FairPoint Communications' (FRP) CEO Paul Sun on Q2 2016 Results - Earnings Call Transcript

FairPoint Communications, Inc. (NASDAQ:FRP)

Q2 2016 Earnings Conference Call

August 3, 2016 8:30 AM ET

Executives

Paul Taaffe - Vice President, Investor Relations

Paul Sunu - Chief Executive Officer

Karen Turner - Chief Financial Officer

Analysts

Umesh Bhandary - Jefferies

Rob Jost - Invesco

Mike McCormack - Jefferies

Operator

Good day, ladies and gentlemen, and welcome to the FairPoint Communications Incorporated Q2 2016 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] As a reminder, today’s conference is being recorded.

I would now like to introduce your host for today’s conference Mr. Paul Taaffe. You may begin, sir.

Paul Taaffe

Good morning. Our speakers today are Paul Sunu, Chief Executive Officer; and Karen Turner our newly appointed Chief Financial Officer. I would like to remind you that certain statements made during this call, which are not based on historical facts, including any statements relating to financial guidance, may be deemed forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Because these forward-looking statements involve known and unknown risks and uncertainties, there are important factors that could cause actual results to differ materially from those expressed or implied by these forward-looking statements.

With that, I will turn the call over to our CEO, Paul Sunu.

Paul Sunu

Thank you, Paul. Good morning. Thank you for joining us. I am pleased to report another solid quarter as we continue to transform revenue, manage expenses and drive improved performance.

Revenue was essentially flat quarter-over-quarter and we are beginning to see a positive impact from our increased focus on delivering outstanding customer service as we are seeing churn at historic lows.

Growth revenue increased quarter-over-quarter and exceeded 30% of total revenue for the first time. Further, the increase quarter-over-quarter in our growth revenue essentially offset the decline in our convertible revenue segment allowing us to transform our revenue mix while improving our revenue trajectory.

Ethernet revenue and Ethernet circuit counts continued their growth in the quarter as we successfully offset customer conversions from older technologies hosted and advanced services revenue grew in the quarter as well.

In addition, we turned out several new datacenter customers and the features and flexibility of our hosted PBX offering continued to appeal the businesses. Broadband subscribers and broadband revenues grew, a second straight quarter with ARPU strength we expected as seasonal customers primarily in Northern New England reconnect the services.

Now we attribute improved trends in broadband subscribers to several factors including reduction in churn, increasing new subscriptions and new tactics around upgrades. For instance, we noticed that customers with slow speed were not taking advantage of higher speeds that were available to them.

So, we proactively offered three next-tier upgrades to these customers to inoculate them to competitive offers and allowed our call center reps an opportunity to up sell to even higher speeds. At the same time, we’ve also experienced solid response rate from our targeted marketing to prospective customers.

While the broadband subscriber growth from the first quarter is not large, we are pleased to see the lower churn rate and increase in upgrades that are providing stability to our subscriber base.

Reduction in churn was not limited to broadband subscribers as residential voice line losses were the lowest for many years. Now I made a similar decoration last quarter, but I am pleased to point out that this quarter’s churn was even lower.

Now let me share some comments about our network. As you know, we have a great fiber-based network and we are enhancing that network impart through the CAF 2 program. The work we’ve done to-date under CAF 2 indicates that we are squarely on pace for our 2016 growth targets.

Our approach is to design a smart network extension under CAF 2, one that can not only meet current bandwidth requirement, but also be ready to evolve to reliably meet future demand. We are also extending our fiber reach in our telecom group markets.

We’ve been edging out of our operating territory in the telecom group for sometime now, but we recently initiated a strategy to extend our fiber reach and I am happy to report that early signs from this strategy are encouraging as we are seeing revenue generation opportunities in Oklahoma, Washington State and upper New York State areas.

We continue to keep a sharp eye on expenses and our second quarter results reflect that effort. Operating expenses were down quarter-over-quarter and year-over-year, primarily due to lower employee expenses. While our overall headcount is down over 9% since last year, our performance continues to improve.

This is a real credit to our management team. I believe we’ve demonstrated over the years that reducing expenses is really just the natural derivative of operating better.

Finally, our improved operations and strong – our platform generates cash. In the past couple of years, we’ve used our cash effectively in connection with our labor negotiations to create shareholder value. This past quarter, we sort ways to continue to deploy our cash in shareholder enhancing ways.

Lastly, we closed a small transaction to acquire a Maine based value-added reseller of unified communications, data networking and cabling infrastructure solutions. This acquisition filled the hole in our product and service offering to small businesses and allows us to be more effective and efficient in completing work at customers’ premises.

We believe that this acquisition is a great platform to leverage our geographic reach an unmatched fiber-based network across Maine, New Hampshire Vermont and to extend these value-added services across our footprint to better serve small and medium-size businesses.

In addition, this past quarter, we were active bidders in the open market for our notes. Now we saw that opportunity based on quota prices to purchase our debt at a discount at par and expected the retiring outstanding debt would provide shareholders the positive benefit of reducing interest expense, lowering leverage and potentially enhancing the economics around refinancing.

However, we found the markets thin and liquid and even though we raised our bid a number of times, we were unsuccessful in taking in any notes. We will continue to explore the full spectrum of alternatives to enhance shareholder value including the potential of repurchasing debt in effective ways and executing tuck-in acquisitions like the one completed in July.

Now as most of you know, we announced in mid-July that Ajay Sabherwal decided to leave FairPoint after filing our second quarter Form 10-Q. So I’d like to thank Ajay for his dedicated service to FairPoint over the past six years. Ajay and I worked well together and I’ll miss our partnership.

Now, I am pleased to introduce to you Karen Turner, who assumes the role of CFO upon Ajay’s departure. I’ve known and worked with Karen for nearly 20 years. Karen and I worked together in Madison River and she has been at FairPoint for the past two years serving as Interim Treasurer and then heading FT&A before moving to lead our telecom group as well as our human resource functions including labor and risk management.

She has also been at my side in developing and executing our strategy and confident that she will be an outstanding CFO for us. So, Karen, welcome and I’d like to ask you to take us through the financial results.

Karen Turner

Thank you, Paul. Good morning everyone. First, let me say that I am excited to assume the role of CFO at FairPoint. I’d like to thank Paul and the Board for their confidence in me. I look forward to meeting those of in the investment community in the coming months.

I would also like to thank Ajay for his service to FairPoint and join Paul in wishing him well in his future endeavors. Now, to the results. We had a solid quarter and I am pleased with our performance. For the quarter, net income was $29.3 million and we delivered adjusted EBITDA of $63.1 million.

Net cash provided by operating activities equaled $46.4 million in the quarter and we generated $31.5 million of unlevered free cash flow. Revenue was essentially flat quarter-over-quarter as our transformation efforts continue and we managed expenses well. As a result, we are reiterating our guidance for 2016.

Now, the details of the quarter, we reported revenues of $206.6 million in Q2, that compares with $206.8 million in Q1. Looking at our strategic revenue categories, growth revenue comprised 30.9% of our total revenues, which is up from 28.1% in Q2 2015.

Within growth products, the three sub-categories of broadband, Ethernet and hosted and advanced services all increased relative to Q1. Broadband revenue of $34.8 million was up both quarter-over-quarter and year-over-year and we were pleased to report our second consecutive quarterly growth in subscribers.

We are continuing to see improving trends in growth churns due to our many efforts to improve customer service, enhance and extend the network and refine our marketing efforts. We are doing so while we also continue to maintain rigorous credit screening for new customers and collections diligence with existing customers.

As we strive for revenue stability, my expectation is, we will continue to take steps like our recent efforts to raise the credit bar to ensure we are generating high quality revenue that has a greater likelihood to stick with us.

Ethernet circuit counts continue to grow and Ethernet revenues increased sequentially in the quarter reflecting the broad adoption of Ethernet technology by businesses and government institutions.

Finally, hosted and advanced services revenue grew relative to Q1. We are attracting more datacenter customers and installing and turning up more hosted PBX systems. We expect to continue our momentum in growth revenue.

Continued network investments like extending our edge out strategy with fiber and telecom group markets, ensure that we are raising more customers with state-of-the-art services and our small acquisition of a Maine-based value-added reseller in July positions us well to broaden our offering to businesses in Northern New England to include products and services that reach into the customers’ premise.

I was involved in the diligence process on this recent transaction, as well as the evaluation of some others that ultimately proved not to be a strategic fit and I could not be more pleased with the competencies of our internal cross-functional teams to effectively and efficiently evaluate acquisition targets.

I remain encouraged by the opportunities we see to expand our offerings, extend our geographic reach and accelerate our objectives through similar strategic acquisitions.

We continue to manage expenses well and on a sequential basis, operating expenses excluding depreciation and amortization decreased $12.8 million in the second quarter of 2016. The decrease was driven by $8.5 million and sequentially lower GAAP compensated absence expense, $2.5 million lower depreciation and amortization expense and $1.4 million lower severance expense.

On an adjusted basis, which excludes items such as compensated absences and severance expense, adjusted operating expenses decreased $1.4 million quarter-over-quarter primarily due to lower employee costs and lower building-related expenses.

We continue to see the positive impacts on bad debt expense resulting from our implementation of stricter credit standards over the past few years. But the sequential decrease in operating expenses in Q2 was somewhat offset by higher bad debt expense due to a non-recurring write-off recovery that occurred in Q1.

Employee headcount declined by 268 year-over-year with the bulk of the reduction happening in July of 2015. We generated $29.3 million of net income in the quarter, versus net income of $18.6 million in Q1.

The increase in net income was driven by sequentially lower GAAP operating expenses, primarily the result of compensated absence expense, slightly offset by higher income tax expense relative to Q1.

We continue to recognize a reduction in operating expense related to the GAAP treatment of the change in the liability of the OPEB plan due to the elimination of post-employment health benefits for active represented employees.

As we mentioned in our Q1 call, the amortization period for the OPEB benefit is based on the 2.5 year term of the changes in medical premium reimbursement arrangement as agreed to in the new CBA.

We expect a continuing impact of the OPEB benefit to net income through Q4 2016, but while the benefit was generally consistent in Q1 and Q2, we expect the net benefit to increase approximately $13 million in Q3 before declining approximately $26 million from Q3 to Q4 based on the components and timing of the amortization.

In addition, while this GAAP treatment impacts net income in 2015 and 2016 for book purposes, this book recognition does not increase our cash income taxes or change our accumulated federal net operating loss carry-forward, which at the end of Q2 totaled $283.2 million.

Adjusted EBITDA was $63.1 million in the quarter, a $1.1 million increase when compared to Q1. The increase was driven by lower adjusted operating expenses. Adjusted EBITDA margin of 30.5% was up 80 basis points from Q2 2015.

Q2 CapEx of $26.8 million increased slightly from $25.9 million in Q1. CapEx of $52.7 million year-to-date reflects the timing of our capital plan for 2016, which generally includes greater capital spending in the second half of the year.

As a result, we continue to expect capital expenditures of $116 million to $120 million for the year. Net cash provided by operating activities increased from $24 million in Q1 to $46.4 million in the second quarter.

The increase was primarily due to favorable changes in our working capital and higher net income, partially offset by a scheduled pension contribution during the second quarter.

As we’ve mentioned on our last earnings call, a growing cash balance creates a spectrum of shareholder enhancing alternatives not previously available to us. So we intend to continue to focus on the cash generation characteristics of the business.

For the quarter unlevered free cash flow of $31.5 million resulted from adjusted EBITDA of $63.1 million, less CapEx of $26.8 million and $4.7 million of cash, pension and OPEB payments.

The timing of required cash payments to the pension plan which occurred in April and July and are expected in September and October was the primary driver of the sequential reduction in unlevered free cash flow relative to Q1. Our cash balance at the end of Q2 was $41.1 million, as compared to $23.1 million at the end of Q1.

The sequential increase resulted from cash generated by operations and the timing of our semi-annual bond interest payment of $13.1 million which occurred in the first quarter. Our $75 million revolver remained undrawn as of June 30 with $14.8 million committed for letters of credit.

Now to guidance. Our expectations remain unchanged since we first issued 2016 guidance in March. For full year 2016, we expect to generate $105 million to $120 million in unlevered free cash flows.

In addition, adjusted EBITDA is expected to be between $245 million and $255 million. CapEx is expected to be between $115 million and $120 million and cash used for pension contributions and OPEB on a combined basis of approximately $20 million is expected.

Overall, expense savings from both new efficiency initiatives and the wrapping benefits of actions already taken should help offset declining revenues. Meanwhile, we continue to invest in our network, while generating significant free cash flow. For the year, we expect scheduled annual principal payments of $6.4 million and cash interest expense of approximately $78 million.

So, before turn it over for Q&A, let me reiterate a few items from our results. Revenue transformation continues with growth revenue exceeding 30% of the total for the first time while our focus on customer service and network investments has allowed us to slow our losses of our legacy product subscribers.

A continued focus on expenses resulted in strong net income, adjusted EBITDA and unlevered free cash flow in the quarter and as a result, we are reiterating our guidance for the year.

So with that, let me ask the operator to open the call up for Q&A.

Question-and-Answer Session

Operator

[Operator Instructions] And I am not showing any questions at this time, I would like to turn the call – actually, we do have one questioner, I apologize from Arun Bhandari [Ph] with Credit Suisse.

Unidentified Analyst

Hi everyone. Just a couple of really quick questions, thanks for sneaking me in here. Just wanted to understand, as far as your sort of seasonality, normal seasonality, you see Q2 and Q3 usually good seasonality-wise. Can you sort of comment maybe, Paul, in terms of how you saw the seasonality this year? Was it sort of inline with expectations? And what do you feel about Q3 at this point?

Paul Sunu

Yes, I think the trends remain pretty consistent. The – it’s always difficult to predict what’s going to be happening, whether you get a bumper crop off, visitors coming up. For the most part, it was inline. I would say that, for the third quarter, we expect about the same.

Unidentified Analyst

Got it. Helpful, thank you. And then as far as sort of pricing and competitive intensity, anything to report from a sort of – in terms of relative to Q1, any sort of puts and takes there?

Paul Sunu

No, we do a really – our team does a really good job of taking a look at competitive pricing. And what we are finding here is that, this is not really about doing it on a state-wide basis, but really on a more like a community and a regional approach, just to understand what the demographics look like and what they are looking for.

So, when we do our marketing efforts, one of the things that we are finding is that, about half of our opportunity is in the broadband really comes from areas with relatively low competition.

And when we market to those areas, we get really good response rates as well as pretty sticky customers and I think that’s what’s helping us with these new subscriptions. Also the work that we’ve done on these upgrades have been very helpful as well. And I’ve mentioned that on the call.

Unidentified Analyst

Got it. That’s all from me. Thank you.

Paul Sunu

All right, thank you.

Operator

Our next question comes from Umesh Bhandary with Jefferies. Your line is open. You can ask your question. If your phone line is muted, could you please unmute it?

Umesh Bhandary

Hi, sorry about that guys. I was on mute. I apologize. In the call, you started talking about sort of the capital structure. It seems like you are in the market to buyback some bonds, I mean, obviously, your term loan is pretty expensive, I mean, what do you mean, obviously that’s fairly short – it’s relative short and I should say. I mean, just give us how you sort of think about the capital structure? And what do you think on options that maybe available to you?

Paul Sunu

Well, we obviously, we get a lot of inputs from bankers and firms how it is that we think about our capital structure and we review them pretty seriously. We just saw that – we saw an opportunity last quarter when we saw our notes being traded at below par and it’s eight and three quarters interest that we pay on those notes.

And thought - we thought if we could move some of those in, that would be a good use of our cash and we worked pretty hard and tried to do that, but a lot of our notes are kind of tucked away. So, as we just – we didn’t find – we just weren’t successful in meeting with the notes.

Umesh Bhandary

Got it. And then, I guess, bid two becoming callable here shortly, what about just calling them?

Paul Sunu

Well, we still – we are still in a period of where we are paying like what with 104 on these. So, I am not sure that, I mean, so that’s a pretty big difference when you are trading below par versus 104.

Umesh Bhandary

For sure, for sure. But just given the kind of the - operate at high-end market from the bank debt market it’s probably – I mean, obviously, we have gotten better advice from the bankers and that’s the way you can do financing.

So, and then, also just on sensible use of cash, so early if you can’t really buyback bonds and I know and it seems like some of your equity investors are hesitating for shareholder returns. I mean, how do you sort of think about in balancing sort of addressing your near-term maturities here versus maybe dividends or share buybacks?

Paul Sunu

Well, we are going to – we’ve been pretty consistent about this which is, we need to be taking a look at the full spectrum of alternatives that’s available to us. And so, when you are valuing dividends, it’s got to be in the context of the total financing position, the business conditions, the sustainability of the free cash flow and all of that.

I think, we have demonstrated that we do have good cash flow generation, but I think that this is one of these things that we just need evaluate in context and we’ll continue to do so.

Umesh Bhandary

Got it. And one final question from me, I mean, look, I think just, obviously, your industry is probably not going to grow at a significant pace, to few guys. Do you think like, I mean, how do you sort of guys see yourself in like three to five years? Do you think that it needs to be further consolidation? And if that is the case, do you guys sort of see being as a consolidator or consolidating…

Paul Sunu

Yes, we’ve been very vocal about this. And I’ve been saying for a long time that this is a consolidating industry and I think one of the things is that, we’ve made great strides having our peers really understand the outstanding operating platforms that we built and why we believe we have to be an active participant in this consolidation. So, I think, so, I don’t know how much more clear I can be on that.

Umesh Bhandary

So, what are you seeing in your views sort of preventing for the consolidation?

Paul Sunu

In these things, there are – I am not quite sure how to put that other than, it takes two to tango, right.

Umesh Bhandary

Got it, and it makes sense, makes sense. All right guys. Thank you so much.

Paul Sunu

Okay.

Operator

Our next question comes from Rob Jost of Invesco.

Rob Jost

Hi, thanks, I am guessing at a couple. So, when I look at the access lines, I am sorry, the access revenues, it’s a little difficult to – I guess, kind of model out it. Can you give me some guidance on what you expect there, going forward? Are we sort of at a point of stabilization there?

Karen Turner

Hi, Rob. This is Karen. So, for access revenues, we saw a decrease of about $1.3 million in the quarter. The decline was driven by just a continued ops and conversion of legacy transport circuits as they are moving over to fiber-based Ethernet circuits. I think that trend is, I mean, that’s been a fairly consistent trend for us.

Rob Jost

Okay, so, in prior quarters, I guess, what it was confusing me is, in prior quarters, we’ve seen different levels of declines. Is there any rhyme or reason to why going forward we should see things accelerate or decelerate from here?

Paul Sunu

What ends up happening here is that there are sometimes there are some lumpiness that kind of comes in due to settlements and disputes, because obviously, we provide access to other carriers and they might have speed stability. We might counter that and then you end up what the settlement that shows from bulking it. So that’s really what explains.

Rob Jost

Okay, and then in terms of the gross margin improvements from first quarter to second quarter, was there any one specific revenue area that drove that or was it more broad based?

Paul Sunu

I think it’s kind of general. Karen, any thoughts on that?

Karen Turner

I mean, certainly the growth that we saw, I mean, there wasn’t like one area that stands out, but certainly in the broadband area…

Paul Sunu

I think the broadband obviously really saw increases and kind of the strength that we saw as to see some seasonal customers came back

Karen Turner

Seasonal, yes, and that was seasonality as well as ARPU.

Paul Sunu

Yes.

Rob Jost

Okay. And then finally, can you remind me if you’ve given this before, I apologize, what your outlook is for regulatory funding is, not only for the rest of the year, but kind of out in 2017?

Paul Sunu

Yes, that’s’ clearly - that kind of – that’s a good question. So, Karen, do you want to pick that up, because we do lose that transition funding, I think.

Karen Turner

So, in Q3, we are actually – we are going to see a step down in Q3 as we have the CAF 2 transition revenue drop-off. So, specifically in Q3, we are expecting about $400,000 less than Q2. And that is due again to the step down in August. So, all in all, this year, we are continuing to receive some CAF support for Colorado and Kansas.

We expect that to continue, but there is a SEC auction for those states. So, we need to wait and see what happens with that. But for right now, we are really looking at a slight step down in Q2 of about $400,000 and then, that’s probably the big thing that we have in our – and that continues on.

Rob Jost

Okay.

Paul Sunu

So, we’ll see a slight step down in the third quarter, because that we are going get that transition revenue in August and then we’ll have a full quarter of that effect in the fourth quarter. So there will be a slight – little bit more of a step down, but after that, it kind of continues until the following August.

Rob Jost

Okay, very good, thanks.

Operator

Our next question comes from Mike McCormack with Jefferies.

Mike McCormack

Hey guys, hey Paul, just trying to get a sense for what you are seeing from customers that might from legacy services to Ethernet and IP. What the sort of average monthly spend looks like the change in it when they move to that technology? And then, maybe secondly, what you are seeing it, you made a comment about the competitive landscape, but just what you are seeing as far as Ethernet pricing goes year-over-year up or down?

Paul Sunu

Yes, thanks, Mike. So, what’s really interesting here, as you know, is that, when you go from your TDM circuit to Ethernet circuit you are getting a lot more bandwidth at a cheaper price, right, on a per meg basis. But what people are doing is they are buying a lot more than what they could get on a cheap one over DS3.

And so, we know that there is that trade-off and so, what you end up doing is, you are selling a bigger pie and you are trying to hold the pricing. And, so, what’s really good about this quarter is that, what we seek to do is to have the increases in our growth area basically offset the decline in our convertible area.

Now we can’t control the finding of when customers go from their TDM to an IP circuit, but if we can, over a period of time, kind of smooth that, also that one-off that’s the other, then we get, we have far greater chance of getting to a period of stabilization.

And so, that’s why this quarter was, from our point of view, a nice thing to see, because we were able to cover that, and we cover it by not only the transition that happens from the TDM to IP circuits, where someone is going from a DS3 to an Ethernet circuit, but also because of the fact that, our team is selling more to new logos as well as we are getting some increases in our other growth areas like the advanced services that we are doing, the hosted PBX products t hat we are seeing, right.

And some managed services that we are doing, which makes all of that a little more sticky. So, to your second question, what’s happening to overall pricing, well, I think we all know that whenever you have something new, it starts out at a higher price and as more of these things become available, there is some commoditization on the pricing.

And I think the Ethernet pricing is no different. So, we are seeing some troughs in that pricing. The way in which we are countering that is with advanced services. We think that having those services will be – is critical, because our customers are looking for that. They are looking for monitoring services and they are looking to make sure that they are having the latest tools and flexibilities to manage their circuit.

Mike McCormack

Great. Thanks, Paul.

Operator

And I am not showing any further questions at this time. I’d like to turn the call back over to Paul.

Paul Taaffe

Great. Thanks again for your interest in FairPoint. We look forward to sharing our third quarter results in November. Have a great day.

Operator

Ladies and gentlemen, this does conclude today’s presentation. You may now disconnect and have a wonderful day.

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