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Qwest Communications International, Inc. (NYSE:Q)

Q1 2007 Earnings Call

May 1, 2007 9:00 am ET

Executives

Stephanie Comfort - VP of Investor Relations

Dick Notebaert - Chairman and CEO

John Richardson - EVP of Finance and CFO

Analysts

John Hodulik - UBS

David Barden - Banc of America

Westin Tucker - J.P. Morgan

Frank Louthan - Raymond James

Tom Seitz - Lehman Brothers

David Janazzo - Merrill Lynch

Presentation

Operator

Good morning, my name is Katie and I will be your conference operator today. At this time I would like to welcome everyone to the Qwest First Quarter 2007 Earnings Call. All lines have been placed on mute to prevent any background noise.

After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions).

Thank you. I would now like to turn the call over to Stephanie Comfort, Vice President, Investor Relations. Please go ahead.

Stephanie Comfort

Good morning everyone, and welcome to our call. We're here to discuss our first quarter results. With us on the call this morning are Dick Notebaert, our Chairman and CEO and John Richardson, our EVP of Finance and CFO.

Before I turn the call over to Dick, I would like to remind everyone that we will be making forward-looking statements. These statements contain risks and uncertainties which could cause actual results to differ materially from those expressed or implied here on the call. Those risks and uncertainties are on file with the SEC. Additionally, we do not adopt analysts' estimates nor do we necessarily commit to updating the forward-looking statements that we make here.

Also, let me mention that in order to supplement the reporting of Qwest consolidated financial information, the company will discuss certain non-GAAP financial measures, including EBITDA, free cash flow and net debt. A full reconciliation of non-GAAP measures is included in the quarterly earnings section of our website.

With that, I'd like to turn the call over to Dick.

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Dick Notebaert

Thank you, Stephanie. Good morning everybody, welcome to the call. With the first quarter results we reported this morning, we were off to a solid start for 2007, as we progressed towards our long-term goal of sustainable value creation.

Our results this quarter build on significant achievements of the entire Qwest team over the past few years and we are committed to continuing this progress in the future. Our focus on the fundamentals produced margin expansion, earnings growth, disciplined investments spending, increased free cash flow, and continued progress on our share buyback program.

We also achieved exceptional customer service levels across the board, further evidence of our commitment to differentiate Qwest through superior customer service. Our results demonstrate that our strategies are working and our intention is to maintain that discipline.

Here are the first quarter highlights. Revenue totaled $3.4 billion, a decline of just under 1% year-over-year and just over 1%, sequentially. Now, both comparisons reflect our de-emphasis of the lower margin legacy products, such as Dial Access and we have talked about that in the past. The anticipated reduction revenue from a large equipment contract is also there. That, we also disclosed as a onetime event last year, and regulatory settlement impacts. Without the impact of these items, revenue would have been slightly up.

The underlying trends continue to support modest growth despite continuing access line losses as customer demand and a clear value proposition for our portfolio of growth products continue to drive volume, ARPU and bundle penetration. Data revenue growth from the quarter was 11% year-over-year, similar to the growth we experienced in the fourth quarter. Data revenues now comprise 35% of Qwest total revenue. That is consistent with our strategy to migrate from legacy to next generation products and services.

I want to comment briefly on our channels. First, mass markets delivered growth both sequentially and year-over-year. As we continue to gain traction on growth products including broadband, our video offering, VoIP and long distance which in turn helped drive, improved ARPU and improved bundle penetration.

Overall data revenues in this channel grew 45% year-over-year, and 10% sequentially. Broadband subscribers increased 37% in the first quarter compared to the prior year with almost half of new customers taking our "Price for Life" offering. Now available at higher speeds and it's available to small business customers. And our broadband penetration improved to 19% from 13% a year ago. Demand remains strong and we see further opportunity to drive penetration through three areas, dial-up migration, new internet users, and competitive share uptake.

DIRECTV subscribers grew 22% sequentially increasing total video subscribers to more than 500,000, up 19% sequentially and more than double where we were a year ago.

Bundle penetration improved to 59% from 57% in the fourth quarter and 53% in the first quarter of 2006. And consumer ARPU increased to $52 from $49 a year ago. And some of our strategies are working, supporting the opportunity for full year, top line growth of 2% to 3% in this channel.

We increased new wireless subscribers, 3.6% and improved wireless profitability through reduced customer acquisition and data cost. Our enterprise and wholesale strategies leverage our state-of-the-art long-haul network and next generation product suite to drive growth as business transitions to our new communication solutions.

It's not apparent in our revenue numbers but we are making progress and we are gaining momentum. The opportunity is definitely there. Although reported first quarter business revenues declined, this channel grew modestly year-over-year after adjusting for the de-emphasis of dial, as I mentioned previously, and for a transition away for certain non-recurring revenue.

We expect this transition will continue to effect channel revenue in 2007. The first quarter represented our toughest quarterly comparison in this regard. Now the good news is that the next-gen growth products including IP, hosting, data integration and VoIP where up nearly 30% year-over-year on an annualized basis and now comprises approximately 21% of our channel revenue.

Evidence of customer demand for our business solutions was our March win of a stake in the U.S government coveted $20 billion Networx Universal contract. As a result, Quest will compete with two other Networx winners to provide leading-edge voice, data and video services, including managed and secured advance data networks to federal agencies worldwide and nationally.

In addition, since signing our largest integrated access contract to date in the fourth quarter was SuperValue, Quest has affirmed the quality if our iQ MPLS product through additional contracts signed with the City of Los Angeles and Cal State University in the first quarter. In addition we inked deals with a number of national financial institutions for solutions that leveraged our state-of-the-art data network.

Now, to satisfy the strong demand for our hosting and managed services, we opened a new hosting center in Seattle in the first quarter. We expect to continue our expansion efforts in support of the demand we are seeing in this rapidly growing area.

Let me switch over to wholesale. Revenue was flat year-over-year, similar to the year ago quarter. We experienced pressure in the carrier segment, of wholesale long distance. The impact of consolidation and selective price increases drove some less profitable minutes off of our network, while improving ARPU and the overall contribution of our wholesale channel.

We continue to focus on selling available capacity to high-value customers, where we see significant opportunity. Our strategy remains consistent, managing the wholesale channel with a diligent focus on profitable growth.

Switching to EBITDA; it increased in the first quarter after adjusting $40 million, charges for securities litigation. Our adjusted EBITDA margin improved to 34%, marking our eleventh consecutive quarter of year-over-year improvement. Our goal remains achieving a very competitive mid 30% EBITDA margin. I said mid 30% EBITDA margin. With our first quarter results we are getting very close.

First quarter adjusted free cash flow of $150 million represented an increase of $300 million year-over-year, with the majority of the increase attributable to improvement in operating results and changes in the timing of CapEx. We still expect CapEx to be in the range of last year's level, as we apply capital investment discipline and a focus on strategic priorities to support the products and services our customers want.

We have continued to upgrade our ultra-longhaul network on a targeted basis and within our stable capital budget in order to satisfy growing demand for our higher bandwidth products. We expect the current stage of these upgrades to be complete in June.

Nearly 50% of our wireline investment is on broadband. Now that's up from just 30% two years ago. You can see what we are doing! We have the opportunity to generate up to $400 million in free cash flow growth in 2007. Now, that's before one time items, as we improve profitability and maintain our disciplined management, the spending, and of our balance sheet.

Finally, we are applying the fruits of that discipline and improved performance to return capital to shareholders. We made further progress this quarter in the share buyback program we initiated last year. Through April, we have completed approximately 35% or nearly $750 million of the $2 billion program. Our commitment is to continue to evaluate additional opportunities to reward shareholders, as we go forward.

As we continue to implement our strategies, our priorities for 2007 are unchanged. First, continued success in growing our mass market channel revenues through increased ARPU and bundled penetration. Our second priority is to return to top line growth in our enterprise business by leveraging our state-of-the-art long-haul network and solutions driven product suite and high growth data and internet products that are becoming an ever more meaningful part of our product mix.

Our third priority is to continue to manage our wholesale channel for improved returns and you'll remember we have been on this path for several years. Our fourth priority is to invest in areas that drive revenue, customer retention and appropriate returns on investment. And finally, our fifth priority, which is really our number one priority, is to deliver outstanding customer service.

In summary, we know what we have to do, we are doing it. The opportunity is there. Our strategy remains consistent and focused based on a commitment to service, to discipline and efficiency while we provide customers with industry-leading products and services they want. We believe we have the resources to execute our strategy in light of Qwest opportunities. We will continue, as we have in the past, to scan for bolt-on acquisitions in a way that makes sense for our business, and for our shareholders leveraging our assets, our brand, and our service capabilities.

Now let me turn the call over to John Richardson, our Chief Financial Officer, for more detail. John?

John Richardson

Thanks Dick and good morning everyone. We are very pleased that the first quarter delivered on so many of the initiatives we focused on, in our past discussions, and I'll begin with revenue.

Our revenue totaled $3.4 billion in the quarter with continued strength in key underlying trends. Specifically, the first quarter revenues absorbed the impact of regulatory fees and settlements, the revenue reductions from a large data equipment contract last year, as well as the strategic de-emphasis of low return products. These items affected total revenues by $75 million year-over-year. We consider the underlying low single-digit revenue growth Qwest achieved to be a more accurate reflection of the trends in our business as we enter 2007.

Revenue in the mass-market channel grew both sequentially and on a year-over-year basis. As discussed in the prior quarter, universal service fund rate changes and regulatory settlements affected the year-over-year comparability. These items totaled $23 million in the quarter.

Excluding these regulatory impacts, year-over-year revenue grew 3%. The success of our bundles and the focus on driving higher value, higher ARPU products continue to offset the impact of access line pressure. Mass market access lines declined 6.5% year-over-year, however, over the same period our total connections increased by 2.4% and our consumer ARPU grew 6.1% to $52.

Our quadruple play including digital voice, high-speed internet, video and wireless allow us to sell more products to existing bundle customers even as we increase the number of customers choosing the bundle. 41% of our bundle customers have three or more products in the bundle up from approximately 30% a year ago and this is helping to increase our ARPU. As an added benefit, each product added to the bundle, especially above the three product mark, increases our ability to retain these most valuable customers.

We see good opportunity for these trends in ARPU and bundle penetration to continue as customers consolidate their communication and video services with us and upgrade or take an Internet connection product for the first time.

There are still approximately 2 million dial-up users in our region that we are targeting for high-speed Internet product. We are having success at reaching new users and converting our competitor's high-speed Internet customers to our product as well.

The penetration of our retail access lines are 19% up from 13% just a year ago. There is still plenty of room for us to grow. Our DirecTV alliance continues to be a strong contributor to our bundling success. We added nearly 80,000 DirecTV customers and more than doubled subscribers from a year ago.

With 7% penetration of our primary consumer lines, there is still room for customers to add a video product to the bundle. With DirecTV providing expanded high-definition line-up, as well as the NASCAR and Major League Baseball packages, we expect the solid growth of our video products to continue.

Qwest business channel continues to feel the momentum of strong underlying trends in key growth products. As Dick noted, these trends were not necessarily visible on the surface. This is due to a couple of items including revenue from a large data equipment contract in the first quarter of last year and our decision to de-emphasize the Dial Access product last year.

These two items alone had a $52 million impact on the year-over-year revenue comparison. We do not expect the Dial product to affect the sequential comparisons going forward, but we will continue to have the year-over-year impact in the second quarter, and to a much lesser extent in the second half of the year.

Although this surface turbulence is distorting our comparisons show continued strong growth and product such as metro Ethernet, Voice-over-IP, Hosting and iQ. The underlying growth in data and Internet revenue on our business channel was approximately 8% year-over-year, after considering these previously mentioned items which worked against the positive trends. We believe this level of growth is more reflective of the activity that we are seeing in the business.

By investing in and developing solutions that meet the changing needs of our customers, we continue to believe in our opportunity to grow Qwest Business Channel in 2007.

We are marketing and launching several business packages this quarter that we believe will attract new business customers and will help to retain existing legacy data customers until they are ready to migrate to our advanced MPLS solutions.

On the wholesale side of our business our quarterly revenues were down 2.9% sequentially and generally flat on a year-over-year basis. This sequential decline reflects normal seasonality, as well as, the impacts of the industry consolidation and targeted pricing increases designed to improve overall profitability.

The general industry trend, the data traffic increasingly replacing voice traffic continued, and the overall pricing environment remained generally stable.

On a year-over-year basis, growth in data revenue of over 10% largely offset access line and volume-driven declines in UNE and Access revenues. We continue to focus on selling available capacity to high-value customers such as re-billers, cable, wireless and VoIP providers. We believe that by selling to these types of customers we will be able to replace the lower return revenue from local exchange carriers lost to industry consolidation.

Wireless revenue was flat year-over-year, while subscribers grew by 3.6%. Subscriber growth in the quarter was driven by our new shared plans, promotions, new phone introductions and successful bundling efforts. Revenues stayed flat due to lower ARPU from our new shared plans and equipment offers, but the profitability in this segment improved.

The wireless segment was breakeven for the quarter and improvement both year-over-year and sequentially. Wireless continues to be a significant part of our bundle offerings and strategic positioning resulting reducing churn and providing a complete solution to Qwest customers.

Now, let me shift to the rest of the income statement. We improved EBITDA and EBITDA margins in the quarter to 32.8%, an improvement of a 180 basis points sequentially and 270 basis points over the prior year. The quarter included a charge of $40 million related to our securities litigation. Without this charge our margin would have been 34%. Adjusted EBITDA of $1.17 billion for the quarter represents over $90 million of improvement from the fourth quarter which had unusual seasonal effects.

From here, we continue to believe that we can improve our EBITDA toward the stated goal of EBITDA improvement of up to $400 million for the year.

Our investment in productivity improvements continues to achieve results in all facets of our operation. Our investment in improved call center management technology and call center consolidation has resulted in improved costs. Initiatives around improving our long haul network through hubbing, grooming and disciplined capital investment have continued to reduce facility cost.

Productivity initiatives had made it possible for us to improve our profitability and our employee count is down 2.9% from this time last year and the accolades for our service have never been better. These initiatives continue to be the center piece of our strategy to drive further improvements in EBITDA and sustain profitability for Qwest.

In addition to improving our customer service the benefit of these productivity improvements can be seen in our operating results. We reduced operating expenses by 6.2% in the first quarter compared to a year ago and cost of sales and SG&A were down $116 million year-over-year with $34 million of that reduction coming in facilities cost and $24 million in employee related cost.

Our productivity initiatives continue to gain traction and we are just beginning to show their full potential in our results. The sequential decrease in operating expenses of $176 million from the fourth quarter was driven by reduced depreciation and amortization, lower traffic volumes both internationally and domestically and the fluctuating seasonal employee cost.

For the quarter, diluted EPS totaled $0.12 per share compared to $0.10 for the fourth quarter and $0.05 per share in the prior year. The current quarter included the $40 million a charge related to our securities litigation as compared to the fourth quarter, which included $61 million gain on the sale of real estate.

Capital expenditures for the quarter totaled $318 million, down both sequentially and from the prior year when our spending was more consistent from quarter-to-quarter. Decline in the current quarter is largely attributed to the timing associated with our specific capital projects.

We generated significantly improved adjusted free cash flow of $150 million in the quarter, and this represents a $300 million improvement over last year's figure. This was driven by better operating results, lower capital expenditures, and favorable results from our balance sheet as both, receivables and payables improved.

As we have previously discussed, we experienced fluctuations in our cash flow from quarter-to-quarter due to the timing of certain payments, with the first quarter traditionally impacted most unfavorably by these items. With the annual bonus payment, semi-annual interest payments and an extra payroll day all grouped in the first quarter. We had approximately $360 million in items that depressed the quarter's results from a more level run rate.

With solid results in the first quarter, we continue to believe that we have the capability through modest revenue growth and continued margin improvements to increase 2007 adjusted free cash flow by up to $400 million from last year.

Finally, the balance sheet, during 2006 we made significant progress in improving our liquidity. Even with the first quarter having traditionally lower free cash flow we maintained a strong liquidity position with cash, and short-term investments of $1.1 billion and net debt of $13.8 billion, and that's an improvement of $900 million from the end of the first quarter of 2006. We expect to be opportunistic in continuing to reduce our leverage, most likely as debt comes due and with the circumstances make such an activity value creative. We will continue to enhance our financial flexibility including simplifying our capital structure and retaining a manageable maturity profile.

You'll also note when we file our Form 10-Q shortly that we adopted FIN 48 in the current quarter and this interpretation clarified accounting treatment for uncertain tax positions. As a result of Qwest adoption we increased our book net operating loss carry forwards approximately $2 billion and are now reporting over $7 billion of NOL’s. I would point out that this change is based on certain tax items being settled consistent with our FIN 48 estimates.

In closing I have to say that we are very pleased with how we came out of the shoot this year. We maintained momentum in our key growth products while driving higher ARPU and improve free cash flow. We continue to eliminate cost from our business while investing in the development of products and solutions that our customers want.

And the year that we said was going to be all about execution, we are very happy with how we executed against our strategies this quarter. And with that let me turn it back over to Dick to wrap up.

Dick Notebaert

Thank you, John. Our priorities for 2007, to repeat what we have said is to drive modest revenue growth, to improve our EBITDA margins, especially through optimization and productivity initiatives and to increase free cash flow.

I think in closing our prepared remarks, one has to say that our strategies are working. Our progress is demonstrable. We have momentum that is tangible and a positive outlook for the future based on the opportunities we have in front of us. And now Katie, we'd be happy to take questions.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from John Hodulik with UBS.

John Hodulik - UBS

Good morning.

Dick Notebaert

Good morning, John.

John Hodulik - UBS

Two quick questions, first, Dick on the business trends, given the tough comps here in the first half, if you look after the second half with the trends you are seeing in the business and what's happening in the industry. How fast do you think this business can grow? And second of all, as it relate to margins, you've been sticking to your guidance for mid 30s, you had 34%. First quarter is usually on the lighter side given that the sequential trends you've been seeing, how do you expect it to trend throughout the year given all the cost cutting initiatives and the forbearance you have seen? Is this expected to be toward the low end and in other words I was looking for a definition of mid 30s, we are talking 35, 36 or sort of closer to 34?

Dick Notebaert

John, well we have been very careful not just say 35, 36 or something, but we've set in the range of the mid 30's and 34 is pretty good and we do believe there is upside and there is opportunity for us to continue what we have done on the run rates on our expenses and productivity improvements. It's a first quarter that's usually if you go back and think about a year ago. John and I were talking about this last night, if we think about a year ago where our margins are always lumpy in the first quarter and sort of be $3 million up gives us a feeling that we are on the right path and we are doing the right thing.

The BMG, on the Business Markets Group, if you look at the wins, we feel that the opportunities there we've had some wins, those sales wins have not translated yet in to revenue because we have to execute, implement, and then start the billing cycle.

So, I think we are still in a position to do what our folks have said they would do, which is to grow that sector of the business modestly this year. And I think we are on a pretty good trajectory, especially, with the Networx contract.

Now Networx, probably won't generate a lot of revenue until fourth quarter, I think, and then it will start to ramp up, because we've got to go through the test cycle and the different things. But, I think it's indicative of where our Business Marketing Group is targeted and going. And John, you want to add anything on the markets issue.

John Richardson

I just think on the margin side, we have our guidance out there of a plus 400 for the year, and we have come out of the year very well. And it gives us increased confidence that the goals we have are in reach.

On the revenue side, John, I think that we believe that the underlying trends in the mass markets area if we take out some of the unusual charges we had about 3% growth rate. And wholesale holding fairly flat this year. And again in that growth, Dick has talked about in revenues and business where the timing is right for us, really I mean, with the technology changes and the industry consolidation. And of course, with the Networx with us, being recognized as a Tier 1 telecommunications provider by the government, we have the opportunity to grow the revenue there. And it's incumbent upon us to execute against that opportunity.

Dick Notebaert

And one last comment on the free cash that John mentioned. There is always the opportunity for variance within and without, so I think we are off to a decent start.

John Hodulik - UBS

One quick follow up. Any comments on the timing of when you would make a decision regarding the return of additional cash to shareholders?

John Richardson

We haven' made a decision and we have had our first discussion at the board, but we have to do what we've done in the past, which is be very disciplined. I think if you look back on our track record, we are fairly predictable. It's pretty obvious, but we are disciplined and I think we'll stay with that for now.

John Hodulik - UBS

Okay. Thanks.

John Richardson

Next question Katie?

Operator

Your next question comes from David Barden with Banc of America.

David Barden - Banc of America

Hey, good morning guys. Thanks.

John Richardson

Good morning David.

Dick Notebaert

Good Morning David.

David Barden - Banc of America

May be just on the income statement, and may be three questions, just three kind of surprises for me. One was on the data and internet revenue segment, the loss of growth momentum in that segment in the first quarter and seeing some nice steady growth quarter-on-quarter for the last year, so and kind of just a very slight sequential down tick. If you could talk about how all these kind of year-over-year pressures you are talking about might have come in to play sequentially on the data and internet revenue line?

And then second, the cost of sales, down almost $100 million quarter-over-quarter. It's just such a huge amount of money saved in one very short period that, I guess the question is really, you talk about kind of the run rate trends, obviously that kind of run rate trend is impossible. But, it just seems like so much must have come to fruition in that quarter that I have to ask where can it really go from here and what was done to get that kind of significant cost savings?

And then the last thing John, it looks like the amortization expense sought of disappeared in the quarter and I just want to get a sense of where that went? Thanks a lot.

John Richardson

Dick, do you want me to take crack at these--

Dick Notebaert

I'll do the first and then you wait on the amortization. On the data and internet revenue, I guess I would push back a little bit. I don't think there is anything there that would give me a feeling that momentum isn't there for us. I guess if I look over in the mass markets, our growth was 37% (inaudible) very solid for us. And ARPU was very good. So, if I look at it, the one thing I would point to that doesn't give me a concern is the change in the one time revenue, that's customer premises equipment, CPE, that's non-recurring revenue versus the monthly recurring revenue which we are really focused on building the MRC, the annuity business.

The other thing is if we look at our wholesale side, the IP long-distance had a slight decline. That doesn't leave me uncomfortable. I think Roland and the guys are focused on exactly what they should be. So, those one time hits, could feed the beast, so to speak, with a one time customer premises sales. But that's not what we are about. We are about sustainable, predictable revenue. So, I think you see us as we said, John and I both said in the opening remarks, we want to deemphasize the dial business and we want to make sure that if we get a huge government contract or good, pardon me, any large contract for onetime that we point that out as we disclosed last year same time . On your question on margin, just repeat that for me.

David Barden - Banc of America

Well, just the cost of sales, Dick.

Dick Notebaert

Yeah.

David Barden - Banc of America

Just $1.32 billion versus $1.4 billion, $1.5 billion in the fourth quarter, $1.42 billion in the first quarter last year and just a big sequential jump downward and there might have been other costs in the fourth quarter obviously, but just such a huge change in one quarter makes me ask the question where can it really go at the margin?

Dick Notebaert

Well, again I would go back and I'd point to two things and not to sound imperative, but when we do a onetime sale of customer premises equipment, whether it's routers or some other type of equipment, that's also an expense item. I would also point out at that margin on the customer premises equipment is usually narrower than the margin on the network or on our annuity business. The other thing is our employee count. You could see that, we had a significant improvement or reduction in that area if you will. And I think that all goes together and to point that out again, I think if you look at this quarter versus what we've done with customer premises equipment in the past, you can see translate there. Let me stop at that point and let John continue.

David Barden - Banc of America

Amortization

Dick Notebaert

One other point. Do you remember on our call, we had for the December quarter, we simply had higher than normal cost. Remember we said that you're better off going in to '07 coming off for the third quarter.

David Barden - Banc of America

Right. The onetime cost from the storm and things like that.

Dick Notebaert

As you look at it sequentially, please take those -- if you go back and look at what we said at the transcript from the December quarter, I think you'll find a very consistent path that helps explain the number you’ve just raised. I think I've done the first two, so John will do the amortization for you.

John Richardson

And David on the amortization side you might recall that in the 2006 10-K we indicated we had done an analysis of the lives of our capitalized software, and as a result of that analysis we extended the lives a bit, and that caused a reduction in the amortization of capitalized software, that's the single biggest reason for the change there.

David Barden - Banc of America

And when will it go to zero or where is the run rate amortization number in the quarter, John?

John Richardson

Well it will never go to zero, because I know we continue to invest, but the run rate that we had in the quarter here is going to be pretty consistent with what we have for the rest of the year.

David Barden - Banc of America

Okay, thanks.

Dick Notebaert

One last thought on the comment on the data growth, I think I just ought to add one thing, if you took out what John mentioned and I mentioned on that one data sale or customer premises equipment sale we had, we actually year-over-year, increased the data growth. If you take up that one-time shop, which we both pointed out in our opening remarks. Okay Katie, we'll take another question.

Operator

Your next question comes from Jonathan Chaplin with J.P. Morgan.

Westin Tucker - J.P. Morgan

Good morning, and it's actually Weston Tucker filling in for John. Just two quick questions. First on revenue: Could you give us a sense on a year-over-year basis in wholesale where we are at in terms of the pressures from consolidation on sort of rolling off year-over-year, and then second just a follow-up on John's question a little bit just in terms of EBITDA margins, you were already at 34%, you are going to mid 30’s, I guess, can you just talk about the opportunities to expand the margins on a sequential basis throughout the rest of this year, if that's something that should be achievable, and if not, just some of the opportunities for that would be great?

Dick Notebaert

Now let me do the second part first. We have to be very-very careful on sequential. We have said for the last couple of years just as we did if you look, as John pointed out, the first quarter is usually lumpy. We did very well in the first quarter; there were some timing issues of $300 million better and the margin did improve.

I think we have to look at it as directional and where we want to go, and we think there is opportunity for us to improve our performance. We have said that, our consistent commitment to our owners is to do that in a sustainable way. So, sure, there is more opportunity as we look at the year. I'll be a little uncomfortable saying that every quarter is going to be better than the quarter before, don't read anything into that. I am just saying that, as I look over the last several years, it's always possible like we did in the December quarter to have something there. What was the other question?

Westin Tucker - J.P. Morgan

Just on revenue in wholesale. How, on a year-over-year basis, is where we are getting at with the pressures of consolidation, kind of starting to ease or where are we at with that?

Dick Notebaert

Well, you got to compliment the wholesale group because remember we lost Verizon, when they bought MCI, and they groomed all that stuff away. It took us two quarters and we got it back which is pretty good. So far, we feel that our ability to find higher ARPU traffic and opportunity is there, and even if some people start to groom some stuff and they haven't, but even if they start to groom some stuff we feel that we could target this with higher margin opportunities in the reseller type business. And, we did see, just to give you a feeling, we did see in this quarter our friends at Sprint Nextel groom some of their traffic away from us and a sizeable amount, don't you think, John?

John Richardson

It is a fairly sizeable amount, absolutely.

Dick Notebaert

And yet rolling the team we’re able to do a good job of replacing that traffic on our network. So I think as we look at the year, we think the opportunity is there even with the consolidation grooming.

Let me stop and just ask John to comment, do you want to comment on my margin comment, anything you want to add to the margin?

John Richardson

You've indicated that there can be bumps in a road as we had in the fourth quarter…

Dick Notebaert

We don't anticipate anything in our cost.

John Richardson

We don't anticipate any, however our cost initiatives are well in place. Our productivity initiatives are reaping rewards for us. We continue to focus in the facilities cost area to drive down cost there. And also in the administrative side of the business we are continually focusing on making sure that we have ourselves sized up for the size and demands of our business. So, we believe that through these modest revenue opportunities we have and cost down opportunities that we can continue to grow our EBITDA.

Westin Tucker - J.P. Morgan

Great. Thank you very much.

John Richardson

Thank you. Thanks for your question.

Operator

Your next question comes from Frank Louthan with Raymond James.

Frank Louthan - Raymond James

Great. Thank you. A couple of questions; looking at the SME business alliance growing a little bit, talk to us about that, I was just seeing a lot of activity across the industry in that sector. How are you defining SME business, and give us some idea of where are you seeing the strength there? And then just entering looking at your videos, 7% penetration, kind of a leader in satellite penetration. Why do you think that you are seeing more success there relative to some of your peers? Are you seeing -- do you think you have less cable competition, just in general, or some thoughts on the success there? And where do you think that penetration can go overtime? Thank you.

Dick Notebaert

Yeah, that's the first time anybody has ever asked us if we had less competition; that felt good, thank you. On the DirecTV, we are really focused in on the bundle and the package, and you can see the increase in the percentage in the take rate. And, we have a very good relationship with DirecTV, Chase Carey and the team.

The other thing is, I think a lot of people are frustrated with the cable company's quality of service and the attitude. And DirecTV as John said, gosh, they have all those HD channels now. That's a great package, great bundle while we had the football package, now you've got the NASCAR package. I think it's an outstanding product, I mean I subscribed to it, I definitely liked it. And we focus very strongly on that versus other alternatives.

On small biz, we grew the lines; we grew access lines in small business. The one thing that Tom Richards and his team and Paula Kruger from the Mass Markets that we've done depending on where you want to draw the line, the one thing that we have really tried to do is to work on tailoring our products or bundles that we have for the consumer, moving them over and tailoring products for the small business person. An example, if you are one man entrepreneur and you are doing HVAC, you really don't want to have to think about, do I buy this product or that product, just give me the package that'll make me more efficient and I don't want to deal with it.

So, Dan Yost who runs our Product Group has really focused in on taking those things we've learned from the consumer and just rolling them into the small business area. It's made a big, big difference for us.

And one last comment on DIRECTV. When we look at the margin that we got in our contract and it's fixed, and then we look at alternatives, that's a very solid business for Qwest. And reselling their service has been very productive for us on a financial basis and we'll continue to pursue that. As we monitor how other people are doing with IPTV or cable overbuild.

Frank Louthan - Raymond James

Just quickly to follow-up. Seeing on the small business that's really sort of the four or five lines or less sort of a small business that is where you are seeing the real success there?

John Richardson

Yeah. And think of just $3,000 in communications spending and below. I mean that's the way to look at this, $3,000 in spending and below. And again, if you look at we moved Price for Life over to the small business customer. I mean we were doing the same things there that we've done on the other side and it's got new traction. We also have looked at enhancing some distribution that we were doing on an outbound basis and that's also paid off.

Frank Louthan - Raymond James

Great, thank you.

John Richardson

Katie, we'll take two more questions.

Operator

Your next question comes from Tom Seitz with Lehman Brothers.

Tom Seitz - Lehman Brothers

Yeah. Good morning, thank you very much for the taking the question. I guess, starting off congratulations on being selected as part of the Networx Groups.

John Richardson

Thanks Tom.

Tom Seitz - Lehman Brothers

Sure. My question is given the breadth of that contract is there going to be any material CapEx spent in advance of bidding on pieces of that contract. I mean, certainly Qwest has done a lot of government business in the past. But, just given how big that is I am wondering is there going to be any sort of spending ahead of bids that will move the needle at all on CapEx?

And then second question following up on Frank, it sounds like your appetite for IPTV right now, even with some of the success AT&T appears to be having, taking that to scale is pretty mute. But, given that half of the wireline CapEx spend is depended on producing higher speeds. Can you update us as to what percent of our access lines are now below say 3,000 feet?

Dick Notebaert

Well, I can't, if I think about 3,000 feet, I can't on the remote -- on top of my head I can't do that for you. I can tell you where the speeds are going. Well, look 83% of our customer base can get high speed internet from Qwest, 98% of them can get a meg and a half or more. Over 50% can get 3 to 5meg, and over 25% can get 7meg, and those speeds are moving up.

Now, we also do fiber-to-the-home on new developments. We have said that before, and we continue to do that. So, our plant is in pretty good shape overall and we think with the remote terminal placement where it is and than if we need to do pair bonding we can get the speeds up to where we need for the customers, bandwidth and future bandwidth, so that they can do streaming, so they can download in content shift based upon some of us would call it consumer emancipation, I saw that in a newspaper article, I kind of like that, so you aren’t tied to the cable company, you can do what you want, when you want. So, I think we are in pretty good shape, we got the IPTV stuff out at mineral in our lab, and we are looking at it. Our problem is that when we look at return on invested capital, if you believe in content shifting, what's the timing of it. And again our penetration rate with DIRECTV and they are reselling our high-speed Internet, and that's pretty good 7%, I mean that's we are adding quite a few customers. So if the customer is happy, we are happy and then that's what matters.

On the Networx contract, on the federal contract my feeling is that we have the benefit over the last year, actually for last several years of having a very good high-speed backbone network, our ultra long-haul as I mentioned in my call and that by the way, that translates into our OC-768 that will be done in June. We anticipate it being done in June, borrowing any foreseen happening. We invested last year in the centers, in the control center and doing the stuff within the context of our CapEx budget. If we get something huge of course we'll deploy capital but it's tied to revenue and that's tied to margin because this is a profitable business. So, to me that's our disciplined approach. John, do you want to add anything on the CapEx?

John Richardson

I think other than as we got ready for this contract we did spend a fair amount of capital and it was within the confines of our capital budget and we believe going forward that it’s a manageable item.

Dick Notebaert

Yeah, what we are doing is we aren’t spending on the legacy. I mean, we have got the zero-based budgeting process that I think we are the only ones in the sector that have gone this direction. And its working and we have been able to invest where we need to like the new hosting center in Seattle, and for the Networx contract. So, I think we are in a good shape.

Tom Seitz - Lehman Brothers

Okay. Thank you very much.

Dick Notebaert

Yeah. Thanks for the question. One more question operator, Katie, this is the last one.

Operator

Your last question comes from David Janazzo with Merrill Lynch.

David Janazzo - Merrill Lynch

Good morning.

Dick Notebaert

Good morning David.

John Richardson

Good morning David.

David Janazzo - Merrill Lynch

On the forbearance topic, can you give us an update, may be walk us through some of the opportunities there, quantify if you can and then talk about the timing?

Dick Notebaert

Yeah David, that's a great question and I thought I might get off the call without answering it. We did get the forbearance petition granted to us. We do feel that there are significant expense and customer service opportunities there to make the customer experience even better and at the same time reduce the expenses. We are in the process as we talk on this call of implementing those productivity improvements.

We would expect to see some portion of that improvement in expenses this year. We would expect to see a meaningful; I think it’s a significant number for that would be in '08 giving us a good running start into '08. So, and I am reticent to give the number out unless John wants to but we'll see some expense savings this year as we execute and make sure that we do this right and then most of it are a good majority that we'll see in the '08 opportunity. Yeah, jump in John.

John Richardson

Yeah, I think that it is a meaningful number and the other thing that I would say is that not only affects in our operating expenses to reduce the network operations expense and the administrative requirements, particularly those that are touching the regulatory frameworks to be operated under. But also, we'll get OpEx savings and we should see some CapEx savings as well. So, it's going to run across the game at the war of operations.

Dick Notebaert

And most important of all the expense is very important for us on our EBITDA, but the customer experience should be a lot more pleasant.

John Richardson

I agree.

Dick Notebaert

Than what we've had to do, we have had this red dot, green dot, different QC, QCI, very complicated and the customer doesn't appreciate all of it. The issue is there, but that will be good for the customer, and again, we are as we talk on this phone and the June quarter already starting to execute that plan.

David Janazzo - Merrill Lynch

Thank you.

Dick Notebaert

Yeah, thank you. And let me close the call by thanking everybody. I think as you look at the press release, and especially that chart on the top, you can see that we had a solid quarter, and let me define solid. Solid to me is making progress on our journey that we've said over the last couple of years, and it's very consistent with what we've done as we closed out the December quarter with what we said. And here we are doing again what we said we would do.

We will continue to look for ways to reward share owners. I talked about that on the Q&A, and we think we still have productivity opportunities and revenue, modest revenue growth is an opportunity that's in front of us.

I'd like to thank everybody for being on the call, and with that we'll sign off. Thank you, Katie.

Operator

Welcome. This concludes today's Qwest's first quarter 2007 earnings conference call. You may now disconnect.

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Source: Qwest Communications Q1 2007 Earnings Call Transcript
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