Covad Communications Group: B. Riley Conference Presentation Transcript

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Covad Communications Group, Inc. (DVW)
B. Riley Conference
March 13, 2007 12:45 pm ET

Executives

Chris Dunn - CFO

Presentation

Chris Dunn

Thanks and good morning everyone. The first slide here is of Safe Harbor. I won't recite this for you. You can read more details on our website.

So, a little background on Covad. You have been listening to a number of companies today in the Voice Over IP space. We also do participate in Voice over IP. But, Covad has a pretty long legacy in the telecom industry. We were founded in 1996, and were the first DSL provider in the US.

We built about 2,050 central offices, call over facilities throughout the US. These are primarily located in the major markets. We have been kind of evolving the business from traditional data-only CLEC to moving into new applications like Voice over IP, Wireless Technology, which we'll get into a little bit more detail as well as other value-added services which we are aggressively working on for 2007.

We have a pretty substantial wholesale business. The company was founded traditionally as 100% wholesale. It provided DSL services for folks like AOL, AT&T, Verizon and one of our largest and strategic partners, EarthLink.

This last year, in 2006 first quarter, we received a strategic investment from EarthLink of $50 million. It was to build on a next-generation network platform in the top 11 markets in the US. So we spent 2006, really building out that network. It has roughly 758 central offices. This network allows us to deploy technologies like ADSL 2+, Bonded T1, Metro Ethernet and other new next generation data services.

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We've about 530,000 access lines in service, about 2,500 VoIP sites and about 3,100 wireless customers. On this slide, we do kind of call out some of those next generation technologies. LPVA is the one that we recently launched with EarthLink. What LPVA stands for is line-powered voice access. It is a true phone company replacement service. Here you are powering the copper loop from the central office, using all the internal wiring within the home, but also provides ADSL 2+ or super fast DSL as EarthLink has been marketing it in the industry today.

So, what is Covad's vision? It has definitely evolved over the last several years. Like I said, the company was founded in 1996. It was primarily selling consumer ADSL and business symmetrical DSL services, wholesale. The company has been through a lot of ups and downs through the years and developed a pretty robust direct business over the last three years.

This slide depicts where other traditional CLEC or facilities-based providers typically play, like what kind of services they offer. As you can see, in the last couple of years, we have invested and have acquired a company in the Voice over IP space, hosted voice as we like to call it, it is called GoBeam. We did that acquisition in 2004.

We recently acquired a company in 2006, called NextWeb. It provides fixed, wireless to SMBs. We are looking at other opportunities in the hosting services or value added services or software as a service marketplace.

As you see here, our direction, where we want to take the company is to not only have the network layer, which we have today and feel is a pretty robust network layer. But we want to build on top of that applications and managed services.

So, directionally a lot of the investments we have been making in the business, a lot of the recent acquisitions we have done and the partnerships we have been announcing through the last several quarters are really driven towards that application and managed services space.

So what's our 'Go to Market', strategy? We have really kind of two large business segments, one we call wholesale and the other one we call direct. Wholesale is more of the legacy business. However we are doing some new product developments, specifically with line-powered voice access in that market place. You can see here, how we go to market in these different business segments.

For wholesale, we target kind of the barbell approach. We go into the mass markets with our wholesale partners like EarthLink and AT&T and AOL, most recently with United Online which we announced in the first quarter. We also go upstream to larger enterprises. For instance AT&T and Verizon use Covad's network to deploy services out of footprint for them today. So, with the 22 states AT&T and BellSouth will now have with their facilities footprint. Services outside of those 22 states they deploy will be typically on Covad's network.

Here, you see the fourth quarter revenues split. We did roughly $68 million in the fourth quarter for wholesale and about $41 million in direct. Now it accounts for 38% of our total revenue, that's up from roughly 5% three years ago. So, a lot of our investment has been to grow the direct business. How we defined direct, direct has been built by Covad and supports the customers. The sale may actually be generated through a pretty diverse crowd of systems integrators, VARs as well as our own direct sales force.

Here you'll see some of the key products that we've been really deploying in these marketplaces. Business ADSL, T1 services had been in Covad's repertoire for quite sometime. Most recently we've entered into the voice space and wireless and we are on the verge of launching ADSL 2+ and Bonded T1 services on the next generation platform.

So, looking ahead at 2007. 2006 was a pretty significant year for us. Not only did we do a pretty sizeable restructuring of the business, reducing operating expenses roughly $50 million year-over-year, our adjusted EBITDA improved roughly $70 million year-over-year from 2005 to 2006. We also did a pretty significant build out. We upgraded about a third of our total network in one calendar year with the next generation DSLAM provided by our technology partners, Samsung.

This technology allows us to launch, not only line-powered voice access, but lot of the other new products and services I referenced. Line-powered voice access or as EarthLink will call it in the marketplace, home phone and super fast DSL service, was launched in the fourth quarter of 2006, really mid fourth quarter in those 11 markets. It has been ramping at a pretty aggressive rate in the first quarter of 2007. We anticipate that ramp to continue throughout 2007.

Here you'll see some of our partners. Clearly with Covad's asset base; the 2050 central offices, the back office, the backhaul of the network and the interconnection with all of the RBOCs has attracted a lot of wholesale partners to sell services on top of Covad's network. So, our two largest wholesale partners are AT&T and EarthLink. Here you will see some other partners as well that we do business with. Most recently we announced United Online and we will be deploying it at an online DSL service within the next couple of weeks. Actually we will be announcing that.

In addition to that, our direct business, where we actually go out and sell our services direct, typically to small businesses. Small, we define as 50 users and up. So 50 to 200 is kind of the market we go after from a small business perspective as well as distributed enterprises. So one of the key value props that Covad has is having those national footprints and having 2050 central offices. As Yum! Brands, for instances you has 13,000 KFC and Taco Bell franchises in the US, can do one deal with one provider at one contract for all 13,000 locations.

And then as we look at the rest of the opportunities in our businesses going forward in 2007, we will continue to look at opportunistic ways to enhance those value-added services. So, we did close on a smaller, wireless acquisition in the fourth quarter of 2006, a company called DataFlo in Chicago. Expanding our wireless footprint from non-only the San Francisco Bay Area to Southern California, Las Vegas here as well as Chicago. Now we will look at those opportunities to expand as well. I will get into a little bit more detail, why wireless is an interesting product line for us.

In addition to that we will continue to look to aggressively expand our value added services proposition. We have recently done a deal with McAfee where we are bundling their security services with our T1 services, targeting the small and medium business players. We continue to look at those opportunities, primarily through partnership and not through acquisition or home grown. Given our network, we are able to deploy these services pretty quickly and efficiently, and are definitely being demanded by the small and medium business.

So, briefly on the financial summary, this slide kind of shows you last couple of quarters on the revenue as well as adjusted EBIDTA. Adjusted EBIDTA is defined as EBIDTA excluding stock option expensing.

We had a pre-dramatic improvement in adjusted EBIDTA. However our revenue line hasn't grown dramatically in 2006 and there is a reason why. In fact we will get into it in the next slide. However the services that I have referenced, the growth products, as we like to define them, things like T1 to the business market place with value added services bundled on top of that. Voice over IP, fixed WiMax as well as the additional line-powered voice deployment, are growing at a pretty dramatic rate organically over the last year. However that growth has been weighted down by some of our losses in the consumer ADSL space and some of the business symmetrical DSL space, which is really the legacy Covad business.

So, making that transition this slide shows three important lines for us that we manage very closely; our total revenue growth over the last several quarters, 7% last four quarters. Our groupings of what the legacy businesses are; these are the businesses if you will that Covad put into the market place in the late 90's. These were very competitive in the late 90's, grew to a very sizable revenue stream, generated pretty nice profit margin for us. However there are really not competitive services in the market place any more or the price compression is so dramatic that it is really not interesting for us to compete there at these dramatic price decreases.

So, we have been seeing a slight decline in that market place. We have been doing different churn efforts by upgrading people from 1.5 megabit DSL service to a 3 meg to a 6 meg services at the same price to maintain that customer base. We have also announced a new partnership with United Online. If we can continue to manage that decline and hopefully flat-line that decline at some point in time, it would be great for our business as our growth services are not yet at scale.

You here in the first quarter of 2006, we did about $48 million of recurring revenue on our growth products and services. We anticipate by the mid point of 2007 that our growth products and services will overtake our legacy products and services as a major contributor to Covad's total revenue picture. That really is the transition in our revenue stream.

So, a lot of investments over the last several years to deploy Voice over IP, hosted Voice over IP on a national basis to move into the wireless space and thus start to build-up a platform to enable Value Added Services. Now we are taking advantage of those investments. But given the transition in our revenue stream, the top-line will continue to probably for the first couple of quarters of 2007 remain at this growth rate that we have seen in 2006. Once the growth services overtake that legacy business product set, we expect the top-line to start accelerating its growth.

So, a little bit more on the growth products and services and what the break-out is. You will see here that, we grew business ADSL. This is really ADSL services with different types of SLAs to our SMB customers. This has grown at about 15% annually. Our Voice over IP business has grown pretty dramatically over the last couple of quarters from a small base to about 80% annual growth. Our T1 business, which is really the longest standing growth business, has grown just under 40% on an annual basis.

New products and services like line-powered voice access, which is really a home phone and data bundled service to the consumer market place. It has an opportunity to create a lot of velocity in our sales channels. That is really kind of launching in this first quarter. This first quarter will be the first full quarter that EarthLink would be selling this product in all eleven market places. T1, Bonded T1 and ADSL 2+ services will be launched in the early part of 2007 and we anticipate to deploy those to the rest of our channels.

So, why are we so focused on these growth services and wireless and interesting things for the total business and the margin structure in our business going forward? What this slide does is depict a recurring margin profile of these different growth products and services. So after we acquire a customer and the customer is on our network, these are the recurring margins we see from these products and services. You will see they are dramatically higher then what Covad's margins are today. So while consumer ADSL and business SDSL are well optimized, there is not a lot margin left in those businesses. The price points are pretty competitive and the cost structure is fixed to some degree because of the [unique] nature of our business.

However when we launch line-powered voice access, we were able to generate additional voice revenue. Voice over IP, which is really a software application on top of our network, is how we look at it. As well as the other services, there is a much more aggressive margin structure. Looking at wireless specifically, in our wireless business we did about $12 million of revenue on a recurring basis. On that revenue, we generated about 75% gross margins and about 30% EBITDA margins

So, as that business grows and becomes more of a driver in our total business, we expect all these growth products and services to contribute to the bottom line of Covad.

In 2006 we did spend a large amount of our time effectively fixing the cost structure, if you will, getting operational expenses in line with the operational business. These new products and services, now that our cost structure we feel is in line with the rest of the business, should continue to grow our gross margin through 2007 and 2008.

The other side of the equation, cash; in 2006 as I said before, we took a $50 million investment from EarthLink, $10 million in equity, $40 million in convertible note, to develop and deploy this next-generation network. We really look at that as specific project, a specific point in time that is very strategic to us. So this cash growth shows, the cash growth in the company excluding that project.

You'll see in the second quarter of 2006, we had a pretty large debt. We redeemed our past liability with AT&T. When the company emerged from bankruptcy in 2001, it took two forms of investment from AT&T to emerge from bankruptcy. In return for those investments, AT&T have a first secured lean on all of Covad's assets. So, by redeeming those liabilities in the second quarter 2006, AT&T has released its lean on Covad.

So, that's a pretty strategic move for us to make. At the same time we opened up a standard Letter of Credit with Silicon Valley Bank of $50 million. That remains primarily un-drawn; more as additional liquidity is needed for the business.

You'll see, we have about $167 million in debt as comprised primarily of two instruments. One is a convertible note that we did in 2004, which is a $125 million convert, which becomes mature in March of 2009. Then the other element is the $40 million portion of the EarthLink investment. We ended the year with total cash at $81 million. You'll see our unrestricted cash, if you will, or the cash that's not tied up in the investment that EarthLink made, grew $6.2 million in last two quarters.

So in summery, looking at our network and looking at the opportunity to take advantage of that network and leverages those assets. Here we have listed the 11 markets that I referenced that were upgraded with this next generation platform. These markets account for roughly 70% of our total revenue today, across all of our product lines. So the opportunity is, not only to leverage that relationship with EarthLink, to have EarthLink succeed in launching their product and services in those marketplace, but also to launch other partners as well as use those that platforms for our own use; whether its Bonded T1 or ADSL 2+. These are the areas that we will focus on aggressively in 2007.

In addition, we will continue to build our wholesale channel, that's a very important part of Covad's business. We have a pretty robust set of APIs and we are pleased to doing business with a national basis. It has attracted people like EarthLink, like AT&T and most recently United Online to signup large agreements with us to deploy DSL services as well as potentially other next generation technology services.

We also will look at opportunities to leverage our wireless assets with FiberTower and Nextlink. So as we look at southern California, the San Francisco Bay Area, Las Vegas and Chicago, we look to expand in those marketplaces but we also are looking at additional marketplaces in 2007-2008 to expand our wireless technology.

We are launching additional products on top of that platforms. So, one key element for us in receiving the strategic investment from EarthLink was, not to have an exclusive right for EarthLink to deploy services on that platform. We can deploy the same services or additional services, whether it's through us or whether it is through even a competitor of EarthLink on that platform. So, we will look to do that in 2007 and 2008.

We will continue to focus on our financial efficiencies. We did a lot of aggressive moves on the financial side in 2006 to get our cost structure inline with the operational business. We feel pretty strong. Our SG&A is kind of industry best if you will, if you look at our competitors. As far as a percent of revenue, we ended the year by 27% of revenue as SG&A. We really now are focusing on our gross margin as we move forward in 2007 and 2008. That will be driven by the success we have in those growth products. The more successful we are there, as you saw the recurring margins for that business line, we expect our gross margins to be improving.

So, with that said, I open up to any questions anyone may have. Yes.

Question-and-Answer Session

Unidentified Audience Member

[Question Inaudible]

Chris Dunn

Sure, so really looking at the footprint reach, the footprint that was upgraded with line-powered voice goes past about 14 million homes. When you get to the 13,000 feet away from a central office, it is a challenge, just any kind of DSL technology, whether it is ADSL 2+ or just traditional ADSL 2 to deliver services at that speed. So it does compress your network at higher speeds. The 8 megabit service that we are deploying with EarthLink crosses about 14 million homes and goes at about 12000 feet from the central office. Once you get past that point, you do start to degrade speed. So, at that point of time the terminology that we use is remote-terminals, which is fiber-fed remote terminal and remote-terminal goes out pass that point. We do leverage that with AT&T's footprint. We haven't entered into that same commercial agreement with Verizon. However with AT&T's recent acquisition of Bellsouth, we expect to expand the remote-terminal reach in the BellSouth territory, which we haven't had in the past.

So that does extend your footprint a bit. But the technology itself, the DSL technology does have a limitation on reach. Another focus area though, when we do look at SMBs for instance, if your SMB is looking to buy a business ADSL line and we have a reach issue, T1 services do go to boundary of the central office. So, there is a much further reach with T1 services. So, there are opportunities to up-sell those customers to other services and still get the same level of service. But that is a technical challenge with DSL.

Do you have any other questions? Right, well thank you. I appreciate your time.

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