PAETEC Holding (NASDAQ:PAET)
Q1 2011 Earnings Call
May 05, 2011 10:00 am ET
Keith Wilson - Chief Financial Officer, Executive Vice President, Treasurer and Director
Chris Muller - Investor Relations
Arunas Chesonis - Chairman, Chief Executive Officer, President, Chairman of PAETEC Communications Inc., Chief Executive Officer of PaeTec Communications Inc and President of PaeTec Communications Inc
Simon Flannery - Morgan Stanley
Brett Feldman - Deutsche Bank AG
Good day, ladies and gentlemen, and welcome to the First Quarter 2011 PAETEC Holding Corp. Earnings Conference Call. My name is Kendall, and I'll be your operator for today. [Operator Instructions] I would now like to turn the conference over to your host for today, Mr. Chris Muller. Please proceed.
Thank you, Kendall. Good morning, everyone, and welcome to PAETEC's First Quarter 2011 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.
As a reminder, in our remarks today, we'll 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've 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 2010 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 will be referring to certain non-GAAP financial measures. These measures are reconciled to the most comparable GAAP measure in our press release and supplemental information, which have been posted on the Investor Relations portion of our website at paetec.com.
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 very pleased to announce our first quarter 2011 results. Overall revenue for the quarter was $495.5 million, with adjusted EBITDA of $91.4 million, and we are reaffirming guidance for 2011. We achieved our 33rd consecutive quarter of positive free cash flow and ended the period strongly with a cash balance of $103.9 million. Cavalier integration activities are proceeding on schedule, and we continue to be encouraged by the fiber and Ethernet expansion opportunities within the acquired network footprint. The creation of our small business unit last fall has already produced stronger upsell results and increased customer satisfaction.
Three significant financial metrics that we have always been focused on as a management team are adjusted EBITDA margin, organic revenue growth and revenue churn. When we compare the first quarter 2011 results to the fourth quarter 2010 results in these 3 areas, we are pleased to report solid performance across the board.
Adjusted EBITDA margin increased to 18.4% from 16.8%; organic revenue growth was modest, but increased for both the core network service and core carrier service revenue streams; and revenue churn remained steady at 1% for core network services and improved to 0.3% for core carrier services in the first quarter of 2011.
New sales bookings for the first quarter exceed our expectations, and were strong across all channels, all product lines and all geographies. Not only has our direct sales force fully embraced our bundling strategy, but the agent organization has as well. The first quarter of 2011 was the best sales performance by the agent channel in the history of PAETEC, with many individual customer deals comprised of bundled network, equipment, data center and security solutions.
During the quarter, we also completed our initial sales force training on the Cavalier footprint, highlighting the added fiber and expanded Ethernet over Copper opportunities. While we increase our net buildings during the quarter, we had significant proposals in our sales funnel for all types of fiber connectivity. At the end of March, we had over 900 active quotes for various product types including the native Ethernet, wavelengths from 1 gig to 10 gig, sign [ph] it up to OC-192 and custom network builds. We expect to achieve 300 new on-net buildings per quarter by the end of 2013.
Bandwidth needs continue to accelerate for our customers and provide many of us in the industry with an unprecedented opportunity to take market share away from the large, incumbent providers.
Our management team is excited about the upcoming May 23 Investor Day we are hosting at the NASDAQ MarketSite in New York City. For the first time, we will be webcasting and recording the event for those that cannot attend in person. During the 4-hour session, we plan to share information about plans in our 3 high-growth areas, fiber and Ethernet, managed services and data center cloud offerings. We will take a deeper look at all aspects of our fiber infrastructure, share thoughts about the pending merger with XETA, which we are targeting to close during the second quarter and describe our go-to-market strategy for our data center hosting and cloud product portfolio. I'll take some time right now to give you a sneak peak at some items we will be discussing at our Investor Day event on the 23rd, with respect to our data center and cloud activities.
We signed an agreement with VCE, which is the joint venture between Cisco and EMC to deploy their virtualization infrastructure throughout our data centers. Customers from all over the country will be able to purchase a variety of services from PAETEC as well our many applications hosted in the cloud. Our 2011 plans call for growing the total number of PAETEC-controlled data centers from 7 to 12. Last week, we executed a lease for a new standalone data center in McLean, Virginia, that has a similar brownfield profile to our Andover location. This site will be placed into service during the fourth quarter 2011 and will provide approximately 49,000 square feet of raised floor space, with capacity for 1,800 customer cabinets. In addition to McLean, we expect to open new data centers during 2011 in Charlotte, Tampa, Pittsburgh, and Rochester, New York, as well as expand the existing Houston and Conshohocken, Pennsylvania centers. And by the end of 2012, we expect to build an additional 6 to 8 new data centers specifically targeting our major markets in the central and western regions. PAETEC has a proven track record as one of the early providers of data center hosting services, having started in this business with the Bethlehem and Conshohocken, Pennsylvania data centers. We believe that with our experienced, technical resources and employees, network infrastructure, customer base and sales channels, the most compelling value creation for our shareholders will be by continuing to organically grow this part of our company and not by paying substantial acquisition premiums. We feel comfortable as a management team with our ability to complete the integration of Cavalier, while also integrating XETA over the near term.
We will continue to be open to additional acquisition opportunities in the future, but feel with our organic data center, cloud, fiber and managed service initiatives, there's no pressure for us to pursue targets at the historically high range of their valuations.
Although we already serviced 86 of the top 100 MSAs in the U.S., there is still room for organic expansion in some very attractive markets. During the fourth quarter of this year, will be opening the Last Vegas and Cincinnati markets. Next year, we'll be -- we will launch the Tulsa and Oklahoma City markets, and bring the total MSAs served to 90 of the top 100.
We believe we can finance our organic initiatives and remain below our CapEx intensity of 10% of revenues. Even though our current net leverage ratio is approximately 3.7x annualized quarterly adjusted EBITDA, we expect to delever the company utilizing our free cash flow generation. By continuing to concentrate as a management team on the combination of organic revenue growth, adjusted EBITDA margin expansion and reduced revenue churn, and by utilizing our consistent free cash flow generation for debt repayment, we believe that our shareholders will be well served over the long term.
Now let's turn the call over to Keith for the detailed financials.
Thanks, Arunas, and good morning, everyone. Before I get started, I want to acknowledge and thank our hardworking employees for their diligent work and continued focus as all of this hard work is beginning to manifest itself in our financial results.
Today, I believe the investor community will begin to see the strong operating metrics that resulted from all the integration and core operating efforts. Yet given the large amount of information to read and digest, I want to ensure that our stakeholders in the investment community appreciate the 2 dominant themes evident in our Q1 '11 results: Revenue growth and margin expansion. As Arunas touched on briefly in his remarks, our sales engine is generating outstanding results and our sales leadership has done a fabulous job in this regard.
In driving margin expansion, our employees have managed our expenditures while identifying and capturing synergy opportunities. I am proud of their determination, teamwork and collaborative spirit, which allowed us to drive both gross margin and adjusted EBITDA margin improvements.
Companies are ultimately about people and our people have -- are outstanding, but also patient and determined. We have firmly believed in the operating and strategic choices over the last two years. And many of these initiatives, when coupled with economic headwinds, take some time to manifest themselves in our financial results. So with today's theme of revenue growth and margin expansion, let's move to the financial highlights.
Revenue growth in every comparative category. Due to the timing of the Cavalier Telephone acquisition, we saw a significant revenue growth on both a year-over-year and a sequential basis. However, on a pro forma comparative basis for the CavTel acquisition, we also generated revenue growth on both a year-over-year and a sequential basis. As indicated in our guidance, the combination of our assets and product portfolio are expected to drive growth during 2011. Significant gross margin and adjusted EBITDA expansion in every comparable category as a result of our operating and strategic initiatives. Our Q1 '11 gross margin improved 220 basis points versus the same period last year. And while our cost of goods sold are growing on an absolute basis, our revenue is growing at a faster pace thus, driving our gross margin expansion. This improvement is largely the result of strategic and operational enhancements, including the contribution of higher margin Cavalier Telephone revenues, improved local network costs resulting from earlier initiatives, to transition Special Access circuits to Unbundled Network Elements and stronger integrated equipment and network cells. The addition of the CavTel revenue has primarily affected 2 of our historical averages that are detailed in our supplemental presentation. These shifts stand out, so we wanted to make sure that we address those. CavTel's typical core customer billed less than that of PAETEC's. As a result, our average revenue per customer decreased from $2,356 in Q4 '10, which did not include any Cavalier results, to $2,079 in Q1 '11, which included the full quarter of the Cavalier results. This dynamic was expected as we view this customer base as an excellent upsell opportunity due to the expanded product portfolio and expanded geography.
Our POTS numbers incorporate the Cavalier Telephone POTS. They were more retail-oriented than that of legacy PAETEC. We can see this when looking at the POTS average revenue per customer, is more than cut in half from $145 in Q4 '10 to $65 in Q1 '11. Consistent with the smaller, retail customer base, the POTS churn increased by 70 basis points from Q4 '10 to 280 basis points in Q1 '11.
It was a 70 basis point increase, not 70 to 280. And while this revenue stream contributes less than 6% of consolidated PAETEC revenues, we believe that we will be able to manage this through our small business division, as we successfully reduce churn levels in this category during 2010 prior to the CavTel acquisition.
We saw stable and improving churn trends in core network services, despite the addition of a perceived softer Cavalier base. Revenue churn remains stable at 1% sequentially, and year-over-year, while the customer churn improved 20 basis points sequentially, and year-over-year, with the inclusion of the full quarter of the Cavalier base. We saw greater efficiencies from our employee base. Given efficiencies afforded to us via the CavTel acquisition, we have been able to reduce our overall employee headcount while increasing our sales force.
And now that we've touched on some of the Q1 '11 highlights, let's turn to the financial discussion. We'll walk through our income statement and some liquidity dynamics. So let's start with Q1 '11 results. Financial highlights for the first quarter of 2011 include revenue of $495.5 million, adjusted EBITDA of $91.4 million; continued free cash flow generation, as Arunas indicated, for 33 consecutive quarters; and net cash from operating activities of $60.7 million. Revenue grew in 1Q '11 over both 1Q '10 and sequentially from the fourth quarter of 2010. 27% growth year-over-year was driven by the Cavalier acquisition but also had a lift from organic growth during the comparison period. On a sequential basis, the inclusion of a full quarter of Cavalier revenue contribution drove 15.4% revenue growth. Additionally, a strong performance from core network services more than offset the seasonal variance experienced by the ISG revenues on a sequential basis. Typically, the fourth quarter is a stronger period for equipment sales and results in variances on a sequential basis to first quarter.
Solid network cost management and captured synergies associated with the integration of the PAETEC and CavTel networks resulted in substantial improvement in overall gross margin during 1Q '11. While the cost of goods sold actually increased by $41.2 million between 1Q '11 from 1Q '10 due to the Cavalier acquisition, the overall gross margin improved substantially up to 52.8% for the first quarter 2011. This improvement was 220 basis points higher than 1Q '10 margin and was driven by a combination of higher margin CavTel revenues, improved local network costs resulting from circuit conversions and stronger margins resulting from integrated network and equipment sales, driven by the IP simple product leveraging all of those.
SG&A expenses for the first quarter grew to $172.7 million including.$2.4 million of stock-based compensation due to the addition of Cavalier. Despite the higher SG&A expenses, as a percentage of revenue, first quarter 2011 adjusted EBITDA increased 39.4% to $91.4 million, up $25.8 million over the first quarter of 2010 adjusted EBITDA. Sequential improvement in adjusted EBITDA was 26.7% or $19.3 million and was driven by a full quarter of Cavalier revenue contribution and the impact of the acquisition integration efforts.
Net loss for the first quarter 2011 was $11.9 million and improved over a $25.9 million loss in the fourth quarter of 2010, primarily due to $13.4 million in nonrecurring integration and transactional costs associated with the Cavalier acquisition in the fourth quarter. The net loss for first quarter of 2010 was $9.5 million, with the primary difference between first quarter 2011 being a $16.1 million increase in depreciation and amortization expense, associated with the Cavalier transaction.
Capital expenditures for the first quarter were $46.8 million and included $1.5 million of integration capital expenditures. As a percentage of revenue, capital expenditures are elevated as compared to historical levels, primarily due to investments in the robust fiber network, expansion of Ethernet over Copper infrastructure and the continued expansion of PAETEC's data center buildout.
Cash balance for the first quarter of 2011 was $103.9 compared to a year-end cash balance of $95.5 million, primarily as a result of cash generated by business operations. And for the full year 2011 outlook, we're pleased to reaffirm our 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. PAETEC's revenue and adjusted EBITDA expectations for the full year 2011, are revenue of $2,025,000,000 to $2,125,000,000 and adjusted EBITDA of $375 million to $395 million.
That concludes our prepared remarks. And we'll open it up for questions.
[Operator Instructions] Your first question comes from the line of Matt Swope with Gleacher Securities.
Could you give a pro forma revenue number that excluded U.S. energy and Quagga too? Is that something that you're willing to share?
It's not something that we've disclosed to the SEC docs, Matt, so I think we're going to -- we're not going to put that out on the phone call.
Okay. But if -- I'm just trying at kind of through year-over-year growth. If I look at Q1 versus Q4, I get a sequential revenue growth of something like 40 or 50 basis points. Is there anything seasonal I should think about in comparing first quarter to fourth quarter?
Well, with the first quarter to fourth quarter, you actually see strength in the ISG business, which would include the equipment side of the house and some of the energy dynamics. So what's embedded in there, and I had articulated in my comments, that you actually had a very solid performance on the core network vis-à-vis the sequential performance. Just because of that variance, you see a lot of equipment purchases at year end as people are trying to spend their budgets.
And Arunas, on Cavalier, as you've now had a full quarter with those assets, do you have any update for us in terms of whether things are better than you thought, worse than you thought in terms of opportunity?
At the end of the day, we did a lot of diligence so we had our officers travel to every single major switch site and fiber POT before the merger was announced. So there's really nothing that was expected from the infrastructure side. I do think that, again, the pleasant surprise has been how quickly the sales force has taken to the fiber expansion opportunities and building out both metro less mile to our customers. And Clint Heiden and his team did a really good job doing a roadshow during the first quarter throughout all the major markets where we have the Cavalier fiber and training the sales organization. We've also launched that into the agent channel. So that's where you see all those 900 quotes coming out right now on the fiber side.
Got you. And was Clint a Cavalier employee or a PAETEC employee?
He was running the Intellifiber division for Cavalier. And he has a pretty long history and his team do also -- he originally was one of the leaders in the early UUNET days.
And how about just another bigger picture question, with the Level 3/Global Crossing announcements, do you see any impact to your business or to the industry in general?
Well, I think Keith and I both have talked about this a little bit. And I think it's healthy for the industry. I mean, healthy Level 3 is good for all of us in the competitive sector. I do think that on the margin, we may see a little less competition on the wholesale carrier side. But we're also going to see opportunities for people like us to have one less competitor out there on the carrier side. So I think, in most situations, it's kind of neutral for us. Global Crossing wasn't really a competitor in the enterprise space in the U.S. very much.
And then maybe just the last one for Keith. Keith, as you look at the capital structure, and your bonds become callable this summer, you just put this new bank facility. And then kind of what's next as you think strategically about what you might take on from a capital structure perspective?
Yes. Thanks, Matt. Good question, I think when it comes to capital structure, conversations like that, I think we like to defer to kind of situational needs. Technically, the bank facility hasn't closed yet even though we've had very good enthusiasm on the marketing, as I'm sure most of the debt folks know, which is why we specifically didn't mention it. But we were out on the market with the $225 million bank deal, $125 million revolver and $100 million term loan, really to be used to support the XETA acquisition, and so we're excited about that. I think, we recognize that we have some relatively expensive debt, which we felt good about, when we issued those on a timely basis. And we'll take a look at what makes fiscal sense on any of the bond issues. So I would hate to suggest, we either will or will not take a look at refinancing those -- the 2015s. But I think as you pointed out, Matt, those 2 become callable in June and that does provide the management team and the board some optionality.
Your next question comes from the line of Simon Flannery with Morgan Stanley.
Simon Flannery - Morgan Stanley
Can we talk a little bit about some of the characteristics of the Cavalier fiber sales? What's the sort of book-to-bills if you're getting this good booking activity? Are we going to really see that impact in Q2? Does it --how long do we expect that? And is there still more room to ramp that into the second half of the year? And then on the integration costs, can you talk us through any specific cost reduction opportunities going from Q1 to Q2 that we expect to see?
Sure, Simon. Thanks for the questions. I think on the fiber side, again, we're focusing with the program internally we're calling proximity for customers that are either inside the on-net buildings or within 500 to 1,000 feet of the Cavalier fiber. Those tend to be projects that have a quicker turn-up opportunity than some of the other longer spurs, sometimes you go out into the suburbs. As an example, the QTS, the one press release we sent out after the earnings call last quarter, we did that turn up with a 20-mile actual new build in about 75 days. So there are opportunities to do things faster even if they have more infrastructure. But in general, we should see all of those sales for the first part of the year completed during the third and fourth quarter for sure.
Hey, Simon, I'm sorry, this is Keith. Can you repeat your question on the integration? Was it expenses or impact?
Simon Flannery - Morgan Stanley
Just looking at what are the kind of the -- where you stand in Q1 in terms of run rate of integration and what are the opportunities in the next quarter or 2 to specific network savings and other opportunities?
Yes, sure. Thank you for that, Simon. We actually feel very good about the momentum that we came into the quarter with in terms of integration. As you can tell from the basic numbers, we did have some separations in the fourth quarter towards the end of the year. So we did enjoy some benefit on the SG&A line, and actually a fair amount of what our expectations were on that, which were somewhat offset by kind of seasonal upticks that you typically see on that SG&A line including benefit recalibrations and some tax impacts. So while the transparency is a little bit muddled because of some of those offsetting dynamics, I think, you'll start to see a little bit more SG&A lift that kind of rolls in through second and third quarter. Where we still think the biggest upside for us is, is on the network side. We have a lot of network initiatives that are put in place. And despite the fact that I think we exceeded most folks' expectations on our overall gross margin and network cost performance, we actually think that there's real leverage to come from that down the road. So we'll continue to look for opportunity on that side of the house. But we feel very good about where we're tracking, and you should start to see -- I think, you'll see the majority of the impact kind of rolling in through the second and third quarter.
And then, Simon, just to sort of echo what Keith said on the network side, we have over 1,000 DS3s we can roll to the Cavalier network that we're releasing on PAETEC, and that's a great opportunity but it's also a little bit of a workload challenge with all of the stuff we're doing for the customer side. So we're on schedule, but there's incredible opportunity. And that's been both a good thing and a bad thing if you're in the internal network operations conference calls. It makes [ph] us nervous.
[Operator Instructions] Your next question comes from the line of Brett Feldman with Deutsche Bank.
Brett Feldman - Deutsche Bank AG
And maybe just sort of a bigger picture one. You've had a lot of companies in your space report this quarter and for the most part, it seems to feel a little better. Last year, I think the theme was cautious optimism. Maybe this year is a little less caution to that. And so I was hoping you could just sort of talk about what it is you're seeing -- what you think the drivers are. And sort of in 2 categories, how much of it is maybe economic issues? Things being less bad or maybe even beginning to get good. And how much of it is some of the secular themes that you referenced, things like cloud computing being a bigger driver of your business?
Hey, Brett, it's Keith, and thanks for the question. It's interesting on a morning, where you see that pretty weak jobs report number come out. I mean, look, one of the themes that we put out to the street last year was that even if we don't see a significant improvement in either jobs or the economy in and of itself, we knew that PAETEC could and should be performing better. And so I think, we're seeing that. I think it's a combination of things, of business confidence. So I think we have seen a stabilization of the economy at a very minimum. And on the fringes, we do think we're seeing things getting better for our customers. We are seeing people get used to, for lack of a better analogy, working harder with less people, thinking about how to leverage technology. These are all things that kind of work to PAETEC. And frankly, our peers benefit, so when you start to talk about things like data centers, when you start to talk about things like energy, when you start to talk about things like cloud services, these are all places where folks can outsource, look to a trusted adviser, to take advantage of. And I think we are definitely seeing some momentum there. We are -- we've got a very consistent product portfolio across the nation now. That's a real difference for us -- for the kind of the full year coming out of 2010 into 2011. We've got a unified infrastructure with our core, with GENBAND, and using Cisco. And so a lot of these pieces that are coming together that we've talked to you guys about over the last kind of 12 months or so, we think are really manifesting themselves into a very enthusiastic sales force, which is becoming very effective at delivering that message to our customers.
Brett Feldman - Deutsche Bank AG
Okay. And so then just a sort of follow-up question here. Last year, for you guys, was a big M&A year and clearly, you're beginning to see some benefits as you start to integrate those assets. As we think out over the next couple of months and the balance of the year, is integration going to continue to be the primary focus? I know you sort of still have a broad M&A strategy that's been authorized by the board, and I'm just trying to get a sense around -- are you ready to take another bite at the apple? And if you are, is there any change in your thinking around which types of assets are most important to you in light of what you bought already?
Those are 3 good questions, Brett. I think, first of all, I mean, we still want more underlying network infrastructure where we have the highest density of our customers. So that will be something we look at. I think the priciness of some of those assets and how much of those assets are really driving enterprise revenues versus carrier wholesale revenues is something we look at. I think, with the footprint we have and the network we already have, just growing that organically, will serve us well truly over the next couple of years. So we don't feel like we have to do something there. There are a lot of customer bases that you could throw on top of our infrastructure and upsell other geographies and product sets into that base. We're already seeing that with the Cavalier integration. To me, it's not so much an integration issue for us, it's almost a training issue. We have such a broad product set, we have so many ways to get into a relationship with a client and a customer that sometimes, our sales force focuses on only 1 or 2 of the sort of arrows that they have versus all 5 or 6. So I think, integration doesn't -- isn't so much a priority as just really teaching the direct sales force, the account base team, as well as the agent channel, how to sell and position our products with the clients.
Ladies and gentlemen, that concludes this question-and-answer portion. I would now like to turn the call over to Arunas Chesonis for a closing remark.
Well, thank you, everyone, for joining us. And we'll see you next quarter. Take care.
Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. Have a great day.
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