Michael. I mean I think, what's possible with the scale of business we have now and the infrastructure that we've acquired from other people, we've told folks we probably will see ourselves migrate from a 7% to 9% CapEx intensity range as a percentage of revenue to somewhere between 8% and 10% over time. And leveraging the infrastructure we have, we think we can continue to expand the Fiber business, the Data Center business and still not break out of that 8% to 10% range, which keeps you very solidly in the positive free cash flow area as a combined company.
Your next question comes from the line of Bob Kricheff of Credit Suisse.
But just one quick thing to make sure I'm look -- I know it's kind of back of the envelope here but looking at it right. I mean, if your pro forma for Cavalier was $1.97 billion on a revenue basis and if you add in the, roughly, pro ratas of $100 million of the expected revenue from XETA, that should get you roughly, call it, $2.55 billion. So is it safe to say that sort of the low end of the revenue guidance could be flattish to kind of down, but that the higher end is kind of in that 2% or 3% range? I know you talked about what you’re expecting organic growth but -- am I doing that math right? That the lower end of the range could be somewhat down a little bit on the top line?
No, Bob. I think what you're missing there is the expectation that XETA closes in the second quarter. So XETA, what their management team has said, right? This isn't specific for PAETEC that they've articulated $100 million in their calendar year 2011, which started in November of last year. And so if you just pushed the $100 million forward for the full year, part of the range could be whether they close at the end of April or whether the deal closes at the end of June. Right now, there's some litigation out there. I mean it's pretty standard stuff, but we just don't know how that will delay any kind of proxy process, if at all. And so we just -- we wanted to provide a little bit of bandwidth there. But if you back into that math, we will absolutely not see $100 million out of XETA this year. It'll be something less. I mean, it's just a question of is it $50 million, is it $60 million, is it $70 million? We don't know yet. But similar to last year, a lot of folks kind of gave us the question of, "Gosh, do these numbers include or not include acquisitions?" We wanted to be crystal clear on this, this year, that the guidance is in anticipation that, that deal will close.
Is there anything else, I know you can go on Bloomberg and see the usual band of suspects filing litigation. Is there anything else that would -- aside that, that possible aspect that would be delaying the XETA transaction?
I guess the best thing, and again, we have to be little bit careful because it is a public company, they have to get the shareholder vote. So they have to put out their proxy and they do have a shareholder vote. So look, we're supportive and excited about the deal. We think the shareholders will see the merit but there's still a process that needs to go through.
Your next question comes from the line of Edward Katz of Morgan Stanley.
It’s Edward Katz for Simon. I was wondering if you could talk a little bit more about the economy this quarter, any trends throughout your different regions that may have differed. And then also the other one was last quarter, I remember you talked about the establishment of the SMB focus groups go after some of the sub-$1,500 per month customers. Could you talk a little bit more about how that's going and what you expect for 2011, as far as any improvement that we could expect from that effort?
Yes, this is Keith. Just on the economy, I would say our perspective at PAETEC is well we see some glimmers of enthusiasm out in the market. I wouldn't say that we've seen a radical change. So I mean if you were to look at maybe 2010 versus what we're seeing directionally for '11, there's definitely more of a positive feel. But I mean, we look at the same statistics that you guys do, and they're kind of all over the place, right? For every statistic that looks like it's got positive momentum, you see things that give you a cautionary tone. So I think our customers are spending not at kind of pre-recession levels, but they are spending. Hiring, still at very muted in our universe. We're not seeing significant hiring. And I think the BLS [Bureau of Labor Statistics] data’s kind of proved that out. And I don't think there's anything significant that we can offer you in terms of regional. I mean, the Rust Belt is still the Rust Belt. And the Southeast is a little bit slow to come back. Northeast and parts of the Southwest are doing okay. I mean, Texas, I'm not even sure it ever went into recession. And we're seeing some of those things, right? Those markets are doing quite well for us. But at the same time, we've seen a lot of momentum out of the Rust Belt despite the fact that the macro numbers out there are pretty modest. So it's kind of all over the place. But I hope that gives you little bit of color.
And Ed on the small business group. I mean, what we did since the last earnings call is we took one of our senior executives, Raffi Yardemian and took two seasoned Vice Presidents from PAETEC, two seasoned Vice Presidents from Cavalier, put them into that separate group so they're focusing on those smaller network customers that have a lot of upside in new products and new services. So part of the acceleration of the Ethernet-over-copper expansion throughout the country came from that group over the last six weeks. They're already proposing and selling a lot of 10-, 20-meg Ethernet pipes to the small business users right now throughout our footprint. They're getting ramped up because we believe similar to, I think, some of the pieces that maybe a Time Warner Cable had in acquiring NaviSite, recently that a lot of the smaller business clients will be early adopters of cloud services as they try to make their operations more efficient and not invest as much CapEx on IT compared with other parts of their businesses. So we see Raffi and the team being prepared to launch those services later this year. Again, they’re going to take advantage of the continued IP Simple bundle with the Allworx hardware solution, partnered with the network rental program. And again energy in those five new states throughout the Northeast and Texas. They're going to take advantage of that as well. So again, they're going to leverage the entire product set for that, that small business customer and they're actually having a lot of traction already in new upsales and win backs from customers who said they were going to leave. So we like the focus that we're having on that small business group right now.
Your next question comes from the line of Mark Rose of RBC.
My question’s around the liquidity, just trying to understand how we finance term and year. Question on the integration acquisition and separation charges in the quarter and I guess, going forward in '11, is there any cash spending implication from those charges? We add them back in EBITDA, and often they're not spent in the actual quarter. So could cash be going out the door in '11 for that? Then on CapEx guidance, I mean, there wasn't guidance but you did say 8% to 10% of revenue range. I mean, that kind of puts you between probably $180 million and $200 million. So when I start running the numbers, you're going to buy XETA, it looks like pro forma cash, it could be in the $50 million to $60 million range. So I was just wondering if you could discuss that.
Yes, Mark. I think fair questions. Depending on where you put the guidance, right? I mean, if my math is right, kind of on the lower end you're kind of $165 million, $170 million to maybe a little bit higher to kind of the $190 million range. So I think, look, historically we've been very disciplined in terms of balancing our CapEx with success. There's clearly some things that we need to spend on to continue to manage the network, but we'll be pretty disciplined about that. When we walked through integration expenses, we did indicate that there were going to be $10 million to $15 million in integration costs. A big chunk of that $10 million that you saw was associated with severance. And a lot of that stuff was already out the door. There'll still be some integration expense that will be required during the year but that's going to yield in terms of the synergies. And then I think as it relates to XETA, yes, I mean, if we use all the cash on the balance sheet, that will definitely put some pressure on liquidity. We do have $25 million available to us under our revolver, and we have been pretty successful issuer of capital. So I think if we're concerned about liquidity and again, I don't want to give any forward-looking statements on what we might do in terms of any kind of securities issuances. If we're concerned about that, we obviously will consider going to the markets.
Your next question comes from the line of Donna Jaegers of D.A. Davidson.
Donna Jaegers - D.A. Davidson & Co.
Two areas I guess of questions. On CavTel, can you remind us of the synergies that you're expecting there and give us a little more visibility on timing of those synergies? And then the revenue shrink at CavTel, it's hard to sort out all the pro forma numbers, but it looks like you guys are still down about 20% year-over-year or quarter-over-quarter? Can you give us some clarity on what CavTel's revenue for the full Q4 would've been?
Donna, I think if you look at the pro forma and you strip out the PAETEC standalone, that number is pretty evident. We did that specifically for your convenience, but I'm not going to say what the number is but it's there for you to drive. 20% seems like an awfully aggressive number. I don't think that, that's the case. Look, we had three less business days in the quarter, and we had weather both on the East Coast and the West Coast. Because again, we think both the trends at PAETEC and Cavalier are right in line with where we anticipated them to be. So I think I'm going to kind of leave it at that. But we've given you enough information in the charts to be able to pull out what the Cavalier numbers are.
Donna Jaegers - D.A. Davidson & Co.
And then Verizon obviously sent a letter around in late December to all their wholesale customers saying that they're going to have some provisioning delays because of the forced cuts that they've made. Is that -- how should we think about that with your business given your exposure in the Northeast?
Good question, Donna. I think what we've been able to do is develop a pretty nice relationship with Verizon on the wholesale side. We spent a lot of money with them in areas that are not last-mile related. On the voluntary side, they like a lot of that wholesale carrier business. And our team’s done a good job getting the attention from Verizon because of those other opportunities we're giving them. So right now, we're not seeing any kind of significant delays in loop provisioning. But having said that, you're still -- you go through your normal issues with any ILEC out there.
Donna Jaegers - D.A. Davidson & Co.
So you're still seeing a one-week delivery on the DS1 or are you seeing the one-month delivery?
We have a quite a variety of intervals with our friends at Verizon. So it's difficult for me to say exactly on per-city basis right now. But I can tell you that a blended interval that we're seeing in the Verizon territory hasn't significantly gone up in the last three months from where we were third quarter.
I mean, Donna, you don't have consistent delivery times between Plano, Texas and Providence, Rhode Island. I mean, it's just it's all over the board and that still all Verizon. So the last point that you had asked about was the synergies. $25 million is what we've put out there for this year with the run rate going into 12% of 30%. So a little bit of back-end lift, but still real meaningful synergies we expect to be achieved in the first half of the year.
Your next question comes from the line of Brett Feldman of Deutsche Bank.
Brett Feldman - Deutsche Bank AG
If I recall from last quarter, you were dealing with some migration to UNE circuits to offer special access as a results of some price changes with AT&T with the merger conditions having rolled off. I was hoping you could give us just an update on where you are in that process.
Yes, I mean Brett, we've made significant progress on that. I think you can see from the margin, we picked up almost 100 basis points on the gross margin line. And actually, if you look at the total cost of sales, that number was down by about $4.5 million. Some of that was due to the usage base declines, just because of business days and weather. But what I will tell you and what I think we tried to articulate to everyone was that our anticipation was that we would, if not be fully caught up, be relatively close during the fourth quarter. I think it's fair to say that we did not get fully caught up on transitioning all the circuits we wanted to UNEs. So there's still some opportunity for benefit kind of in the first half of the year because of that. But we did make significant progress. And I think you see that in the numbers.
Brett Feldman - Deutsche Bank AG
Well, is this sort of a one-and-done kind of thing, where AT&T sort of did make the price adjustments on all the circuits were they had intended to? Or could there be another wave of this at some point during this year?
We don't foresee another wave of this, Brett. I think we're close to making up the difference in the hit we took earlier last year. We still have thousands of circuits to go on the conversion, which will take us the bulk of the first part of this year as well as some next year. But that's really an opportunity for us to reduce our cost. We don't see necessarily a new regulatory change forcing rates up or down, and we don't see AT&T and Verizon necessarily being more aggressive than they just were.
Brett Feldman - Deutsche Bank AG
And then just on a different topic here, I'm just is looking at Slide 4 of the supplemental deck where you're giving us the sales force excluding Cavalier. And it looks like in the fourth quarter, there was a decent reduction in direct sales and account development. I was hoping you could just talk a little bit about what was behind that.
Sure. But I think you hit on a great point. What we did is because we have such great overlap with the Cavalier infrastructure and the PAETEC infrastructure, we really took best-of-breed sales management and sales reps throughout both companies. So although you see the reduction on the PAETEC standalone, you'll see the combined company actually went up in net sales heads because we did take a lot of the strong Cavalier talent there.
Brett Feldman - Deutsche Bank AG
And I think you talked about some severance charges in the fourth quarter. Was it partially associated with this?
Well, we did a significant RIF at the closing of the deal. So that was a big chunk of it. And we did do some reduction as well inside of PAETEC kind of prior to the close. So that was part of it.
I would now like to turn the call over to management for closing remarks.
Well, thank you, everyone, for your participation. And we look forward to our next quarter's call. Bye-bye.
Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Have a good day.
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