PAETEC Holding's CEO Discusses Q2 2011 Results - Earnings Call Transcript

Aug. 9.11 | About: PAETEC Holding (PAET)

PAETEC Holding (NASDAQ:PAET)

Q2 2011 Earnings Call

August 09, 2011 8:30 am ET

Executives

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

Analysts

Michael Rollins - Citigroup Inc

Frank Louthan - Raymond James & Associates, Inc.

Operator

Good day, ladies and gentlemen, and welcome to the Q2 2011 PAETEC Holding Corporate Earnings Conference Call. My name is Laura, and I'll be your operator for today's call. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes. I would now like to turn the conference over to your host today, Chris Muller. Please proceed.

Chris Muller

Thank you, Laura. Good morning, everyone, and welcome to PAETEC's Second 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 the Q&A session.

As a reminder, 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 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 in today's call we will 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.

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 today to announce our second quarter 2011 results. PAETEC generated revenues of $507.1 million, adjusted EBITDA of $98.6 million and achieved its 34th consecutive quarter of positive free cash flow. We are also reaffirming guidance for the full year 2011.

As you all know, we announced a definitive merger agreement with Windstream Corporation last week. However, on this call, we will only be addressing our quarterly results, and will not be discussing the proposed merger or taking questions about the merger. Please wait for the upcoming filings for more information about this transaction.

Our Cavalier integration activities are proceeding on schedule, and the increase in EBITDA margin to 19.4% this quarter helps to illustrate the benefit of combining the 2 networks and customer bases onto one platform. Overall sales bookings were very strong during the second quarter, with record results especially from the south region. We are on track to open up the Las Vegas and Cincinnati markets during the fourth quarter, which will bring our on-net coverage total to 88 out of the top 100 MSAs, and we added 20 new on-net buildings during the quarter and have a growing funnel of last-mile fiber proposals from our sales organization.

We expect the XETA Technologies acquisition, which closed on May 31, to further strengthen our field support activities and drive incremental network sales just as the Quagga acquisition has done for our western region operations. We plan to discuss the XETA integration activities during next quarter's earnings call.

Our data center cloud initiatives are moving forward this quarter with approximately 88,000 square feet of new data center space in McLean, Virginia, Rochester and Houston, which are all currently in the construction process. We also launched our infrastructure as a service product set called, server virtualization, which provides customers with the ability to purchase computing and storage as utility.

We look forward to being able to discuss in greater detail the proposed merger with Windstream in the future with all of you after the SEC documents are filed. Now let's turn the call over to Keith for the detailed financial results.

Keith Wilson

Thanks, Arunas, and good morning, everyone. Leveraging off of last quarter's themes of revenue growth and margin expansion, PAETEC continues to perform well on both initiatives. PAETEC is gaining momentum on a number of fronts as we work to continue the strong integration efforts already evident in the current quarter's financials. During the quarter, PAETEC closed on the XETA Technologies acquisition at the end of May, which was a full month later than we anticipated than the original 2011 guidance. That being said, we are excited to integrate one of the strongest managed services platforms into the already substantial PAETEC Quagga managed services business.

Before I lead into the financial results for the quarter, I would like to discuss a number of operating metrics that illustrate the positive direction of the business during the quarter: sequentially improved average revenue per customer in core network services to $2,116 per customer, up approximately 1.8% or $37 per customer per month; sequentially improved average revenue per customer in core carrier services to $19,636, an increase of approximately 3.4% or $654 per customer per month; improved core network services churn down to 0.9% per month; sequential improvement in POTS churn down to 2.7% per month; and finally, continued improvement of adjusted EBITDA margin to 19.4% as the impact of corporate initiatives and synergy realization positively impacted the business.

So let's start with the Q2 '11 results. Some of the highlights include: second quarter 2011 revenue of $507.1 million; second quarter 2011 adjusted EBITDA of $98.6 million; second quarter 2011 net loss of $9.4 million; the 34th consecutive quarter of positive free cash flow, which increased to $45.7 million for the second quarter; second quarter 2011 net cash provided by operating activities of $51.8 million; and a quarter end cash balance on June 30 of $102.6 million.

Now let's turn to the financial discussion. Total revenue of $507.1 million for the second quarter of 2011 increased 28% or $111 million over the second quarter of 2010, primarily due to 21.3% growth in network services revenue, which resulted principally from the inclusion of a full quarter of revenue from Cavalier Telephone. PAETEC's acquisition of Cavalier Telephone closed in December 2010.

Core network services revenue for the second quarter of 2011 was $334.2 million, an increase of 17.3% or $49.4 million over the second quarter 2010, primarily due to the inclusion of Cavalier Telephone for the full 2011 quarter. Particular strength continues in advanced data solutions and the growth of multilocation MPLS services utilizing the nationwide PAETEC network.

Core carrier services revenue for the second quarter 2011 was $61.3 million, an increase of 36.2% or $16.3 million over second quarter 2010, primarily from the inclusion of Cavalier Telephone for the full 2011 quarter. Contribution from backlog services provisioned during the quarter also drove stronger growth rates.

Integrated solutions revenue of $45.2 million increased 98.3% or $22.4 million over the second quarter of 2010 due to the inclusions of the results of Quagga and one month's contribution of XETA and the growth in our IP Simple product.

Adjusted EBITDA for the second quarter of 2011 increased 51.4% or $33.5 million to $98.6 million over adjusted EBITDA of $65.1 million for the second quarter of 2010. Adjusted EBITDA margin, which represents adjusted EBITDA as a percentage of total revenue improved 300 basis points to 19.4% from the second quarter of 2010. Operational expense synergies and improved network cost margins were the primary contributors to the improved adjusted EBITDA margin.

Cost of goods sold for the second quarter of 2011 increased 21% or $41.3 million. The increase in cost of goods sold for the second quarter of 2011 resulted from the Cavalier Telephone and XETA Technologies acquisitions. Despite higher overall cost of goods sold, gross margin improved substantially by 270 basis points to 53% for the second quarter of 2011 from 50.3% for the second quarter of 2010.

The improvement was driven by a broad array of 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 sales driven by the IP Simple product, which leverages PAETEC's proprietary Allworx platform.

Selling, general and administrative expenses for the second quarter of 2011 were $173.3 million including stock-based compensation of $2.9 million, which represents an increase of $36.5 million over the second quarter of 2010, primarily due to the Cavalier Telephone acquisition. As a percentage of total revenue, SG&A expenses were 34.2% for the second quarter of 2011 compared to 34.5% for the second quarter of 2010.

Net loss for the quarter of 2011 was $9.4 million compared to the second quarter of 2010 net loss of $7.5 million. The increase in net loss was primarily due to increases in noncash depreciation and amortization expense and interest expense. Increased depreciation and amortization expense was driven by the acquired Cavalier Telephone assets, which include substantial fiber-optic infrastructure. These increases were substantially offset by improved operations.

Now in sequential results. Total revenue for second quarter 2011 increased 2.3% or $11.5 million over the first quarter of 2011, revenue largely due to the inclusion of a full month of XETA Technologies. Core network services revenue for the second quarter of 2011 decreased 0.8% or $2.6 million over the first quarter of 2011 revenue due to the continued migration of services to be more efficient, but lower-cost IP-based services.

Core carrier service revenue for the second quarter of 2011 increased 3.5% or $2.1 million over the first quarter of 2011 revenue. And integration solutions revenue for the second quarter of 2011 increased 24.5% or $8.9 million over the first quarter of 2011, primarily due to 1-month contribution from XETA Technologies.

Adjusted EBITDA of $98.6 million for the second quarter of 2011 represents an increase of 7.9% or $7.2 million over adjusted EBITDA of $91.4 million for the first quarter of 2011. Adjusted EBITDA margin was 19.4% for the second quarter compared to 18.4% for the first quarter of 2011. The strong margin improvement was a result of the impact of acquisition integration efforts, as well as positive results from our ongoing operational initiatives and solid operating expense control.

Second quarter 2011 cost of goods sold increased 1.8% or $4.2 million from the first quarter of 2011 due to the inclusion of XETA Technologies for the month of June. Gross margin for the second quarter of 2011 was 53%, an increase from 52.8% for the first quarter of 2011. Cavalier Telephone integration efforts, network migration projects and higher margin products all contributed to the solid improvement in overall gross margin.

SG&A expenses for the second quarter of 2011 were $173.3 million including stock-based comp of $2.9 million and increased 0.3% or $0.6 million over the first quarter of 2011. The nominal increase in SG&A expenses was inclusive of the addition of XETA Technologies for the month and was illustrative of strong operational cost control during the quarter.

Net loss for the second quarter of 2011 was $9.4 million compared to net loss of $11.9 million for the first quarter of 2011. The reduction in net loss was primarily due to improved operations, which was partially offset by increased depreciation and amortization expense.

Now we'll look at actual second quarter 2011 compared to pro forma second quarter of 2010. The following pro forma results for the second quarter 2010 give effect to PAETEC's acquisition of Cavalier Telephone as if it had occurred at the beginning of 2010. The pro forma information is not necessarily indicative of what the combined companies results of operations actually would've been if the acquisition had been completed as the dates indicated nor results that may be obtained in the future.

Actual total revenue of $507.1 million for the second quarter of 2011 represented an increase of 3.7% or $18.2 million over the pro forma total revenue of $488.9 million for the second quarter of 2010. The increase in actual total revenue was primarily attributable to an increase in revenue from PAETEC's acquisition of Quagga in June 2010 and XETA Technologies in May 2011.

Actual adjusted EBITDA of $98.6 million for the second quarter of 2010 represented an increase of 12.2% or $10.7 million over the pro forma adjusted EBITDA of $87.9 million for the second quarter 2010.

Actual cost of goods sold for the second quarter of 2011 was up marginally at $238.1 million compared to pro forma second quarter 2010. For the second quarter 2011, gross margins improved 130 basis points to 53% due to improved operating leverage associated with the transition of SPA circuits to UNEs.

SG&A expenses as a percentage of actual total revenue were stable year-over-year. Actual net loss of $9.4 million for the second quarter of 2011 decreased 37.6% or $5.7 million from the pro forma net loss of $15.1 million for the second quarter of 2010 as improved operating performance offset increases in acquisition integration and separation expenses.

Capital expenditures. For the second quarter of 2011, capital expenditures net of integration expenses were $50.2 million, an increase of $18.8 million from the second quarter of 2010. As a percentage of total revenue, capital expenditures were 9.9% for the second quarter 2011, excluding $2.8 million of integration capital. Corporate investment continues to focus on expansion of the fiber network, enhancements to the data center portfolio and growth investments for core telecom services.

PAETEC had: June 30, 2011 cash balance of $102.6 million compared to our first quarter 2011 cash balance of $103.9 million. Semiannual interest payments on indebtedness marginally offset solid cash flow from operations.

Cash flow provided by operations increased to $51.8 million for the second quarter of 2011 from $36.9 million for the second quarter of 2010. Free cash flow for the second quarter of 2011 was $45.7 million, the 34th consecutive quarter of free cash flow generation and a $12 million increase from the $33.7 million for second quarter of 2010. Free cash flow for the second quarter of 2011 increased 2.6% from $44.5 million for the first quarter of 2011.

At June 30, 2011, PAETEC had $1,499.8 million in debt outstanding, which was comprised -- composed of: a $99.8 million principal term loan under PAETEC's credit facility; $650 million principal amount of senior secured notes; and $750 million principal amount of senior unsecured notes. PAETEC also had a senior secured revolving credit facility under which it could obtain, from time to time, revolving loans of up to an aggregate principal amount of $125 million. At June 30, 2011, the revolver is undrawn.

So in summation, we're pleased to affirm -- reaffirm full year's 2011 guidance. PAETEC's revenue and adjusted EBITDA expectations for the full year of 2011 assume, among other matters, that there's no further significant decline in economic conditions and that there are no significant changes in the competitive or regulatory environment.

PAETEC's revenue and adjusted EBITDA expectations for 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 I'll now ask the operator to open up the call for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Frank Louthan from Raymond James.

Frank Louthan - Raymond James & Associates, Inc.

I believe you said you got 60 buildings on in the quarter. How is that tracking for your targets that you laid out from -- at your Analyst Day for getting more buildings on fiber? And looking 12 months out sort of excluding the combination with Windstream obviously, but where would you see -- where do you see the trajectory of your revenue coming from -- what percentage of your revenue beyond your own fiber about a year from now?

Arunas Chesonis

Frank, it's Arunas. On the earlier part of the call, I mentioned that we actually added 20 buildings on-net that during the second quarter. And the way these things and the ramps work over a period of time, you get the sales force trained, motivated. Proposals take time. So 20 net new added in the quarter is actually within our guidelines to get that goal to 300 per quarter by the end of 2013. I don't have the actual revenue breakdown, what we expect as far as revenues on our own fiber to the less -- to the actual building itself. That's something we can take a look at for you in the future.

Frank Louthan - Raymond James & Associates, Inc.

Okay, great. And I apologize if I missed this as well, but any -- can you give us an idea from a regulatory perspective and sort of timeline with closing the merger, how many different states do you need, approval, specific approval from the PUC for the transaction? And to what extent does the regulatory side of things going to weigh on the timing of the closing of the deal?

Keith Wilson

Frank, it's Keith. I think in the spirit of having the call, we're not going to comment on anything related to the merger. I think what I can tell you is that PAETEC serves businesses in 46 states currently. And we've been through regulatory approvals for every financing we've done and every acquisition we've done. So we're -- I can speak on behalf of PAETEC that we're very comfortable with dealing with regulators and we've got a pretty efficient process there.

Operator

[Operator Instructions] Your next question comes from the line of Michael Rollins from Citi Investment Research.

Michael Rollins - Citigroup Inc

I had an operational question and then just a strategic question. So operationally, just wondering if you could talk a little bit more about what you're seeing out of the economy? Are you seeing any change in the sales cycle, the interest levels, the pipeline, in the most recent months just given some of the questions recently with the latest market performance? And then strategically, I'm just wondering if you guys could share -- I know you want to really keep the comments to the quarter and the results, but since this is a public opportunity just to hear from you guys, is there something that you could talk about in terms of process or strategically what drove the decision around the merger with Windstream?

Keith Wilson

Mike, this is Keith. I think again in the spirit of -- you most certainly have the right to ask the question, and it's our responsibility to make sure we keep everybody on point. So I think in the latter question, we're going to defer on that one. And we'll have really robust discussion about the process in our proxy statement. As it relates to the first one, I think most of the folks who are on this call and the interaction that we've had with you and with investors, I think Arunas and I have always been very balanced about the economy. I think that we have -- we've been very excited about PAETEC's prospects of operating within what we have always viewed as somewhat of a choppy economy. And we think our value proposition, in many ways, plays very favorably in that environment. We're out there bringing new technology to our customers, new solutions. We're doing it in a very cost-efficient manner. So I would say that from where we were last quarter, we have not seen any significant change in the economy. I think the macroeconomic things that are hitting Washington and the rest of Wall Street are troubling for sure, but as it relates to the day-to-day operations of PAETEC and as it relates to the day-to-day relationship with our customers, I would say that nothing's really changed.

Arunas Chesonis

Michael, and I would agree with Keith. When we went and discussed with all of you on Investor Day that the trends in the industry in the next several years and you think about the managed services trends and how people aren't able to hire as many folks that are specialists and want to outsource a lot of that OpEx to carriers like ourselves, and where the cloud and data center initiatives are going to play for people to save CapEx and OpEx and push it off to other providers like ourselves -- all those trends will only be strengthened over the next couple of months with some of the other economic issues. We haven't seen anything to change that the last 3 months.

Michael Rollins - Citigroup Inc

And if I can just follow up on 2 other quick questions. If you did a full pro forma with all of the acquisitions in there, so XETA, Quagga, just everything that you own today, what would pro forma full-in revenue growth look like sequentially from 1Q to 2Q? And then can you also give us an update on the synergy number? So how much you've saved through synergies relative to what the target opportunity is so we could just think through some of those opportunities over time?

Keith Wilson

Yes, Michael, we would have -- if we had done the analysis, we would have offered that up for folks. We tried to keep integrity in terms of what we reported. So I'm not going to take a -- hazard a guess on what the pro forma sequential was. But what I will tell you is that sequentially, on an actual basis, we did see $7 million in improvement in EBITDA. And so on a run rate basis, that's over $28 million in annual improvement for the operating performance of the company. I think we feel very comfortable that we have in place all of the initiatives necessary for achievement of that full $25 million in synergies that we've discussed. And I think there's a chance that we may exceed, but there are other initiatives that we had in place to improve the fundamental performance of the company as well. If you look at that pro forma year-over-year, EBITDA was up almost $42 million annualized. So it's about $10.7 million. Those are very significant numbers on our EBITDA level. So I think we're very comfortable: a, in the integration of the business; b, the synergies that we're achieving and in addition to all of those really the kind of the core operating performance of the business. So we think all of those things are performing quite well right now and are excited about the momentum.

Arunas Chesonis

.

Well again, thanks, everyone for joining us today. And we look forward to maybe talking to you again next quarter. Take care. Bye-bye.

Operator

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

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