EarthLink, Inc (NASDAQ:ELNK)
Q4 2015 Earnings Conference Call
February 18, 2016 08:30 ET
Trey Huffman - Senior Vice President and Treasurer
Joe Eazor - President and Chief Executive Officer
Louis Alterman - Chief Financial Officer
Mike Crawford - B. Riley & Company
Barry Sine - Drexel Hamilton
Mike Latimore - Northland Capital Markets
James Moorman - D.A. Davidson
Arun Seshadri - Credit Suisse
Scott Goldman - Jefferies
Good morning. My name is Hope and I will be your conference operator today. At this time, I would like to welcome everyone to the Fourth Quarter 2015 EarthLink’s Conference Call. [Operator Instructions] Thank you. Mr. Trey Huffman, Senior Vice President and Treasurer, you may begin your conference.
Thank you very much, Hope. Welcome to the call everybody. During today’s call, we will refer to earnings slides that are available for you to view in the Investor Relations section of our website at earthlink.net. Following our comments, there will be an opportunity for questions.
Before we continue, I would like to point out that certain statements contained in our earnings release and on this conference call are forward-looking statements rather than historical facts that are subject to risks and uncertainties that could cause actual results to differ materially from those described. With respect to such forward-looking statements, the company seeks the protections afforded by the Private Securities Litigation Reform Act of 1995. These risks include a variety of factors, including competitive developments and risk factors listed in the company’s SEC reports and public releases. Those lists are intended to identify certain principle factors that could cause actual results to differ materially from those described in the forward-looking statements, but are not indented to represent a complete list of all risks and uncertainties inherent to the company’s business.
In an effort to provide useful information to investors, our comments today also include non-GAAP financial measures. For details on these measures, including why we use them and a reconciliation to the most comparable GAAP measures, please refer to our earnings release and the Form 8-K that has been furnished to the SEC, both of which are available on our website at earthlink.net.
After Joe’s opening comments, Louis Alterman, our Chief Financial Officer will discuss the company’s financial results. Now, I am going to hand things over to Joe Eazor, our Chief Executive Officer and President. Joe?
Thanks for that riveting introduction, Trey. Good morning, everyone. I am finding a bit of a cold, so I apologize if I have to cough or hack during my comments. I am going to spend a few minutes giving a recap of 2015 and then move into our agenda for 2016. Louis will follow with more information on our financial performance and our outlook.
So, allow me to set some context first. Two years ago, I laid out a multiyear plan for EarthLink with the goal of becoming the industry leader in network services in the cloud world. That journey is outlined on Slide 4. We spent much of 2014 on stabilizing our performance and operations and then 2015 became a year of performance improvement. As we move into 2016 and beyond, we are pivoting more and more of our attention to growth-related activities, while continuing to drive strong financial and operating performance. In line with this roadmap, 2015 was a year of significant progress. Some of the highlights for ‘15 were we achieved operational and financial improvements across the company, including improved churn management allowing us to retain incremental revenue from price increases across our retail businesses as well as achieving record low churn in our consumer business the last two quarters of the year.
Enhanced capital productivity resulted through more focused and disciplined capital planning and allocation. Streamlined SG&A was driven by moving to business units and rationalizing excess capacity and improved gross margins were delivered by further optimizing our network. As a result of these efforts, we generated more cash flow than any year since 2011, up 41% over 2014 and achieved a 4 percentage point improvement in EBITDA margin – adjusted EBITDA margin over 2014 from 18% to 22% all on declining revenue.
At the corporate level, we were able to use this enhanced cash flow to reduce our net debt by $48 million and reduce our annual interest expense by $10 million. We managed to achieve all of this while investing in our core products and planting seeds for new product rollouts in 2016, which I will discuss in more detail in a few minutes.
As I have previously discussed, moving our organization and operating model to business units facilitated much of these improvements, instilling more focus in operating discipline and allowing for better decision-making closer to our customers. Each business unit made good progress throughout the year as summarized on Slide 5. Our consumer business continued its history of operational excellence through strong data analytics and lean operating model delivering record low churn, finding new revenue opportunities and producing strong cash flow. We continue to look for ways to bolster our revenue in this segment and have seen early success in the recently launched ad platform.
In a small business unit, we streamlined cost and realized benefits from our improved segmentation and analytics following the playbook we have used in consumer over the years. We have talked about renewals as a key performance indicator for this unit and we experienced continued improvement in contract renewals throughout the year. For example, Q4 2015 renewals were 70% higher than those in Q1 of 2015.
The carrier/transport business delivered record bookings and invested in network capacity to support future growth. We are seeing strong demand for both lit and dark fiber services. In 2015, we installed more than twice as much recurring transport revenue as we did in 2014 leveraging our unique fiber assets and strong execution by the business unit team. We closed the year on a high note by signing a long-term dark fiber lease arrangement that will deliver $5 million in cash in 2016 and approximately $10 million in revenue over the 20-year life of the deal.
Additionally, to address growing demand, we are making selected investments to improve our reach and capacity as demonstrated by our recently announced metro ring in Chicago. In our enterprise and mid-market unit, we made progress on our go-to-market transformation and invested in and launch new products and product enhancements. As you know, we brought in a new leader, Gerard Brossard, towards the middle of last year and embarked on revamping our sales, marketing and service delivery efforts. This has included new leadership in channel sales, establishing a strong inside sales motion in hiring a new leader, building a national large accounts team and program and investments and improved sales systems and operations.
Additionally, we recently moved Rick Froehlich, our former Corporate Products and Marketing Leader to be the leader – the business unit leader of direct sales and marketing. Rick has extensive sales experience with a clear demonstrated track record of success. We now have an exceptionally strong team in place to drive growth. These transformations take time, but there are early signs of progress that includes strong wins in our partner channel over the last few months. Additionally, we launched key new products like Wi-Fi with in-store analytics, IP stack standalone and hybrid network solutions and applications performance optimization as a prelude to SD-WAN. These changes will continue to take route and demonstrate progress throughout 2016 building market momentum into 2017.
Also during 2015, we continued to refine the focus of our product and services portfolio. For example, we discontinued unprofitable businesses like TechCare and OSDA and divested our sub-skillset of IT services, products and capabilities. While these actions further reduced our revenue for ‘16, we will still deliver strong financial performance and continue to invest in and focus on the core products that will drive growth and our success in the future.
So, in summary, 2015 was a year of significant progress, a lot of progress on our journey. And we are heading into 2016 as a much stronger company. As I mentioned earlier, 2016 will continue to focus on improving our performance across the business while shifting more and more focus to driving growth. Please refer to Slide 6 for the summary of our agenda for 2016. Our three main themes for this year are operational excellence, investment in growth and gaining market momentum as a result, and considering strategic alternatives that would accelerate our path of success.
As for operational excellence, I have made it a theme that we will be operationally excellent and have performance plans to achieve industry leading benchmarks across all of our businesses and all of our processes. We have made gains in certain areas, but we still have a significant room to improve. First, we must continue to improve our customer experience. We already received good marks on this front relative to our industry peers, but I believe that our industry sets a relatively low bar and that we need to set our sights much higher. We have established a new Chief Customer Officer and rolling out programs will put us on the path delivering world class customer service from the sales process all the way through billing.
Second and closely related to this, we will define to roll out best practices and systems across our quote to cash processes. In recent years, our people have made tremendous progress integrating and optimizing processes and systems in a fragmented environment. However, as a much stronger company, we can now further reengineer this entire process to improve customer interaction, reduce order and installation errors and shorten service delivery intervals. These changes will enhance customer retention, increase customer satisfaction, reduce costs and create opportunities to expand our relationships with customers, potential customers and partners. While this will extend beyond 2016, we expect to lay the foundation, develop the roadmap and made solid improvements this year.
Third, we need to drive even more productivity out of our assets. It is not just a matter of reducing costs. We need to get more revenue out of our network assets and more cash flow out of each dollar we spend in OpEx and CapEx. Our network and other teams have done an excellent job on this front, these efforts will continue in 2016. Finally, we must continue to improve our demand generation sales engine. We deliver significant value to our customers and we are continuing to invest in enhanced products and services. However, we need to do a better job of making sure customers, potential customers and partners understand and appreciate our value propositions. This will include more clearly documenting, communicating and proactively engaging with customers, potential customers and partners around these capabilities. This will drive increased pipeline, bookings and lower customer acquisition cost per dollar of book sales throughout the year.
The second major item on our agenda is that we will accelerate our investment and growth to deliver market momentum in 2016. We are aggressively working on an industry leading set of services around SD-WAN. We are finalizing our solutions in a lab environment and we are launching with these multiple beta customers within next couple of months. We plan to have our full suite of offerings from professional services through complete turnkey SD-WAN solutions launched into the market in Q3 of this year. We expect SD-WAN to revolutionize the industry over period of years and therefore we are putting EarthLink at the forefront of this change. Having the full suite of services from MPLS, hybrid SD-WAN MPLS and standalone SD-WAN will allow us to maximize the value for each of our customers depending on their individual needs. With the rapidly changing cloud network environment, especially the emergence of SD-WAN, many of our customers are in need of professional services to help them develop the roadmap and plans for optimizing the network and applications performance.
We have incubated a small professional services capability over the last year that we will further invest in and grow in 2016 and beyond. This will bring more value to our customers and pull through more comprehensive network services for EarthLink. We are also developing stronger industry specific solutions around cloud networking with a very strong presence in the retail sector and/or investing enhanced efforts in healthcare and potentially other industries. As I mentioned earlier, we continue to clean up our products and revenue portfolio last year, including the sale of our subscale IT services products and capabilities and the discontinuation of unprofitable businesses like OSDA and TechCare. We will continue these efforts into 2016, but expect this to be the last year of significant changes along those lines. Finally, while we are driving improved sales productivity, we are increasing our sales headcount in the mid-market business unit to more adequately cover the market. Now with better tools, systems, products and training in place, we can more successfully bring in solution selling representatives to further drive demand and bookings, including both hunters and farmers.
The last key item on our agenda is to consider corporate development alternatives to accelerate our strategy. As we have improved our operations and balance sheet, we are in a better position to consider these options. We are not signaling any kind of eminent transaction, but we are saying that because we are stronger, the transaction or transactions to add services capabilities or to increase scale or to further improving the portfolio are more possible now than they were a year ago. Of course, we will apply the same discipline to evaluating transactions that we have applied to operating our business over the past 2 years.
So to recap, I believe we accomplished a great deal in 2015. We have refined our portfolio of services to those that give the best chance to success and that maximize financial returns. We established an operating model that enables our people to better focus through efforts and deploy capital more productively. We simplified our operations, creating efficiency throughout the company, reducing costs and improving margins. We significantly accelerate – accelerated our transport sales, leveraging the value of our fiber network assets. We made progress implementing a new go-to-market model in our enterprise and mid-market business unit. We leveraged better analytics in our small business unit to improve customer retention and reduce turn and therefore, we generated strong cash flow and smartly used it to improve our capital structure and reduce our debt service.
In 2016, we will continue to drive operational excellence. We will invest in growth to gain market momentum and consider strategic alternatives that would accelerate our path to success. I am more optimistic than ever about the opportunity in front of us and our ability to seize that opportunity. Also in closing, I would be remiss if I did not take the time to thank David Koretz and Wayne Wisehart who will be resigning from our Board of Directors before April – before our April Shareholders Meeting. David and Wayne have both served on our Board since 2008 and have made a lasting impression on EarthLink. We wish them both well.
Now, I will turn things to Louis to address our financial and operating results and guidance.
Yes. Thanks Joe. As Joe said, 2015 was a good year for our company. One perfect and there were things we can improve upon, but net-net, we did make significant progress both operationally and financially. We have got a lot of reasons to be upbeat about the future. I will spend some time reviewing our outlook for 2016, but first let me start with our 2015 results, Q4 results revenue and gross margin are on Page 7. This is the second quarter we present our information in this format. We have now got a full year of results presented in BU detail. And so in a few months when we report our results for Q1, we will be able to show your full year – year-over-year comparisons to give you better view on how each business is trending. Before we dive in, I want to remind everyone a couple of things. First, this slide shows a completely unfiltered view of actually how we run the business. We didn’t produce it for IR purposes. This is actually how we are organized and we will continue to evolve the presentation over time of the information as our operating model matures.
As I said last quarter, we are out ahead of industry by showing this level of detail and I like being able to provide you the visibility. Second, it’s important, you know the customers were signed is not based on the they buy today, but rather based on which services they should buy given the characteristics of their business, things like number of locations, industry vertical and employee count. This structure enables every business unit and importantly every employee in a business unit to focus on the needs of a particular set of customers, that’s been the driver of our success last year and we are confident that approach will maximize our long-term results. And third, dispute settlements and reserve adjustments regularly impact our revenue and gross margin results. At the bottom the page is the footnote, which outlines the various impacts by quarter and by segment. That footnote also includes information about the impact of our IT services, asset sale. We will lose two months of revenue in Q1 from that and there months per quarter beginning in Q2. I won’t read all this information now to you, but it’s there for your reference.
Okay. I will start with enterprise and mid-market. Total revenue from enterprise and mid-market – from that segment was $106 million, that’s about 7% lower than the levels we have in the first half of the year. The quarter-over-quarter changes in the first half of the year were aided by price increases. We didn’t have that in the second half. The BU – this BU includes customers ranging from as few as five locations to customers with thousands of locations. As you would expect that means, it includes revenue from higher growth, strategic managed network services, as well as more mature voice and data products, but all the customers in this segment are prime candidates for our managed network services. Joe described the activity we are undertaking to increase bookings and therefore, revenue in this segment. This transmission does take time, but we are confident that we are taking the right steps and we will capitalize on the long-term growth potential from these customers in this segment. As for Q4 bookings were above where we expected, they ramped throughout the quarter. We had a really robust December, which is pretty atypical for somebody selling to retailers and so we are encouraged by that.
In our small business segment, Q4 revenue was about 15% lower than the Q1 level. The price increase dynamics I just discussed for enterprise and mid-market also played a role here. Pricing changes going in during Q1, there is a full quarter benefit in Q2 and then you don’t have anymore quarter-over-quarter benefit in the second half of the year. But in contrast enterprise and mid-market were the most important long-term business drivers, bookings here and small biz primary driver is churn and renewals to aid churn. As Joe mentioned, the team delivered excellent results on both fronts in Q4. 2015 renewals were already trending about 50% higher than 2014 levels and they went up another 25% in the fourth quarter. In addition, churn ticked down sequentially from 2.4% to 2.2%.
So, while churn management is paramount as I just said, we are also working to deploy new services to this customer base to make our business stickier. As an example, in another month or two, we are going to launch EarthLink’s hosted office. That’s a service bundle that makes it easier for small businesses to gain the future functionality of both hosted voice and Office 365, so they get a complete productivity solution. Look stepping back, I know there is secular pressure here, but as we spend more time in the BU model, we are managing the segment better and better. We are deploying deep analytics and changing the way we interact with this customer base. So over time, we will improve the ability to predict customer behavior and preempt churn. As that happens, we intend to extend the cash flow tail of this business much like we have with consumer.
Carrier/transport revenue was $34 million. It’s the third straight quarter of narrow sequential growth. Bookings have been strong all year and that continued into Q4. Obviously, the dark fiber deal was a big win. It feels good to put $5 million in the bank and then have a maintenance stream to come over the next couple of decades. And importantly, we sold it to an enterprise rather than to a competitor.
As you have heard us talk about throughout last year, we did have a churn event that we expected in early 2015 and we had – it had been pushed a few times – pushed back, that churn did eventually happened in late Q4 that will cause about a $0.5 million impact per quarter beginning in Q1. So, you may see revenue tick down slightly before it resumes sequential growth. And when you combine that with the portion of the segment that comes from mature wholesale and usage-based products, there is some amount of pressure. However, offsetting that, the demand for higher – the highest margin product we have, which is transport, has proven to be quite strong. 2015 was the best year in recent history of carrier bookings and we have made further investments, including the Chicago ring build-out and I am quite confident our team is executing well.
Consumer revenue declined 9% from the prior year and 1% sequentially, that’s better than it had been and it continues to improve. We had double-digit declines a year earlier. Consumer declines are decelerating a little bit better than we had planned, that’s not by accident. One thing that the team did was advertising revenues, which are seasonally strong in Q4, but they also made a change in advertising inventory replacing a small ad space with a more effective one that ended up generating 10x better CPM. Churn ticked up slightly in the quarter from an all-time low of 1.7, 1.8 that was entirely due to the shutdown of the clear wireless network. We had prepared for that a long time ago. So, it was a nonevent. We expect the long-term attenuation and churn to continue in 2016.
So, looking at the total company, revenue was $260 million, about $8.5 million – I am sorry about 8.5% lower than the year ago quarter. Gross margin – moving on gross margin contracted quarter-over-quarter, that’s primarily just because Q3 had larger favorable settlements and cost of revenue, we have talked about that the settlements were lumpy. Absent settlements, there is some natural pressure in small biz and enterprise mid-market, because churning customers tend to be at higher margin than newer customers. However, we can at least partially offset that with the favorable mix impact of selling higher margin transport revenues. And in 2015, we more than offset that any pressure with our pricing actions and with variabilizing certain cost out of our network. John Dobbins and Gerry [ph] did a great job there. We have put it altogether and our full year total company gross margin was 170 basis points up over 2014. We will continue to take similar actions in 2016, but you should note they are lumpy from quarter-to-quarter. Over the long run, pricing actions and network grooming are only going to take us so far and so that’s why we are focused on the flattening the top line.
Moving to the income statement on Page 8, I have just covered revenue and gross margins, so we will go further down to P&L. We continue to improve our cost structure in the fourth quarter. SG&A was 2.6% better sequentially and down over 13% from the year ago quarter. Look, we are relentlessly seeking efficiency in this business. We understand that as revenue leaves the business, we need to aim to eliminate an equivalent percentage of cost. And in fact, because we are trying to find investments and growth across multiple areas of our business, we actually need to find a higher proportion of cost savings. The team has a strong record of driving efficiencies in the business. We talked about this subject all the time. And everybody is committed to running the business with the same level of discipline that we have. We do have more opportunity to take out SG&A this year as you see in our guidance, but as we move past the low and medium hanging fruit, things like the quote-to-cash redesign efforts that Joe mentioned will be essential to driving further efficiencies for the long-term.
Adjusted EBITDA was $54 million, that’s up about $1 million from a year earlier, even though revenue was $24 million lower. Adjusted EBITDA margin was just under 21%, even though it had ticked down from Q3 that’s still higher than a year earlier by about 200 basis points. Net income came in at the high end of our guidance range. Inside of that, we did record about $4.5 million of restructuring charges and that was part of what enabled the continued SG&A reduction.
Moving to CapEx, we invested $27 million in the fourth quarter, that’s well inside the guidance we provided last quarter. We saw an uptick in demand for additional capacity in certain fiber outs. And so in order to meet that demand, we spent about $5 million in Q4 for equipment. Additionally, we did take advantage of some year-end incentives from suppliers for some other capital items. For the full year, we invested $88 million, that’s down around $50 million from a few years – a few years ago and 15% lower than 2014. Q4 adjusted EBITDA and CapEx, when you net those out, you get $27 million in un-levered cash flow. For the year, we delivered a $155 million in un-levered free cash flow, that’s an increase of $45 million or 41% from 2014. Obviously, that’s a huge improvement. We are quite proud of it, but we are not spending too much time celebrating.
Page 9 shows an updated view of our balance sheet. As you can see at the bottom of the page, Q4 was a lower cash flow quarter, because just the timing of our coupon payments that we make in the quarter. However, as you can see at the top of the page, we are still able to reduce our gross debt again. We repaid $5 million on our revolver. We ended the quarter with a slight increase in overall cash. Looking at the full year, we eliminated – we reduced gross debt by $91 million, net debt by $48 million and in the process, took down our debt service by $10 million or about 20%. All the key credit metrics, gross leverage, net leverage, interest coverage, etcetera improved in 2015. We also amended the credit agreement earlier this month that gives us a little more flexibility to repurchase notes and/or pursue various types of borrowing. We are not obligated to do either. We will continue to be nimble and opportunistic as we manage balance sheet.
Moving on to our 2016 guidance, we show the details on Page 10 and put it in historical context on Page 11, so feel free to toggle back and forth. Joe talked about the IT services asset sales. So, I won’t repeat the rationale, but I do want to mention the transaction and the context of our 2016 guidance. Those assets produced about $37 million in run-rate revenue and about two-thirds of that was in enterprise and mid-market, the remaining third was in small business and all that’s factored into our guidance. So for full year 2016, we expect revenue between $950 million and $975 million. There are several factors that will impact 2016 revenue.
First, as Joe mentioned, we have intentionally exited and deemphasized revenue streams that were not strategic or not growing or low margin. Second, last year, we took an aggressive set of pricing actions, because our analytics prove – our analytics proved to us that we had room to do so. Clearly, that worked out well in 2015. Pricing actions are a delicate balance between current year revenue and future churn. And in 2016, our plan is to take smaller pricing actions – sorry in 2016, our plan is to take smaller pricing actions than we did in 2015. We are getting more and more surgical in our approach and we are confident we are striking the right balance. Third, we had favorable settlements in 2015 that contributed $6 million. We are going to continue to fight aggressively. We hope to realize some benefit from settlements in 2016, but the nature and direction and timing of all that is not something we can reliably predict.
Looking more specifically at how we expect each of our business units to perform. Our cash flow businesses, I will start there consumer and small biz that will continue to shrink, but our guidance anticipates we will attenuate the declines in 2016 compared to 2015. We are actively working to deploy products to extend customer relationships in both of those businesses and we are improving the customer experience to reduce churn.
Our carrier/transport business has elements of strong growth inside of it. As a result, we expect that to improve from an annual decline of 12% in 2015 to something closer to flat in 2016. And that’s inclusive of the step down that I mentioned in Q1 due to the late 2015 churn event. Enterprise and mid-market has both shrinking and growing revenue streams. We have got tactics in place to manage both. We have talked a lot about the changes in the go-to-market motion. So overall, we expect a decline in 2016 to be less than it was in 2015 and you should expect we will be demonstrating tangible signs of progress this year, pipeline, bookings, etcetera and we expect to see the benefits those changes start to show up in our top line over time.
We expect to generate between $205 million and $220 million in adjusted EBITDA, again that’s after the impact of selling the IT services assets. So, what we are saying is that we expect our margins to be approximately the same in 2016 as they were in 2015 despite the revenue decline. There is a lot of work to make that happen in cost of revenue and in SG&A. We have got plans in place, we are in execution mode and we have got confidence in the team’s ability to deliver.
Our CapEx ranges a bit wider than it’s been historically. We are guiding $85 million to $105 million, which roughly mirrors the CapEx we spent the last two years. The primary reason for the top half of the range is we are planning on greater success. We are expecting to sell and book more business. And as we do that, we will have more success-based CapEx. The inverse is also true, if for some reason we don’t gain the traction in sales that we expect, we would be investing less success-based CapEx and you would see us in the middle or the bottom end of the range.
Moving to the bottom of the page, we get to net income, which we expect to be near breakeven for the year and positive on a quarterly basis by the end of the year. That’s a huge improvement from the $43 million loss and much bigger losses that we have had in the past. We are guiding to a range of a net loss of $7 million at the low end to net income of $1 million at the high end. I saw a couple of folks already picked up on this, but we did note that our amortization expense will decrease throughout the year. There is a footnote in the tables accompanying the press release. So, if you are doing any modeling, you should check that out and it provides more specific insight by quarter. Also we do expect to record a gain on the IT services sale in the first quarter and that will favorably impact earnings.
So in closing, look first of all, we have got more work to do before I am satisfied with our sales and revenue profile, particularly in enterprise and mid-market, we do need to deliver on the go-to-market transformation and accelerate our bookings momentum. But the team is taking the right steps to improve that trajectory. We have got better visibility of the pipeline. There is real customer demand. I see it when I talk to customers and prospects. And the team is approaching the market in increasingly disciplined fashion. I have got a lot of confidence in Joe and his leadership, and all that gives us reason to be upbeat. Our customer retention is getting better across all business units. There is more we can do to reach the next level. I have seen this work for years in our consumer business, Brad and Mike Flannery are executing well in small biz. At the same time, we are challenging every area to improve.
In the meantime, our carrier-transport business had a banner year. We closed it on a high note. Consumer continues to outperform. Our new operating model is proven to be effective. We are taking out – we have taken a lot of costs. We generated cash. We used it to de-lever. That’s difficult work, but the team has stepped up over and over and I am proud of their efforts. We have got a lot of work to get done in 2016, but we have got the team in place to make it happen. Lastly, I would also like to thank Wayne and David for their contributions these 8 years. They have been very thoughtful advisors and put a lot of time and energy into this company.
So with that, I would like to open up the line for questions.
[Operator Instructions] Your first question comes from the line of Mike Crawford with B. Riley & Company.
Thank you. First off, I would like to ask about the dark fiber deal and that the couple of questions related to products. So with – you mentioned Louis to put $5 million in the bank and now you have 20-year maintenance stream, can you say anything more about this route, how unique is it compared to your total physical network and whether this is a primary – expected to be primary router or a backup router for your enterprise customer?
Yes. Thanks Mike. Unfortunately, I can’t disclose too much detail about it just given the arrangement we have with the customer. But it’s – this we have talked about explosive growth on the internet and data needs going up and so this is a just good example of us being in front of the right people with the right route.
I will try one more time. So if you have about 250,000 fiber mile physical network, where close to half of it, I believe has been dark, is there – does the deal like this help to put a bracket on maybe the value of the dark component of your network?
Yes. Hi Mike, everything – every route is going to be valued differently depending on the uniqueness of it and especially the importance of it to the customer. So it – again, it’s the same answer we have given in the past, it’s not one blink of statement we can make about the value of the – each of the total routes of our fiber network, it’s route by route. And one of the reasons a fire sale never made sense to us as it would dump down the value of these important unique routes.
Okay. Thank you, Joe. And then just switching gears on some of your new product initiatives, you have in your new secure Wi-Fi and analytics service and I am just wondering what it is that drives your analytics capability and who you are using for visualization, etcetera?
Yes. So we are partnered with the in the small box – smaller box retail space with AirTight. They are our partner and we leverage their analytics suite – their Wi-Fi solution analytics suite that allows to a retailer to capture all kinds of useful information for anyone that interacts with our Wi-Fi network in the store, connects seamlessly to our network. And we have rolled out numerous installations in this case, some of our larger customers and it’s – they have been a great partner and we deliver that service seamlessly between EarthLink and AirTight.
Okay. Thanks. And then that the final one is what will be new for customers that will take your EarthLink hosted office that you are launching in March?
The hosted office is aimed at the small business customer set. And the first thing we did – honestly I can’t remember if we talked about this on the last earnings call or not. We published a marketplace portal to our small business customers, where they can sell provision services from EarthLink and renew existing services and then sell provision new services and there will be an automated installation process. And so that’s being published and rolling out. I think it’s already extensively rolled out. And so, as an example, one of the things we are presenting to the small business market is this hosted office suite and it’s based on Microsoft products leveraging our capabilities. So I would think we are – that’s just an example of the kinds of things we will keep doing between partner products and our own products. But now that we have this kind of the self service capability with our small business customers, we will be able to do that more frequently and with more success than we have in the past.
Okay, great. Thank you.
Your next question comes from the line of Barry Sine with Drexel Hamilton.
Hi, good morning folks. Wanted to on Slide 7, you start off talking about enterprise and mid-market and the first bullet is on a churn in legacy. You did about $106 million in revenue in the quarter, if I do the math I would take out IT services from that. I think you are at about $100 million run rate, a couple of questions around that. About how much of that is the legacy we might see continue to decline, how much of that is growth, you have talked about adding sales people, can you give us any metrics on how much you grew sales people, what you are seeing with bookings, when you can stabilize that $100 million and when you can get it to growth?
I mean so, we are not – we are not publishing metrics inside the BUs, but let me try to answer the question in a way that helps – that’s helpful, Mike. So last year, obviously IT services came out. We also as part of that business, there was TechCare business that we shutdown during the year and we deemphasized use – low margin usage kinds of services during that 1 year or 2 years. So all those things were happening throughout the year and the fourth quarter run rate started to see some of those things materialize and that’s one of the reasons we saw the decline. Inside that mid-market enterprise business unit, there is really four customer segments. There is a larger enterprise segment. There is the – which were the top two segments larger enterprise and medium-size enterprises. Then there is, what we would typically call the true mid-market and then there is a lower end of the mid-market. And that bottom end, that lower end of the market or what we call our Tier 4 customers inside mid-market enterprise business unit is traditionally the legacy product base with active, active efforts to transition them to more network and managed network kinds of solutions. And that’s where our inside sales team and some of our channel partners will continue to attack much more aggressively. From a revenue split perspective, we haven’t published that, but we saw a sizable chunk of our mid-market enterprise business that is in the growth products. And I think with the sales and market transformation plus the new products roll out, we will see a material improvement this year in that business unit from book sales, installs and momentum going into ‘17 on a revenue basis. So, I apologize not – we are not splitting out detail more than that, but that should give you some flavor for that business unit.
And just on that business unit in terms of the sales headcount, I think I heard that you have growing sales headcount dedicated to that unit?
So the first – yes, the first part of the activity there was to manage out – I mean, I don’t know any other way to say it, but non-productive headcount, which took place over the back half of that year, laid out processes. So move everyone to Salesforce.com, layout better sales disciplines, get new leaders for each sales motion in place and have the engine running better. And as we do that, we will begin to add sales reps during the year – this year, we already are starting. And so we didn’t really start that activity to very late in the year and are really just now getting going on adding reps during 2016.
Okay, that’s all really helpful. Thank you very much.
Yes. Thanks, Barry.
Your next question is from the line of Mike Latimore with Northland Capital Markets.
Hi, good morning. Nice quarter. On the – I guess, Louis, did you say that the fourth quarter bookings in the enterprise and mid-market were robust is that what you said?
I said, December was about – the fourth quarter was about we expected, but it ramped throughout the quarter and we closed a couple of larger ones in December, which I said was just atypical. Usually, you don’t get command the attention of retailers at that time, but we had a good quarter – or had a good close to the quarter.
Yes, by the way, let’s to be clear, we attribute. So, we had earlier start during the year on improving how we work with our channel partners for a new leader place earlier in the year and middle of the year by the time Gerard came in. And that team started making traction. And I attribute the robust December and actually end of January by the way in bookings in large part due to that team’s activities.
That’s great. Is that – can you elaborate a little bit there just – which services – what retail verticals, anything like that?
Yes, it’s primarily more success in retail, in core network services and high – both MPLS and hybrid services, so MPLS and in Internet-based networks and also included in that are some of our value-added services, including our hosted voice solution and other services that we are selling alongside our network.
Got it. That’s great. And then as you think about the year, I know you have given your revenue guidance. I mean, does sort of implied in the guidance, do you see kind of quarterly revenues stabilizing on a sequential basis by year end?
Yes, we are not giving that level of details. Certainly, we expect the quarterly trends to improve over time, but we haven’t said – we haven’t picked a spot time where we say where sequential revenue is flat. It will be lumpy because of settlements and because of the timing of price increases. Even though they are smaller than 2015 we are still doing some, but no I think when you normalize all that you will see revenue improved throughout the year, but we haven’t declared the date at which it’s flat.
So, you mentioned price increases, those mostly go into effect in the first quarter here?
That’s right. But you typically get some benefit in the second quarter, because they don’t hit on January 1. So you get three months room.
Okay, got it. And then you may have given us in the past, but you mentioned, TechCare and OSDA coming out of the model, how much revenue influence did that have on ‘15 versus ‘14 let’s say?
Yes. So, OSDA was just a couple of million dollars and TechCare is more like $6 million or $7 million, but think of it as sort of winding down throughout 2015, so you get maybe $3 million or $4 million impact in ‘16 over ‘15 by having a full year.
Yes, okay. And then on the SMB hosted office, are you going to be sort of voice part of that, is that going to be the business cloud phone system or something else?
Yes. So, we actually have rolling out our own hosted voice solution that’s scaled down for the small business sector, the one that we use in our mid-market and enterprise base. So, we basically have scaled that down and automated the service delivery functionality in that, so that it can now be a service – it can be a small business offering.
I guess on the strategic alternatives front, it sounds like you are more comfortable with kind of the structure of the organization now and might look at making acquisitions I guess at some point. Can you provide any color on just kind of how you view that from a financial perspective? Do they need to be accretive within a certain amount of quarters or years or whatever? I am into that little more kind of metrics around what you kind of use when you analyze the acquisitions I guess will be helpful?
Yes, I mean – clearly start with the strategic value and what is it due for us and our path to success in growth that we are trying to achieve or scale or whatever the agenda item we would be looking at. So, the strategic value is the first big filter. Though on the financial front, obviously, the ability to capture the value from a cash return perspective is the number one criteria that we look at. The accretion and dilution are interesting, but if it is a significant repositioning or helps us in some way generate a much stronger cash return over time that I don’t see making decisions purely on accretion and dilution. But we are kind of speculating here. So, we look – we know what our strategy is, we know what we want to accomplish and we look for acquisitions or divestitures for that matter that accelerate our path to that success. And we keep looking and like we told you earlier, there is – we are not seeing here knowing that something is going to be imminent, but given that we are a stronger company, we feel much more comfortable that these kind of actions were prepared for them and can integrate and manage effectively or maybe 1.5 year ago, even a year ago we were quite ready.
Okay, thanks a lot.
Your next question comes from the line of James Moorman with D.A. Davidson.
Yes, thanks for taking the questions. First of all, just back end of the enterprise and mid-market question, so the small business you have seen pretty nice improvement in churn and I think you have kind of cut sales over the past. So, is that kind of the same answer of the mid-market of how you are kind of maintaining or declining churn even though you have kind of maybe shipped resources or move to kind of optimize that business? And then also in the dark fiber, I understand you don’t want to really sell to your competitors and you rather do enterprise, so is that the kind of the way to look at it that you kind of slowly maybe look more for enterprise customers or do you ever consider lighting some of that and filling more lits?
Yes. Okay, good. Got it. I will start with the second one. So, yes, we don’t want to put it in the hands of our competitors and don’t feel like we need to. So, we are focused with dark fiber on selling its enterprises unless it’s just some completely commoditized route, but that’s rare. So certainly, our unique routes we like to sell it to people that are going to consume it and not resell it. And we laid it as we get – as we have demand for lit services. So, that’s what the sales teams out there doing is trying to sell lit services and when they get a deal, we light it up. And if we get a deal for dark, then we get a different revenue stream and they light it up. So that’s that. Churn and enterprise and mid-market was other question. So, it’s – whereas small business is very similar to consumer, lots of customers playing a relative small amount. You can do deep analytics. You can sort of manage the group from one central location, right and just sort of analyze which customers you are making money on, which ones have this product to that product, this tenure, that tenure, contract expiration dates all those things and then take actions sort of based on algorithms and rules.
With enterprise and mid-market, it’s much more sort of hand-to-hand combat and just good old fashion account management. So, yes, churn has been getting a little bit better there. It’s lumpier because you have bigger customers. So, you could say if we lose some big customer and it can sort of make your month or your quarter. But yes, we are putting in basic blocking and tackling disciplines have put in and are enhancing blocking, tackling disciplines around account management, having a quarterly business review with the customer, getting out ahead of the contract expiration date, bringing in, having executive sponsors for our largest customers, just there is I can rattle off 20 things, but we are doing a lot of things that help us just be more proactive about keeping engagement with our largest customers and having them sign up for more business over time.
Yes, you bet.
[Operator Instructions] Your next question comes from the line of Arun Seshadri with Credit Suisse.
Hi, guys. Thanks for taking my questions. Just wanted to get a sense for – I think, Joe, you talked about increasing sales sort of sales reps, just wanted to get a sense for sort of scale? How much of an increase in sales reps are you expecting this year? Any color on the number of quota carrying reps and sort of talking about how much do you expect to spend this year?
Well, so it’s not a one size fits all answer. So, inside our inside sales motion if you understood that. So, we have been building a stronger inside sales motion. We are actively actually building that capability. I would argue that we didn’t really have much of a capability there. And we are building that capability and we are processed to hire probably 10 to 15 folks and in the first couple of months of this year, just to have a good start on the inside sales motion. And then for the rest of the field reps, covering both channel and direct, we are looking at roughly 30-plus percent increase in our QBRs over the year, because we are not adequately covering the market. And we did reduce capacity last year. So we will do this in a judicious fashion. And we have got a very clear headcount plan. But the good news is, we now have the systems the training, the product materials, etcetera in place to onboard people much more successfully than perhaps we have in the fast past. So it continued to add inside sales folks and then on the direct and indirect side we are probably – we are increasing over 30% this year our QBR headcount.
Great. Thanks for that Joe. And then as far as the CapEx plans for 2016 I think you had laid out that you expect some success-based CapEx, how much of that expectation of success-based CapEx comes from deals you have already signed versus deals that you expect to sign. And also if you could comment on what type of payback you are expecting on success-based CapEx?
Yes. It’s a good question, Arun. So, it ramps a little bit more towards the second half than the first half. So the success-based CapEx in the first half of the year, you might see is probably 60%, 70% driven by deals we have already signed. Certainly, on the smaller customers, you can sign a deal and install them in a month or two months. Larger customers might take a year. So there is a lot of – lot of the CapEx in the first half of the year would be deals we have already signed. But then as you get into the second half of the year it probably flips and you get maybe a third or so is deals we have already signed and the rest is deals we are going to be landing. As far as payback, we look at every individual deal. We fully load the deal up with all the upfront costs, whether it’s a commission or the CapEx rolling a truck, people installing the service. And then we look at the ongoing margin of the deal and our rule of thumb is we want to get our cash back in the first two-thirds of the committed contract. So if somebody signs a 3-year deal, if we are not making our – all of our cash back by the month 24, we are not going to take the deal or we are going to push them to a longer-term in order to get the deal done. That’s the edge at which we will accept the deal, we get – that’s not the average deal. On average, we do a lot better. And then you can calculate IRRs on that and it looks good, but I mean, really customers, they don’t leave you in month 37 that you typically get a renewal, sometimes with the write-down, sometimes without and you can make assumptions about that and calculate IRRs and we certainly do that, But to sort of keep it conservative, we want our cash back while they are still under contract.
Great, that’s very helpful. Thank you. And then finally, as far as the carrier-transport, I think you talked about – I think if I heard you right, you said you expect to be flat revenue wise in ‘16 inclusive of the $0.5 million quarterly churn, is that right?
Yes. To be clear on carrier-transport, there is a wholesale business. It’s both our transport business and our carrier wholesale business. And there is parts of the wholesale business that we have effectively deemphasized because it’s low margin work, which are just good old basic wholesale minutes. And so we are as we have cleaned up that portfolio over the last year and then into this year we expect the transport revenue and the wholesale work that we are focused on to overtake that business will grow, but this is kind of that last transition year if you will from that going forward.
Okay, great. And then is that visibility largely an expectation of ‘16, is that largely a result of bookings that you have already had in that segment or is there some sort of how much of that is as a result of…?
So, we are still installing bookings from 2015, yes. We are also already seeing some good traction in 2016. So, it’s both actually.
And part of why that team has so much success is on the carrier-transport side were really good at getting stuff installed quickly. And so yes, we will turn up a lot of revenue this year that we will sell this year.
Got it. Thank you very much.
Your final question comes from the line of Scott Goldman with Jefferies.
Hi guys, good morning. A few questions if I could as well I guess just from a high level Joe, maybe helpful, obviously a lot of volatility in the market these days and even some banks I think predicting almost 50% chance of recession. Just wondering what you are hearing, seeing from the macro side of the equation and what you have baked in terms of expectation of 2016 around the macro. And then the other ones, you have talked a lot about and are excited about the SD-WAN opportunity, wondering if you can maybe help size that up for us how big an opportunity it is, is it something that’s going to appeal to new logos for you or is it something that you think you have an existing base where you can really sell some of the services into. And then lastly, maybe just talk a bit about the small business renewal process, you guys have talked a lot about how renewals are up, wondering what the balance there is in terms of improving churn, which you are obviously seeing versus what you may have to give up on the pricing side of the equation in order to get those renewals if there is any trade out there? Thanks.
Yes. So on the macro – kind of general economy issue honestly we haven’t seen a direct impact from the demand side on that front. And given where we are and it’s still the market potential that is in front of us. We have set a relatively low share of the market. I still think our upside outweighs any potential economic downside for 2016 in the market. So I don’t – I feel like our guidance this year never say never, but our guidance this year and expectations for the year are factor in any concerns about the economy, just because there is still market opportunity for us. Secondly – by the way in a number of solutions help for these costs for our customers and therefore, can’t be even in a down economy be an opportunity for customers to take out more costs. On the SD-WAN, so what’s interesting, I think in the datacenter world as it virtualized it look longer and things moved to the cloud that – I think that path is taking longer. I think SD-WAN we see a lot more action not just lit service on this front, with some really technology players as well as some larger enterprises already adapting partial SD-WAN solutions. For us, we think the opportunity there is certainly significant opportunity. And largely for a while it will be in the hybrid network space. So, when people already got a strong MPLS network installed, but they want to add SD-WAN either on top or use internet for a growth storage that they are adding or locations that they are adding were used to be IT sec, I think more of that will become SD-WAN. And you can use SD-WAN to drive the applications optimization, etcetera across both in MPLS and internet base network. It’s going to take some time for that demand to materialize. So we are still on the front end of this. I think we will see some traction this year, but I wouldn’t expect major numbers in SD-WAN for – it’s going to take a few years for that becomes widely accepted as network protocol in my view. But I do think we will start to see some traction this year certainly, in 2017.
And then finally, on the small business renewals and turn management. As we have discussed before, the small business folks, similar to what we have done in consumer years ago, have taken a very structured segmented approach, an analytically-based approach to how to manage and target different customer segments for renewals. So again, it’s more sophisticated and focused and that’s with price increases in renewals. And the second thing we have done there, or third – second, third and fourth is we have trained many more people, anyone that comes in contact with the customer now has the skill set and capability to offer renewal. And then the final thing is we have also pushed the portal out so customers can automatically renew their services with some prompting from us. So it’s a variety of fronts that are working on the small business unit to facilitate increased renewals. By the way, it will get even better because we are still training more people, more of our reps, people calling for care or repair, now those people will be trained to offer renewals. So, more and more people to touch the customer will be able to offer extensions and renewals and even new services as we are rolling out.
Great. And if I could sneak one more in maybe for Louis, we have talked a bit about strategic alternatives on the call today, just wondering how you are thinking about where the balance sheet is today and to the extent of that if you were to participate and maybe a transaction to add more scale or add new capabilities or something, how you think about that in the context of the balance sheet? Thanks.
Yes. I mean, I think it would depend on the transaction. Obviously, we have had a bias towards de-levering and you saw us get this authorization on the credit facility to do more. So, absent – absent transaction, I think you would see us continue to chip away at the debt and reduce debt service. And then depending on market conditions, we have a range of options around considering a refinancing or recapping the balance sheet. Obviously, we have got call dates coming up this year and we have got our revolver comes current in a couple of months. So, we will have another year after that, but have the cash on the balance sheet to pay it off. If there was a transaction, then I mean I am not even going to speculate, because it would depend on the type of transaction, but obviously you would want to put in the appropriate capital structure for it, but I think we are speculating at that point, because as Joe said, there is not anything imminent and so there is not a strategy to talk about.
We appreciate everybody’s time and look forward to talking to you soon.
Thank you. This does conclude today’s conference call. You may now disconnect.
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