Level 3 Communications Q2 2007 Earnings Call Transcript

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Level 3 Communications, Inc. (LVLT)
Q2 2007 Earnings Call
July 26, 2007 10:00 am ET

Executives

Valerie Finberg - VP of IR
Jim Crowe - CEO
Kevin O'Hara - President & COO
Sunit Patel - CFO

Analysts

Tim Horan - CIBC World Markets
Jonathan Schildkraut - Jefferies
David Janazzo - Merrill Lynch
Jonathan Chaplin - J.P. Morgan
Ana Goshko - Banc of America
Mike McCormack - Bear Stearns
Colby Syneasael - Merriman Curhan Ford
Vance Edelson - Morgan Stanley
Chris Larsen - Credit Suisse
Donna Jaegers - Janco Partners
Tom Watts - Cowen & Company
Jason Armstrong - Goldman Sachs
Qaisar Hasan - Buckingham Research
John Hodulik - UBS
Greg Mesniaeff - Needham and Company

Presentation

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Second Quarter Earnings Release Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and the instructions will be given at that time (Operator Instructions). As a reminder, today's call is being recorded. I would now like to turn the call over to Valerie Finberg, Vice President of Investor Relations. Please go ahead.

Valerie Finberg

Thank you, Jeannine. Good morning, everyone, and thank you for joining us for the Level 3 Communications second quarter 2007 earnings call. With us on the call today are Jim Crowe, Chief Executive Officer; Kevin O'Hara, President and Chief Operating Officer; and Sunit Patel, our Chief Financial Officer. Before we get started, I would like to remind everyone that some of the statements we will be making today are forward-looking in nature and involve risks and uncertainties.

Actual results may vary significantly from those statements. Please note that on today's call, we will be referring to certain non-GAAP financial metrics. Those metrics are reconciled to the most comparable GAAP measurement in our press release. The press release, including the non-GAAP reconciliation, is posted on our website. With that, I will turn the call over to Jim.

Jim Crowe

Thank you, Valerie. As is our normal practice, we'll start with the financial -- excuse me, operational highlights and an analysis of the progress of integration of the acquisitions we've made by our President, Chief Operating Officer, Kevin O'Hare, he'll turn it over to Sunit Patel, our CFO, who will provide a financial analysis of the quarter and some comments about the balance of the year. I'll have a few summary comments and we'll open it up for questions and answers. Kevin?

Kevin O'Hara

Thanks, Jim. Overall, the second quarter was a good quarter for Level 3. We made significant progress on the integration of all acquisitions, core services revenue grew 2%, the pricing and demand environment remained favorable and new sales again grew nicely. In the quarter we continued to spend a significant amount of time launching our product set to the sales force and training them on everything from products to processes.

The combination of the Level 3 value proposition and a favorable demand environment allowed us to enjoy a very strong sales quarter. In fact, sales in Q2 were stronger than in Q1. We believe the reasons for the strong sales performance include industry consolidation, which has improved the market dynamics and demand, which remains robust, as well as the attractive relationship between price and demand.

We also believe that the breadth of the service portfolio enabled by the combination of our local and intercity networks is particularly attractive to our target customers. I'll take a minute to walk through the trends and opportunities that we're seeing in each of our market groups.

Our wholesale market group enjoyed a very strong sales quarter and their funnel of customer opportunities is very healthy. During the quarter, however, installation intervals grew substantially and this resulted in us not realizing the growth in core revenue that we had anticipated. I'll talk more about the specific challenge and what we're doing about it in my integration section. From a pricing perspective, as in previous quarters, we're seeing greater pressure in the transactional business than in solution sales, but we continue to be able to maintain pricing discipline and still close a very large amount of new business.

Our business markets group has had the most organizational change since the acquisitions, and has been assigned a challenge of positioning Level 3 in the enterprise space. A market segment where Level 3 has not historically been very active. Despite the challenges associated with consolidating product sets, repositioning the sales force, and introducing the Level 3 brand to the enterprise customer base, business markets group had a very solid sales quarter and also enjoyed approximately 4% quarter-over-quarter growth in core revenue.

While it's still very early in the process, the quarterly results are encouraging. We believe that consolidation by the largest competitors, combined with the unique set of metro and intercity assets and products that Level 3 can offer our target customers makes us an attractive service provider to a large percentage of the enterprise market. From a pricing standpoint, there are very different market dynamics in the enterprise sector for facility-based service providers. Often we compete with only one other provider. As a result, we're not seeing the type of pricing pressure that we see in the wholesale business.

Our content markets group continued to see very strong demand in growth from both our existing customers as well as new customers. Sales for the quarter were also higher than in Q1 and core revenue grew 8% quarter-over-quarter. We launched our initial CDN services this quarter and the early results to the level of interest are encouraging. While we're pleased with the early results, as we've stated previously, we do not expect our CDN business to contribute meaningfully in 2007.

Our European market group also enjoyed a strong sales quarter at a very strong revenue quarter with core revenue growing 10% quarter-over-quarter. Our top 10 customers for the quarter in alphabetical order were AT&T, DT, Comcast, Commonwealth of Pennsylvania, EarthLink, Qwest, Sprint, Time Warner, Verizon, and Vonage. The top 10 customers represent 33% of total communications revenue and without the SBC contract revenue, 28% of total communications revenue. In the first quarter, the top 10 customers represented 35% of communications with SBC and 29% without. The diversification of our customer base continued to improve this quarter and we expect this trend to continue over the course of the year.

Moving to integration, this quarter we made good progress on the overall integration front. The total head count for the business continued to decrease faster than anticipated and we're on track to complete the great majority of all reductions by the end of the third quarter. A key objective during the integration process is to make sure that we do not compromise our sales momentum. We've also been focused on ensuring that the excellent reputation that Level 3 has earned over the years for customer service does not get degraded.

As I've mentioned previously, it's inevitable that as employees from seven companies learn new business processes and systems, that some inefficiency will be incurred during the transition. During the quarter, we experience some of this inefficiency and as a result, performance in certain operational areas did not meet expectations. From the outset, we believe that consolidating the processes and systems that support the entire Level 3 business was both a key to successful integration, as well as to driving our SG&A costs down over time.

Also, as I've mentioned in the past, Level 3 was committed to redesigning our operating support systems and processes independent of any acquisition. As we develop these new processes and systems, we're often working in a hybrid systems environment that has elements of both the legacy Level 3 systems, as well as various systems from the seven acquisitions. During the interim period of time, where we have consolidated certain organizations and functions, but where we have not fully developed or implemented the end-state processes and systems, our employees are being trained on and need to operate with elements of many of the legacy systems.

Operating in this interim environment has added operational complexity to certain functions. As a result of this complexity, the average period of time it takes to convert certain new service orders into revenue has been extended by up to 50 to 75%. This challenge has been compounded by the historically high level of sales that we've seen. The effect of the challenge was a dampening in growth of core revenue during the quarter, particularly in wholesale markets.

This hybrid environment will continue in varying degrees until the development of the end-state systems are completed. We're implementing new systems releases in regular intervals during 2007 and the work will continue through 2008. While this is the most complex part of the integration, we remain confident in our end-state architecture and will make meaningful progress towards our end-state environment during the balance of 2007. However, we're also making changes to the current hybrid environment. We have assigned a proven executive to lead an assessment of all interim operating processes and systems. We've made important leadership changes in certain operating groups.

We've streamlined certain activities and organizations to eliminate some of the complexity, and we're adding additional resources in select functions. While the operational complexities are a challenge, they are within our control and we have an operations team with a long track record of resolving these types of problems. While they've had an impact to date, it might cause short-term volatility and revenue growth, I don't believe that the operational challenges will have a meaningful effect on the opportunity available to Level 3. In the meantime, we're working closely with our customers to communicate our progress and ensure that we're meeting their needs.

From a network perspective, all IP network interconnects have been completed, as have the majority of interconnects to the transport network and we expect to be substantially complete with all physical interconnects in the third quarter. All of the network operation control centers have now been physically consolidated into Denver and Atlanta. The CDN business required minimal physical integration. We've augmented the CDN network and have officially launched our initial services and we're pleased with the early results.

We'll be rolling the services out to our European customers in the third quarter. The integration of Servecast does not require much physical integration. It's much more of a product and capability acquisition where we're focused on adding the acquired capabilities into our CDN product family to enhance the attractiveness of our offering, particularly in the area of streaming video. A key part of the synergy assumptions from the acquisitions was an improvement in gross margin, as we optimized the acquired networks, migrated traffic from offnet providers directly on to the Level 3 metro facilities and focused our sales efforts towards high margin on net opportunities.

We made good progress this quarter and our gross margin expanded from 57% in the first quarter to 58% in the second quarter. We expect to continue to see margin expansion throughout 2007 as we continue with these efforts. Over the course of 2007, we expect gross margin to increase into the low 60s in percentage terms, as we make progress in each area. The results to date are encouraging. While the operations this quarter were challenging, they're limited to the interim environment we're operating in and do not put at risk the end-state architecture or the schedule to get there.

From the beginning, we have said that we would be substantially complete with integration in 2007, but the systems work would continue through 2008. We remain on track with both of these objectives.

In summary, we're pleased with the overall results this quarter. Despite core services growing slightly slower than anticipated, we achieved significant cost savings and an expansion of our EBITDA margin and believe that we're realizing the benefits of the acquisitions. Our closed sales are strong and the funnel of opportunities is still robust.

While the integrations are progressing well overall, the operational complexities that we're working our way through could cause short-term volatility, but we do not believe they effect our longer-term prospects. Perhaps most importantly, the challenges we're wrestling with are within our control and the customer demand and the pricing environment remain favorable. With that, I'll turn the call over to Sunit.

Sunit Patel

Thank you, Kevin. In summary, for the second quarter, we did better than we expected toward realizing synergies, but fell short of our core communications services revenue guidance, given some of the challenges we experienced in converting sales to revenue. Core communication services revenue continued to grow and was $888 million in the second quarter, an increase of 2.1%, but below our projections of 890 to $910 million.

Transport and infrastructure revenues grew 3% in the quarter. We expect that growth to accelerate over the year, as we turn up the large inventory of orders in hand. Pricing remains stable, with infrastructure pricing for services such as Colocation and Dark Fiber continuing to increase in the single-digit percentage range and the transport services pricing is staying within a plus or minus 10% annual change, depending on the speed of the service and the market.

IP revenues were down slightly in the quarter, driven primarily by rerate of some of our larger IP customers, including our largest IP customer. We continue to see strong traffic growth on our IP network and expect the revenue growth to accelerate over the year. Our IP contract durations have continued to expand and the average term land is now about 18 months. The annual price decline for IP high speed IP services is still expected to be 20 to 30%.

Our voice revenue growth in the quarter was low due to migration of one customer's wholesale voice traffic as a result of industry consolidation and slightly lower ramp of wholesale minutes than expected. We believe that the voice business should show stronger sequential performance for the balance of the year.

Our Vyvx revenues were up nicely in the quarter, driven by both seasonality and improving demand, driven by increasing demand for high-definition programming for sports and we expect continued growth, as news and entertainment continue to shift to HD. Other communication services revenue were $71 million this quarter, just over the high end of our projected range of 65 to $70 million. In the second quarter, revenue from SBC contract services was $76 million and above our projected range of 45 to $60 million.

Communications cost of revenue decreased to 437 million in the quarter from 450 million in the first quarter, primarily due to the benefit of integration and ongoing optimization efforts. Accordingly, gross margin increased to 58% in the second quarter from 57% in the first quarter. We are pleased with our progress on network expense optimization. We are ahead of where we thought we would be at this point in the year and are likely to achieve our 2007 targets for annualized network expense reductions before the end of the year. Our communications SG&A expense, excluding non-cash compensation charges, decreased by $12 million to 403 million in the second quarter, compared to 415 million in the first quarter.

This was primarily due to the benefits of reductions in head count and other operating expenses associated with integration efforts. Non-cash compensation was 24 million in both the second and first quarter. Our integration expenses for the year to date are approximately $60 million. In the second quarter, we incurred approximately $30 million of network and operating integration expenses. On the first quarter call, we indicated that we would incur over half of the total integration expenses in the first two quarters of the year and we believe we are well over halfway through spending on integration for the year.

We still expect to spend about $100 million in total integration expenses, as we projected at the beginning of the year. On the capital expenditures side, we incurred approximately 35 million in capital expenditures related to integration during the quarter, and we believe we are on track for total integration capital expenditures of 75 to 100 million for the year.

Regarding integration synergies, as of the end of the quarter, we had achieved annualized run rate synergies of approximately $140 million, with approximately 60 million in annualized network expense synergies and approximately 80 million in annualized operating expense synergies. We are very comfortable that we will exit 2007 at or better than the 200 million in annualized synergies we had estimated at the beginning of the year. We also expect to achieve the base $200 million run rate reduction earlier in the year than we expected.

Consolidated adjusted EBITDA was $193 million in the second quarter compared to 170 million in the first quarter, above the midpoint for the projected range of 180 to $200 million. It is important to note that communications adjusted EBITDA improved $26 million over the previous quarter, even while total communications revenue declined. Since integration costs did not change much from the first or second quarter, this increase was primarily driven by synergies.

In the second half of the year, we'll also get additional benefit on margin contribution from revenue growth and decline in integration costs. Our communications adjusted EBITDA margins increased significantly. Communications adjusted EBITDA margin was 19% in the second quarter versus 16% in the first quarter. This margin should continue to expand in both the third and fourth quarters.

Capital expenditures in the second quarter were $170 million versus 155 million in the first quarter. This increase was primarily due to higher integration spending and success-based capital in support of customer contracts. Consolidated free cash flow was negative 141 million during the quarter versus negative 248 million in the first quarter of 2007.

Working capital was a little higher than expected during the quarter, primarily due to higher than anticipated accounts payable payments and an increase in accounts receivable during the quarter. Typically, the first half of the year is a heavier use of cash due to annual bonus payments, vendor prepayments for software, business insurance and equipment maintenance. Additionally, in the second quarter, the accounts payable balance declined as we reduced the level of liabilities outstanding as a result of integration activities.

A majority of the decline in accounts payable during the quarter was in the area of network expenses. We are now caught up on this effort and we expect to see accounts payable balances to remain relatively steady for the remainder of the year.

Accounts receivable increased in the quarter as a result of an increase in day sales outstanding over the course of 2007. Improving this measure is a key area of focus across the business for the balance of the year. While in aggregate the use of cash was slightly higher than expected in the quarter, we expect that working capital will be a source of cash in the third and fourth quarters and will largely mitigate the use in the second quarter.

Net cash interest expense was $77 million in the quarter. As a result of our ongoing evaluation of our purchase price allocations related to the acquisitions we have made over the last year, depreciation and amortization expenses increased in the quarter. We expect quarterly depreciation and amortization to be approximately 250 to $255 million per quarter for the rest of the year.

Turning to the third quarter and the rest of 2007, we are projecting core communication services revenue of approximately 905 to 925 million for the third quarter. Other communication services revenues are expected to be 60 to $65 million and SBC contract services revenues are expected to be about 40 to $60 million, resulting in total communications revenue of 1.005 to $1.05 billion for the quarter. Consolidated adjusted EBITDA is expected to be in the range of 210 to $230 million in the third quarter.

We believe the continued benefits from operating and network expense synergies realized to date benefits from additional synergies expected in the quarter and lower integration expenses incurred during the quarter, combined with planned operational processes to accelerate the installation of contracts signed early in the year will enable to us increase adjusted EBITDA and the adjusted EBITDA margin in both the third and fourth quarter. We are maintaining our full year 2007 guidance that we established earlier this year and reiterated on the first quarter call.

We're not narrowing the guidance ranges as we expect to continue to experience volatility, as we work through the integration processes and short-term challenges that Kevin described. The inventory of unfilled orders continued to grow in the quarter and the expected ramp in usage revenue such as voice and IP in the second half of the year from existing customers and new customers give us confidence that the underlying demand for our services remains strong.

We are reiterating guidance for our annual core communications services revenue growth rate of 17% for the year, which is based on annualizing the growth from first quarter 2007 to the fourth quarter of 2007. Given the 2.1% sequential growth from the first quarter to the second, our guidance implies an accelerating ramp in core communication services revenue, and adjusted EBITDA in the fourth quarter. From a revenue growth perspective, we expect the revenue ramp to accelerate over the course of the year, driven bring the operational improvements that Kevin outlined and historic and expected seasonality in the second half of the year.

From an adjusted EBITDA perspective, we gained the benefit of several trends in the third and the fourth quarter. First, the accelerating ramp in communications revenue will contribute at the gross margin line. Second, network expense savings expected to accelerate as we realize the benefit from planning actions taken in the first and second quarters. Third, operating expenses should continue to decline in the third quarter and some in the fourth quarter.

Finally, we expect that integration costs will also decline over the second half of the year. The additive effects of this trends are expected to drive a more pronounced ramp in adjusted EBITDA in the fourth quarter. We still remain comfortable and confident with our guidance for 2008 consolidated adjusted EBITDA for 1.15 to $1.3 billion that we established earlier this year and reiterated on our first quarter call.

So in summary, while it was a challenging quarter on the core communications services revenue growth front, we are pleased with our progress on integration from a synergy perspective and are even more confident of meeting and exceeding our synergy targets for 2007 and 2008. We believe that the operating environment remains strong and we are optimistic about our ability to drive significant core communication services revenue growth during the second half of the year and simultaneously continue to improve our profitability. With that, I'll turn the call back over to Jim.

Jim Crowe

Thank you, Sunit. During the first quarter call, I said that now that we had substantially completed the work aimed at insuring our financial strengths and liability, our entire Company was focused on insuring that we properly integrate the acquisitions we've made. As both Kevin and Sunit have emphasized, we are in the intense part of this effort. While sales are above expectations, and that's very good news, we are struggling a bit to convert those sales into revenue.

As a result, backlog is rising. Many times that's good news, but it's not if we miss customer due dates. DSOs have stretched out, resulting in an increase in working capital. All of these short-term issues result from complexities associated with selling, provisioning and billing services, utilizing multiple platforms. While the specific problems that we're encountering are hard to predict, we knew problems would occur. I want to make several points about our effort.

As we have said over and over again, we realize that acquisitions succeed or fail based on how well the subsequent integration efforts are managed. We have a team of executives who have planned and managed many such efforts. We've seen integration done well and we've seen mistakes made. That experience is incorporated into our integration plan. We have a detailed plan to insure that we have one network, one set of business processes and systems, and most importantly, one organization. We have over 200 full-time individuals whose job it is to project manage this effort.

Obviously, there are many thousands of people involved at the effort itself, but the effort is managed by a large group of experienced people and we expect the majority of this effort to be completed by the end of this year. And while we will no doubt have some surprises, as we did this quarter, I have great confidence that we will successfully achieve our goals because as Kevin said, these are issues under our own control.

On a more strategic note, the overall market position, our overall market position is good and continues to improve. The wholesale market, particularly for complex and end-services and solutions is robust and it's underpinned by what we think is a very long-term explosion of internet-based commerce and entertainment. The enterprise market is particularly attractive. We have about 1% of a very large market.

Pricing is attractive, and we have what we believe is a unique set of end to end backbone and metro assets, which constitute a real competitive advantage. Our new content markets group has the right intellectual and technical assets to address a market we expect to be very large, as traditional media and new media, both migrate to IP-based wired and wireless access. And given our operational leverage and our organizational and financial strength, we think we're very well positioned to take advantage of these positive fundamentals. With that, operator, would you explain the question-and-answer process.

Question-and-Answer Session

Operator

(Operator Instructions) And we will go first to the line of Tim Horan with CIBC World Markets. Please go ahead.

Tim Horan - CIBC World Markets

Thanks. Good morning, guys. Jim, usually when you run into problems like this in the past, well, not you, but other companies in the industry, it usually does take a few quarters to kind of turn things around. Could you maybe give us a little more insight on your confidence there? And you obviously seem to be very confident. And then kind of related to that, if you go by your guidance here, it looks like the fourth quarter you're going to be doing kind of close to 5% sequential revenue growth and kind of 25% EBITDA margins.

That doesn't really line up too well with your '08 guidance, because if you kind of trend that out, it looks like '08 you're looking for around similar margins, but I would expect the margins should be quite a bit higher in '08, unless some of my revenue estimates are too low -- or too high for '08, I'm around 20% growth in '08 and that might be too high. Maybe you can give us some color on the puts and takes on '08 guidance. Thanks.

Jim Crowe

Yes, with -- I'll take those in different orders. With respect to the accelerating growth that you comment on, 5% growth in the fourth quarter, I'd simply point you to the last several years, where we've seen similar kinds of acceleration of growth. Fourth quarter, third quarter are typically accelerating quarters and historically the fourth quarter has been our best quarter in terms of growth for several years. I think last year, correct me, Sunit, we were in the 8% range in terms of sequential revenue growth.

We're not predicting that this year, but we do feel pretty good about the kind of sequential growth we see. With respect to '08, we have a EBITDA guidance which we're comfortable with, and we're not going to go further than that, other than to say it's pretty unusual I think to give guidance that far out. We felt given the number of moving parts in the Company, that was worthwhile, but we hope and believe it's if anything conservative.

With respect to our confidence and the ability to integrate, we've now been at this two quarters. Your comment about it taking a couple of quarters or three quarters, whatever, to deal with operational challenges associated with integration, I would agree with. We are into this a couple of quarters and we are expecting a couple of more quarters of heavy effort. We are confident, to go right to the point, because all of the issues that we're dealing with are under our control.

All of us. Sunit, Kevin, myself, have been involved with dozens of integrations over the last 20 years and it's certainly been my observation that the problems that are lingering are long-term, occur when you change the problem definition. That is the nature of the problem you're dealing with. When you hold the issue constant, when you don't continually change the problem, we think we're pretty good at making certain that we achieve our goals.

Where you run into difficulty is when you make another acquisition prematurely and then add another burden on top of the one that you're dealing with, and as I've said in the past, and I will repeat again, we're not going to change the problem, including making any other acquisition that changes substantially our integration effort until we're comfortable that we have our arms around what we're dealing with today and that all of our systems, processes and organizations are properly integrated. Next question?

Operator

Our next question is from the line of Jonathan Schildkraut with Jefferies. Please go ahead.

Jonathan Schildkraut - Jefferies

Thank you. Could you give us a little bit more color on what's going on the content distribution side, when you might launch some of those products more formally and what areas are you focused on, are you just focused on kind of the traditional content distribution, or are you doing kind of add insertion, flash, et cetera?

Kevin O’Hara

Yes, this is Kevin, Jonathan. We actually launched in the states in May, with the initial product set, and we -- with the acquisition of Servecast, which had more streaming and video capability, we'll be integrating that into the CDN family of products and formally launching that in the near term. So we did officially launch in the second quarter. The early results are encouraging, but it's very, very, very early in the process.

Jim Crowe

Yes, and I think I'd add a couple things. We are aimed squarely at where we think the market is expanding and growing. That is large style distribution media, video, if you would. Initially we were aimed at a file, in file format. Later in the year we're going to be aimed squarely at streaming. We have a product rollout schedule which calls for our streaming product to be announced later this year. I'd reiterate what Kevin said. This effort is expected to contribute significantly next year. This year is still a product rollout effort.

Jonathan Schildkraut - Jefferies

Thank you.

Operator

Our next question is from the line of David Janazzo with Merrill Lynch. Please go ahead.

David Janazzo - Merrill Lynch

Good morning. Kevin, it'd be helpful to me if you could give us a flavor for some of the types of integration issues you're dealing with, systems, possesses, some of the actions you're taking, over what timeframe we could expect to see the results. And then how you're managing customers, how you're managing customer expectations to make sure that they're not unduly disappointed.

Kevin O’Hara

Okay. I'm going to break the integration test down into two parallel paths. One is kind of the long-term organizational process and system, the end-state. We recognized even going back to the WilTel acquisition that neither Level 3 nor WilTel had the right end-state operational support systems or business processes to support the kind of business that we wanted to become.

So from the beginning, we started putting in place effectively a new back office for Level 3 and while that effort was under way, we continued to operate some of the legacy systems in parallel. And as we got new functionality ready for implementation, we would release that functionality to whatever group, and effectively retire one legacy application, replace it with the desired end-state application.

With the subsequent acquisitions of the metro companies and then particularly Broadwing, we continued to push ahead with consolidating groups. The one that is probably the simplest to get your mind around are the network operating control centers, where we have already this year gone from 9 knocks to 2 knocks, but at the same time that we have been able to eliminate seven of those knocks, we haven't been able to eliminate 100% of all of the legacy applications from all of the companies.

So effectively in those two knocks, the employees in those knocks are having to learn elements of the legacy systems and operate in what is a fairly complicated environment while we are developing the end-state processes, the end-state systems. Those systems releases come out on regular intervals. They've already started. We've seen some improvement. We remain on track for the deliverables for the balance of '07 where we get meaningful improvement, but they'll continue into 2008. So with each passing release, there will be some relief, meaningful relief by the end of this year.

It's operating in that interim period where they're relying on various legacy systems and processes, complicating their jobs beyond what we would expect in the end-state and beyond what they were as a series of seven or eight stand-alone companies. So that's the challenge. It's really operating in this interim environment where we're having to maintain elements of the legacy systems and continue to operate with those while we're putting in place the end-state systems.

Now, one other comment, all applications were not created equal. Some have a much more meaningful impact than others. Some are very small and minor in fact, but in aggregate, we're operating a very large number of applications today. That number goes down materially over the course of the next 18 months. It's already gone down by a couple of hundred, which is considerably ahead of where we thought at this point in time, so the end-state architecture, the end-state business processes, the end-state systems, we remain very confident on and we remain confident in the program that gets us to those systems.

What we are wrestling with right now is the challenge that managing the multiple systems has posed to certain of our operating groups, but we're working diligently to get our way through that. In the interim, we are assessing even all of those interim operating procedures. We're not waiting for end-state. We've made some management changes, some organizational changes. We've put a proven executive in charge of assessing all of the interim business processes to see if there's some simple short-term things that we can do to improve the process.

We're actually spending a lot of time improving the interim environment while in parallel we continue to execute against the long-term solution. We are already starting to see some improvement in the interim operations, and that interim improvement is not coming at the expense of the commitment to the long-term road map. So we've kind of got two parallel efforts under way. It's that interim, the interim operations that are posing a challenge in the near term.

David Janazzo - Merrill Lynch

And then how are you managing the customer expectations?

Kevin O’Hara

Like the best thing to do with customer expectations is continue to talk to them. And as we said, wholesale markets group is the group that has seen the biggest effect, Sureel Choksi, the president of that group, has effectively been on the road for about the last four weeks and I suspect that between Sureel and his team, Jim, myself and Sunit, we're spending a lot of time talking to customers to try and maintain their confidence as we go through this. But in the short-term, there's no substitute for communication and over-communication.

Jim Crowe

And I might add, in wholesale market groups, we have a limited number of large customers. Each of these customers have dedicated individuals and some have teams who specifically make sure that those customers have access to all of the resources in Level 3. At times it's not as automated as we would like it, which means it costs us more than we would like. And that's an opportunity over time, to further improve the kind of margins which are already pretty good. But each of those wholesale customers have dedicated groups that make sure they don't have to deal with any of these complexities themselves. We deal with them internally and then present what we hope is a much smoother interface to the customer.

David Janazzo - Merrill Lynch

Thank you.

Operator

Our next question is from the line of Jonathan Chaplin with J.P. Morgan. Please go ahead.

Jonathan Chaplin - J.P. Morgan

Good morning. Thanks for taking the question. So in my view, I think the biggest controversy going into this quarter was whether you're going to be able to hit your revenue and EBITDA target for the full year. And it's very encouraging that your on track in terms of the integration piece and the synergy piece. I think there were a lot of concerns about the complexity of the integration.

You seem to have that more or less well in hand, but more importantly, I think is your ability to hit your targets on the cost side. Given that the core revenues were a little bit below expectations this quarter and third quarter core revenues are a little bit below where we had expected, we have this big ramp in revenue expectations for the fourth quarter, it would be incredibly helpful to get some kind of understanding around how much revenue got pushed from the second quarter into the third quarter because of issues with installation or activation and how much revenue will likely get pushed from the third quarter into the fourth quarter.

I think that would go a long way to explaining to giving people comfort around the ramp in revenues in the back half of the year. And then secondly, I'm just wondering we still have a very wide range out there for guidance generated both the revenue and EBITDA and I understand that there's a great deal -- that there's a great deal under way at the moment. It's difficult to zero in on a narrow range, but, based on what you see in the business today, do you think you're still on track to hit the midpoint of guidance for revenue and EBITDA? Thanks.

Jim Crowe

Yes. With regard to your first question, how much revenue got pushed forward and does that revenue support the kind of projections that we've made, I think that's a really good question. Obviously that's what we're looking at when we reiterated guidance. So I guess my answer would be sufficient revenue got pushed forward to give us confidence that reiterating guidance was the right thing to do. I'll make a comment when I get through the next question.

That is should we be narrowing range? There is a pretty good ramp at the end of the year and we recognize all of that. I think Sunit addressed the point in his remarks where he said we are not narrowing range, because there's still volatility. And I'd simply underline that. Now to my more general question. I know there is a legitimate desire to understanding with precision each quarter-to-quarter set of results. We have great confidence in our long-term ability to continue to deliver and over the long-term when you look at our margins, you look at our market, you look at our growth, we think we're well positioned.

But what we don't want to do is get some set of false precision where each and every quarter we narrow our range down to $1 one way or another. We deliberately gave a range and our confidence is within the range. It's not at the midpoint of the range. It's not at the high end or the low end. It's the range itself. If we felt we could narrow the range, we would have, and I'd refer you to Sunit's comments about that.

Jonathan Chaplin - J.P. Morgan

Jim, if I could follow up quickly, on the -- just on the shortfall this quarter, with the revenue that got pushed out, would that have been enough to make up the difference between the revenue reported and the midpoint of the range on core communications revenue?

Jim Crowe

I'm sorry. If I wasn't clear, I'll say it again. The amount of revenue that got pushed out, and this is true today, it was true through the quarter, is sufficient for to us make the guidance that we have provided for the third quarter and the full year. That is the reason we are reiterating guidance.

Jonathan Chaplin - J.P. Morgan

Great. Thank you very much.

Operator

Our next question's from the line of Anna…

Jim Crowe

It's incumbent on us to turn up that revenue and as Sunit and Kevin and I, I hope emphasized, the whole organization is focused on that effort. We have confidence in our ability to do that. The amount of revenue available to us is sufficient to make targets. Okay. Next question, please.

Operator

Our next question is from the line of Ana Goshko with Bank of America. Please go ahead.

Ana Goshko - Banc of America

Hi. Thanks very much. To get a little more granular just on what's going on in the revenues, was there anything unexpected, had that happened in any of your revenue segments that's notable other than the service activation delays? So for instance in the voice segment and in the IP segment, it was pretty flat, and you did highlight the wholesale customer migrating off in voice and the repricing in IP and wanted to know if that was fully expected or if there was anything in any of those segments that showed up that you didn't anticipate last quarter when you gave the overall core communications guidance?

And then my second question is you talk about the systems issues delaying the provision of services and creating a customer backlog for new services, is there anything going on that is impacting existing customers? I know in the past, you said that Broadwing had relatively higher churn, TelCove had very low churn. Is there anything going on either in the billing or provision of service, quality, customer care, that is increasing churn in your existing base or causes concerns that that might increase?

Jim Crowe

Yes, with respect to your first question, I think we make a real effort to disclose anything that's material that was unexpected and hopefully we've done that job. Obviously, below that level of materiality any business is a combination of offsetting positive and negative effects, but I think those are all below the level that you're talking about. With respect to your second question, Kevin?

Kevin O’Hara

Yes, Ana, we haven't seen any increase in churn attributable to any of the service issues. In fact, to the contrary. The typical conversation with our customers is we would like to you fix this, we'd like to you get our order installed. We're going to escalate and put pressure on you, and we would like to do more business with you. There is a very -- which I think is telling about the state of the industry right now, in that while certain customers are certainly pushing us, it has not had a financial effect other than the revenue delay and in fact, it is many of our existing customers that are causing our sales to be at record levels and higher than expectation.

Ana Goshko - Banc of America

Okay, and then could you tell us what the European revenue was in the quarter? Because that was 54 million last quarter. I think that was pretty much all core and it was a really big increase last quarter. I'm wondering how that's tracking this quarter.

Sunit Patel

Yes, I think the revenue was 88 million Core.

Ana Goshko - Banc of America

Okay. So that's a very notable increase, if I've got it right. It was 54 last, is that right?

Jim Crowe

Give us a minute here. We're shuffling some papers.

Ana Goshko - Banc of America

Okay.

Sunit Patel

It was 59.6 million.

Ana Goshko - Banc of America

Okay, that makes sense. Okay. Thank you very much.

Jim Crowe

Next question?

Operator

Our next question is from the line of Mike McCormack with Bear Stearns. Please go ahead.

Mike McCormack - Bear Stearns

Thanks, guys. Couple of questions. First, on the wholesale voice weakness, can you just give us a little more color on, you mentioned one specific customer, but how much of that customer is left to sort of churn off? Also, why were the new minutes weaker during the quarter?

And then secondly, on the contract wins, I mean you mentioned talking about a backlog, but could you give us a sense for the growth in that sales pipeline during the quarter, and because of the activation delays, maybe a sense of -- I think you mentioned earlier the risk of customer loss and what you're doing to abate that, but how much risk is there that we lose some of those customers that are sitting in the pipeline? And as part that have answer, maybe discuss the install intervals and where that's moved?

Jim Crowe

I think I said earlier that the backlog or the pipeline or signed orders not yet activated were sufficient to make our projections and guidance and I think we'll stick with that. We don't disclose beyond that, and --

Mike McCormack - Bear Stearns

Is it a bigger number than it was last quarter?

Jim Crowe

It's a bigger number than it was last quarter because, as you can see, we expect a ramp in revenue, which necessarily requires a bigger number. And part of the reason is that we shy away from that is particularly when you're dealing with everything from a fixed monthly payment that is pretty, for instance, for a high speed, or for a wave length, you're dealing with usage, where a customer may not know precisely what his own needs are.

For instance, in certain kinds of voice, our customer will give us an order for a particular amount and that customer may not -- well, will not know with precision what his own needs are, plus or minus some percentage. So we don't want to give some sense of false precision by giving you a backlog. It's far better to project revenue, which allows us to take account of all of that. Kevin?

Kevin O’Hara

In terms of the wholesale customer that migrated off as a result of their acquisition and integration, their remaining traffic is somewhere between zero and diminimus. In the voice business, sometimes, it'll come back on for short periods of time, but it's effectively, it's not contributing today.

Mike McCormack - Bear Stearns

Just on the--

Kevin O’Hara

I'm sorry. Go ahead.

Mike McCormack - Bear Stearns

I was going say on the new minutes, I think you said it was a little bit weak as well.

Kevin O’Hara

Yes, and the new minute weakness was related to some of the service activation challenges that I've talked about.

Mike McCormack - Bear Stearns

Okay. Any comment on the install intervals?

Kevin O’Hara

Yes, earlier in my comments I said that they've extended out and for certain services out to 50 to 75% beyond where they have been historically.

Jim Crowe

And as Kevin said, they have not effected churn at this point. We want to make sure that continues.

Mike McCormack - Bear Stearns

Hey, Kevin, the synergy run rate, we talked about this last quarter I think, but if you hit 140, I'm assuming that's an exiting second quarter run rate. I suspect we're going to start to see that sort of pile up in the EBITDA numbers in the back half of the year. Is that a fair assumption?

Kevin O’Hara

Yes.

Mike McCormack - Bear Stearns

Okay. Thanks, guys.

Operator

Our next question is from the line of Colby Synesael with Merriman. Please go ahead.

Colby Syneasael - Merriman Curhan Ford

Hi, guys, how are you?

Jim Crowe

Good, good.

Colby Syneasael - Merriman Curhan Ford

Just one quick question. I noticed in XO's 10-Q last quarter that they mentioned the risk was that they are being sued by Level 3 for something involving their IRUs that they use from you guys. Can you explain to us what that relationship is and give us a reminder just what exactly is happening over there?

Jim Crowe

Yes, it's under litigation. It goes to trial here sometime in the future. Past that, I think we'll put out any press release on anything material for reasons I'm sure that are obvious. It's ongoing litigation and we want to make certain that we don't -- I don't say anything that the attorneys are unhappy about tomorrow morning.

Colby Syneasael - Merriman Curhan Ford

Well, can you at least remind us what that relationship is, what are the services that they are--

Jim Crowe

They've procured fiber from us under an IRU that stretches back a few years prior to -- I think at the time they were even called XO. That fiber is under the terms of an indefeasible right of use. That is they gave us the cash up front. It's subject to a contract defining what the use of that fiber can constitute, and that's the subject of the dispute.

Colby Syneasael - Merriman Curhan Ford

And is that on a nationwide basis, that contract that they have with you?

Jim Crowe

Well, the term nationwide is, I suppose, it'd be in the eye of the beholder. It's a substantial footprint. I'd leave it to others to characterize whether it's nationwide. It's certainly a substantial footprint.

Colby Syneasael - Merriman Curhan Ford

Okay. Thank you.

Operator

Our next question is from the line of Vance Edelson with Morgan Stanley. Please go ahead.

Vance Edelson - Morgan Stanley

Hi. Thanks for taking the questions. First on your appetite for more acquisitions, could you provide a little more color there? I know you don't want to layer on more than you can handle, but you do continue to find new candidates, including one this month that was acquired. Are there more out there that you're regularly looking at and can you just give us a feel for the hurdle rate when you consider additional acquisitions?

Jim Crowe

Yes, sure. And let me make it clear that the kind of acquisition that we announced, that is our acquisition of Servecast, with a capability that we were developing internally, a streaming capability, that is taking media from the existing owner of that media, and doing all that's necessary, ad insertion, et cetera, et cetera, to make that media available over the internet. That's capability we're working on and if anything, we think this is less effort than would have otherwise been expended, that is it shortens an interval and reduces an effort that we would have otherwise had to make.

That kind of acquisition is normal and we may in fact make others if we think they make sense. They'd be small and they'd be acquisitions that don't increase the integration burden. With respect to our appetite, we remain hungry. There are other opportunities that we think -- who knows whether one could ever make a deal or not. That depends on a lot of things, but, yes, there are continues to be a market where consolidation creates opportunities and future consolidation will create future opportunities.

With respect to our own timing, appetite, anything we might do, we're not going to do anything that would change the nature of our integration plan. That plan is well developed. That plan is being worked. We have confidence in that plan, and I believe I speak for Sunit and Kevin, the three of us were all part for a short time of an organization that suffered because it kept doing serial acquisitions and changed the nature of the integration plan. We're not going to do that. When we believe demonstrably to our own satisfaction that integration is sufficiently along, so service activation and the other issues we've talked about are clearly progressing properly, then we'll consider acquisitions. But until that time, we're not going to.

Vance Edelson - Morgan Stanley

Okay. Thanks for that additional color. And just following up on the prior callers question, the 60 million in network savings so far and the 80 million in operating synergies, if we annualize that we'd be at 280, do you think that the run rate in realized savings slows down the rest of the year or is 280 a reasonable figure to expect as the run rate by year end? Thanks.

Sunit Patel

I think we said those are annualized. So, that means we have achieved $140 million, the 60 plus 80 of annualized savings compared to a target we had of $200 million. So I think what we're saying is we expect to hit the $200 million of annualized saving between network expense reductions and operating expense reductions as we had outlined from the beginning of the year and we probably will hit that target reduction a little earlier in the year than the end of the year as we had said earlier and then the savings increase will continue some more especially in the area of network expense reduction both this year and nest year. So, the annualized reduction is 140 million at the end of the second quarter.

Jim Crowe

I want to add one thing to my comment about acquisitions, which I've said in the past but for clarity I want to make certain I say it again. It takes four to six months from the time one signs an acquisition to the time one closes an acquisition. During that period nothing occurs other than some initial planning. So obviously when I say we would not consider an acquisition, we wouldn't consider it until we're four to six months away from being very comfortable that integration is solid and the goals we've set have been accomplished. Okay, next question?

Operator

Our next question is from the line of Chris Larsen with Credit Suisse. Please go ahead.

Chris Larsen - Credit Suisse

Hi. Thank you. Kevin, in your prepared remarks, you said that you're seeing some transactional pricing pressure. I'm wondering if you could give us an idea of who's out there being price aggressive? And then, Sunit, if I go through the guidance and I take the midpoint of the third quarter and then do the implied fourth quarter, it implies about an 80 million ramp in EBITDA and about a 110 or so million ramp in core revenues.

I assume that that core revenues contributes about 65 million to EBITDA; AT&Ts, or the SBC contract probably puts about 5 to 10 million of pressure, again implied from the guidance. Could you maybe walk through, if that's 55 million where the other 35, or 25 to 30 million might come from?

Kevin O’Hara

I'll take the easy one first.

Chris Larsen - Credit Suisse

Okay.

Kevin O’Hara

We don't get into naming names in terms of what's going on. What I will tell you in terms of --

Chris Larsen - Credit Suisse

Rhymes with?

Kevin O’Hara

in terms of where the pricing pressure is coming from. We like to compete on solution, we like to complete -- excuse me, compete based on our collection of assets, particularly the fiber assets in the metro and in the inner city. And while we do participate in the transactional market in IP in transport, etc., our focus is really on trying to go to where customers are prepared to pay for the value that we believe that we deliver.

I've made that comment for each probably of the last, I don't know how many quarters, but probably four or eight and the only reason for stating it today was to kind of reiterate that the market dynamics haven't changed, they haven't gone backwards. They remain very favorable for us.

Jim Crowe

And I want to underline what Kevin just said. I think both of us have said now for some four to eight quarters, that industry pricing, if it didn't change, we'd be pleased and there are indications it's improving. I think this whole quarter, our comments, our press release would underline that. That's not a short-term trend. Pricing hasn't been an issue and we don't expect it to be an issue.

We've explained where we have our opportunities and challenges. We don't regard pricing across all our products and services as the issue today and we don't see any fundamentals in the market that would indicate that it will become any kind of short-term issue. Sunit?

Sunit Patel

Yes. With respect to your question on the guidance, I think a couple of points. One, we said last quarter and I say it again this quarter that the level of expense savings on network expense reductions will continue to accelerate over the course of the year, so that's helping us. You're going to see some reductions in the level of integration expenses, we said 100 million, we spent 60 million year-to-date, so you're going to see some reduction there. That helps us again over the second half of the year in terms of ramping up.

The third thing to keep in mind is we have experienced and expect to experience sharper declines in our SBC contract services revenues, so as you get to a point in the third and the fourth quarters, the growth in the core revenues, which that accelerates combined with the other and SBC contract revenues not declining as much in absolute terms causes your total revenues to increase, which then contributes to gross margin contribution also. In addition, keep in mind that we do have the quality of service benefit in the fourth quarter on the SBC contract.

That's $12.5 million. So I think there are a whole range of things, as I described. Operating expenses also will continue reduce again in the third quarter and we expect it to reduce in the fourth quarter, so when you look at all of these things added together, it drives a more accelerated ramp in the EBITDA. And as Jim pointed out earlier, there's enough moving parts, just with those pieces, and given the amount of unfilled orders we have on hand, we feel pretty good about the revenue ramps. So put it all together, we think that given the volatility that we've talked about, we are comfortable with the range that we have outlined as opposed to pointing to any part of the range.

Chris Larsen - Credit Suisse

Thanks.

Jim Crowe

Next question.

Operator

Our next question is from the line of Donna Jaegers with Janco Partners. Please go ahead.

Donna Jaegers - Janco Partners

Hi. Thanks for taking my questions. Two quick questions. On the business that you do with large customers like Qwest, Verizon, and AT&T, and not the WilTel part of the AT&T business, how much visibility do you have of them moving to their own network since they've just all added OC-768 backbones? And then the second question's on sales turnover in your enterprise space. I'm hearing that there's been a lot of turnover in the telco sales force so if you could just address that.

Kevin O’Hara

Donna, this is Kevin, I'll take them both on. I think we've got good visibility in terms of what some of those customers are doing in terms of their traffic, and based on what they've already done and what we believe they're going to be doing in the future, we've factored all of that into our outlooks. Their deployment of higher speed technology, we don't think in and of itself has any impact in terms of our outlook on the opportunity available with those folks. In terms of sales turnover, I wouldn't consider that one of the areas that I'm concerned with at this point in time.

We've had a fair amount of sales turnover in the short-term, primarily because we have been repositioning the sales force in terms of what we expect from a productivity standpoint, what we expect from a gross margin standpoint, what we expect from a sales discipline standpoint and I don't think that you'd see our sales up in absolute terms if sales turnover was a problem. In terms of the stability of the sales force, in terms of the results that they're delivering, I'm pretty pleased to date.

Donna Jaegers - Janco Partners

Okay, thanks.

Jim Crowe

Next question, please?

Operator

Our next question is from the line of Tom Watts with Cowen & Company. Please go ahead.

Tom Watts - Cowen & Company

Hi, good morning. I just had a couple questions focusing on the business markets group. You had mentioned that the OSS problems were primarily in the wholesale sector. Are those affecting the business markets group at all? And when you talked about the end game systems you were looking for, how close are we to the business market in that within the business market and what other things do we need to put in place in business markets to really get it up to the full revenue, new revenue generation capabilities that you're looking for?

Kevin O’Hara

The goal over time is that we have one network, metro and inner city, one set of capabilities, and one operating environment in terms of the operating support systems, the back office, the processes, etc. And that would include business markets group and wholesale markets. So all of the groups are wrestling through with the challenges, including the business markets group. The business markets group challenge is simply a little easier to wrestle with because it's a little bit smaller in absolute terms.

You can see their revenue results quarter over quarter, even wrestling through that. So we're actually pretty pleased with the business markets group, even though they face some of the same challenges that hasn't had the same affect. I think that the opportunity there, we're pretty pleased with the progress to date, 4% quarter-over-quarter is pretty good growth considering where we are in the process. And as we get our arms around the processes, the systems, etcetera, I think that we'll probably start to push the gas pedal a little bit more in terms of the size of the sales force in that area.

Right now we're being careful not to compound the problem, but we think that the results are good to date, performance is good to date, but we think that there's an opportunity available to us as we start to get more confident in our abilities to manage greater scale.

Jim Crowe

I want to add a comment. When we acquired the various companies that are now components of our business markets group, I think we announced at the time we had a blended annualized revenue increase of about 13, 14%. We said at the time we wanted for this year to get that kind of number up into the 17% range. At 4% a quarter, we're probably a little ahead of that.

We said at the same time that longer term, we didn't see any reason why we couldn't see annualized growth in the mid-20s, and I still -- that's a longer-term number, but I still believe given a base of roughly $1 billion of business market group revenue, a market that's in the $100 billion range and the kind of assets that we have that we can't -- that we should see revenue growth rates in the mid-20s. Now, that's not going to happen next quarter, but an increase from 14 to 18 is certainly -- or whatever 4% compounded is, is certainly a good starter and that's only in a couple of quarters.

Tom Watts - Cowen & Company

Great. And do we also have some backlog built up as related to the systems issues in the business markets group? And then secondly, do you see some product additions you need to make there to address the competition?

Kevin O’Hara

In terms of the backlog, our backlog in business markets has also grown, not quite in percentage terms in-line with wholesale markets, but the backlog there has clearly grown as a result of good sales performance as well as some of those extended installation intervals. In terms of product set, we've got -- in the near term, we're trying to focus on keeping the product set fairly simple and not going into a product set that has hundreds or thousands of products. We think that there's a series of very simple products if you can deliver them over your own fiber.

That is very compelling to customers. The early results would indicate that. Inevitably, we will be adding capability, either features to products or products as we go through time, but there's not no gaping gaps right now. In fact, we've been eliminating products to make sure that we can execute against a very targeted product set for the next probably year or so and we'll carefully add features or products as we go.

Jim Crowe

I guess it was last week I met with representatives of our indirect channels. These are a communications service providers that buy, in effect, business market services wholesale from Level 3 add value and add real value to various verticals, maybe law firms or billing capability and sell to their customers. And the uniform message that I got, and bears on your question, is that we could see quite a bit more sales out of that channel, we were in a position to turn the sales up in a more efficient way. So there's an awful lot of opportunity sitting, waiting for us and we're confident as we said earlier that we're going to be in a position to take advantage of it in the next couple of quarters.

Tom Watts - Cowen & Company

Great. Thanks very much.

Operator

Our next question is from the line of Jason Armstrong with Goldman Sachs. Please go ahead.

Jason Armstrong - Goldman Sachs

Great. Thanks. A question on capital spending. You've had some integration spending, but the bulk is still tied into success-based capital. And there's a bit of a disconnect here between higher levels of success-based spending but a lighter revenue growth trajectory than we had expected, at least near term. I guess a couple of questions related to that.

First, you talked about 50 to 75% install interval delays. What's the historical lag in time frame between success-based capital and ultimately realization of revenues and how much of that slipped here? And then second question, you used to talk much more about sort of best in class capital efficiency ratios. I think the comment previously was as low as $0.25 in capital spending translates into $1 of incremental recurring revenue. Has that changed at this point, is there a higher level of incremental capital intensity in this business? Thanks.

Sunit Patel

Jason, I'll take that. I think, one, obviously, there is a lag period between when you spend the capital and when you see the revenue turned up, usually, it's on the order of a quarter or so for some of the infrastructure projects that can be a little longer, similarly for new product ramps, the lag can be a little longer. In terms of capital efficiency, we've said and we think it's true that for us to drive a 17%-type revenue growth on core revenues and if that costs us 12 to 14% of revenues in CapEx, we think that is at or above or quite a bit above anyone else in the industry.

You can certainly look at everyone else's CapEx as a percent of revenue and see what kind of revenue growth and incremental margins they are driving with that. So based on the measure of incremental margin contribution and the amount of revenue growth, we think that the capital we are spending as a percent of revenue does make us one of the most efficient carries out there. And then to your question on $0.25, yes, we've always said also in the past it's about $0.25 to $0.50 of capital for every new dollar of annualized recurring revenue. That still holds. We just simplified it to make it as a percent of revenue. But that is implicit and that continues to be true about with what we've said in the past about the relationship between incremental capital and revenue.

Jim Crowe

Just a comment. The $0.25 to $0.50 plus maintenance capital is the 12 to 14% of annualized revenue at a 17% growth rate. Those are the same metrics. If you take $0.25 to $0.50 capital per incremental annual dollar plus add our normal maintenance capital, that's non-success based and if you grew our revenues at 17%, you'd come up with the metrics that Sunit now uses. As he said, we simply simplified it.

Sunit Patel

And keep in mind, on top of that this year, we have 75 to 100 million of integration CapEx.

Jason Armstrong - Goldman Sachs

Okay. Maybe just a follow-up. If you look at the guidance for this year, you're sort of already trending towards the high end of the capital spending guidance, so you basically can't really have a pickup there, but you're implying decent revenue pickup, especially in 4Q, to even get into the low end range of guidance, especially midpoint, you're talking 100 million or so in pickup, is that sort of conceivable that you could do that because there's such a lag between success-based and maybe you've spent a lot of the capital already and you can have a big revenue uptick like that without incremental capital from here?

Jim Crowe

Let me put a caution in here. The kind of numbers we're talking about are trend line over quarters, not a quarter. The reason I want to emphasize that is if you were to parse the actual capital spending over weeks and months in a quarter, you wouldn't find a lock step $0.25 of capital for each new dollar of revenue. That fluctuates quite a bit. When we do a complete network upgrade, for instance, last year we completed a shift from discrete optronics to photonic integrated circuitry.

We've completed a change to our IP network, emphasizing ethernet. All of those occur around the $0.25 to $0.50. And I think at one of our conferences we talked about how in any given point there's a whole series of differing curves, network upgrades, maintenance, success-based capital and it's over the longer term that you see the more logical relationship. Trying to do it in any one quarter, I think, would be false precision.

Jason Armstrong - Goldman Sachs

Okay, great. Thanks, Jim.

Operator

Our next question is from the line of Qaisar Hasan with Buckingham Research. Please go ahead.

Qaisar Hasan - Buckingham Research

Hi. Thanks. I just had a couple of housekeeping questions. One, Sunit, maybe you could tell us how much in gross margins is remaining on the SBC Rotel contract?

Sunit Patel

Yes. It's pretty limited, I think, maybe on the order of lows 10s of millions, 10 million or so. I think that given what we are looking at the rest of the year, we should be at or above that. There's not much left there.

Qaisar Hasan - Buckingham Research

Okay. And then the other question, I just wanted to follow up on an earlier question that was asked about the European business, and I think you indicated that revenue over there has gone from 60 million to 88 million --

Sunit Patel

I corrected, I think I said it was 59.6 million.

Qaisar Hasan - Buckingham Research

Okay, right. So 59.6 has gone to 88 --

Sunit Patel

We didn't say it was going to 88. We said it was 59.6 million.

Jim Crowe

That's what it went to.

Qaisar Hasan - Buckingham Research

Oh, that's what it went to.

Sunit Patel

Yes, in the second quarter. So I apologize for that.

Qaisar Hasan - Buckingham Research

And what was the number for the first quarter, just so we have an apples to apples?

Sunit Patel

It was about $54.4 million.

Qaisar Hasan - Buckingham Research

Okay. And then the other question I had was just on the IP side. Obviously, that's something that we would have hoped would be a bigger driver of growth for your top lines, as it turned down in the second quarter. I was hoping to get a little bit more granularity in terms of traffic growth and pricing trends over there outside of this one client where you had to adjust prices.

I think, Jim, you had mentioned last quarter that you were seeing IP traffic growth of 100% annualized. Is that still the case? We also saw a strong need to back into IP revenue growth. If you take the 25% or so pricing compression, the 100% traffic growth, you should be posting with all things being equal about 13% sequential revenue growth over here. Can you help us walk through maybe where there might be some leakage?

Jim Crowe

Yes, I checked these numbers in anticipation of the question. For the first half, our growth was in the 100% range. It's volatile quarter to quarter, and as we said earlier, in terms of revenue, we had a rerate from our largest IP customer. Unit growth continues to be strong, but that's a one-time reduction in anticipation of growth in the future.

The kind of math you indicated is correct, but trying to apply it in any one month or quarter could be perilous because it's -- you get too many moving parts with rerates, increases, etc. But longer term, over any kind of trend line, yes, I think we feel very good about it. I would also point out that high-speed IP is what less than 10% of our total revenue now?

Kevin O’Hara

8%.

Jim Crowe

8% of our total revenue. While it is a fundamental foundational service and certainly an important service for all our other services, it's not the contributor it might have been a year ago and a half ago.

Sunit Patel

A couple other points to keep in mind. Historically, the fourth and the first quarter are usually seasonally strong as schools get out, so second and third quarter are seasonally weaker quarters, so keep that in mind.

We also think that from a rerate perspective, we are mostly usually done with most of our rerates in the first half of the year versus the second half of the year, so there's less rerate risk and also keep in mind that the average duration of our IP contracts from a couple of years ago have gone from 12 months to 18 months so that also is a positive thing on a going-forward basis. As far as traffic growth, we continue to see fairly healthy traffic growth apart from the seasonality facts I mentioned.

Qaisar Hasan - Buckingham Research

But I would have thought all these affects in terms of the contract lengths extending out et cetera and volume discount would get factored into your mid-20s pricing compression that you've talked about. Or are those pressures over and above this price compression level?

Sunit Patel

No, I think that's an average over the course of a year sort of to extrapolate from any one given quarter would not be a fair comparison. You've got to look at it on a year-over-year basis, and that's what we said. In annual terms, 20 to 30% is a good range and we continue to feel good about it.

Qaisar Hasan - Buckingham Research

And if I can sneak one more quick question. In the past you've also talked about hoping to get about 60% incremental margins on all new revenue growth. I know there are a lot of moving pieces in this quarter with synergies, integration expenses, and etc. But I was wondering if you can give us a sense whether once you adjust for all these moving pieces, whether in this quarter you sort of got to somewhere along the range of that 60% incremental margin on the new revenues that you did bring on?

Jim Crowe

No. I think what we've said is that we expect $0.15 of incremental operating expense that's been prior to acquisitions, our experience, and it's our goal in the future and we think it's a reasonable, completely achievable goal. What we've also said is that gross margins depend on mix, but we think 70 to 80% gross margins are certainly achievable in the longer term. So if you had 75% gross margins, than your number would be accurate. And we still feel those are completely achievable.

Qaisar Hasan - Buckingham Research

Okay, thank you.

Operator

Our next question is from the line of John Hodulik with UBS. Please go ahead.

John Hodulik - UBS

Okay, thanks. A couple quick questions. First, back to the provisioning intervals, at this point have the provisioning intervals stabilized or are they continuing to get longer, or are they starting to come down? And again, you might have mentioned this earlier, but has that begun to had any affect on your sales funnel, even as late as July? And then lastly, on the voice revenues, there's a little bit lower than we'd expected.

It seems like you've seen some migration out of this more established larger traditional voice providers. Meanwhile, the non-traditional providers, we had Sun rocket last week, Vonage is obviously having some problems. It looks like we're seeing sliding in companies like Skype. Can you comment on the quality of the existing base and is that of any concern to you as we look for growth in that segment over the next year or two?

Kevin O’Hara

John, in terms of the interval, the intervals have stabilized and there's some kind of -- we've made enough changes that it's stable and I think that there's some early indications that the steps have been appropriate. We haven't seen a meaningful improvement at this point in time, but they're not getting worse. In terms of have they had any affect, for instance, looking at the July figures, the first quarter was a very strong sales quarter that strength in sales grew throughout the second quarter and we haven't seen any abatement in that.

We continue to see very, very strong demand, including with existing customers, including with customers that are working with us as those intervals have extended. To date, it has not had an impact. We don't want to rely on that for very long so we're working pretty hard to try and get those back in and make sure that it does not have an impact.

Jim Crowe

With respect to the last question, quality of voice revenue. We have a very broad portfolio of customers. For instance, I think your comments are accurate about various segments, but cable, for instance, is the fastest-growing segment for us. We have a strong emphasis on wireless, 800 service, which is sold to a wide variety of customers is a real emphasis for us. So I think we're diversified enough so that the quality of our backlog is not an issue for us.

Voice in and of itself is always a bit volatile. That's why what I mentioned earlier, it's a usage-based business, predicting with any certainty in a quarter is always a bit challenging, but over the long-term, we think we have a compelling product, with fundamental advantages having to do with the nature of our architecture, particularly the local interconnections that we've built up over the last six or seven years. That's just an advantage that we think distinguishes us from virtually any other provider. Okay. We have time for one more, I think.

Operator

Certainly. Our final question today will from the line of Greg Mesniaeff with Needham and Company. Please go ahead.

Greg Mesniaeff - Needham and Company

Thanks. Just made it. A quick question for Kevin. Regarding the OSS integration challenges that you referred to, are any of them in any way tied to any recent changes in pricing and in volume dynamics? Or put differently, what explains the lag between when you've made some of these acquisitions and now that these issues have come to the floor?

Kevin O’Hara

Yes, there's one word that describes it, it's called Broadwing. All of the previous WilTel and Level 3 were in a very serious business and they had superior capabilities to us for voice, so we effectively opted into their capabilities there. We opted into the Level 3 capabilities from other areas. So the integration there, even in the interim, was pretty state forward.

We didn't put much stress on it. For the metro companies, they were at various stages of maturity from a systems and process standpoint, but none of them had sufficient scale to really kind of create a lot of stress. Broadwing had sufficient scale, was sufficiently different, and we're introducing sufficient number of changes, particularly trying to get the legacy Broadwing selling to on-net services, taking the Broadwing customers and integrating them into Level 3 systems.

It was just the scale of Broadwing relative to where we were in the overall implementation of our end state architecture. We are too far along to opt into their systems and our systems weren't far enough along to make that transition smooth, which is what's caused us to operate in this hybrid environment.

By the way, that was always the plan and the integration from an organizational standpoint, a functional standpoint, Sunit mentioned that our costs are running ahead or cost savings, the synergies are running ahead of plan. So all of that is running in-line with expectations. The challenge is that it has created for our people as we've had to teach them elements of all of the different systems, that complexity is what's creating the extensions in the short-term. But it was plain and simple Broadwing. You can measure, as we started to really push that functionality over when some of these challenges started to rear their heads.

Greg Mesniaeff - Needham and Company

Thank you, that's very helpful.

Jim Crowe

Boring in a little bit too, I'd say the very thing that we have been focused on accomplishing, that is the ability to offer end to end services, not simply from a pop to pop, from one city to another, but from our customers location to customers location on that including metro, that is a very powerful thing. But think about what that requires in terms of provisioning.

When you had Broadwing in and we move traffic over to network components that may have resided in two, three, four different previous companies, today we're doing more of that manually and by brute force than we would like. I'll reemphasize, we have a plan in place, we think we have experienced people who've done this before, we have confidence in that plan, that confidence is reflected in our guidance. With that I'll thank you for your attention, and operator, that's the end of the call.

Operator

Thank you. Ladies and gentlemen, today's conference will be available for replay beginning at 5:00 p.m. Eastern time today and running through August 9th at midnight. You may access the playback by dialing 320-365-3844 and entering the access code 877643. That dial-in number for the replay again is 320-365-3844 with the access code 877643. That does conclude our conference for today. Thank you for your participation. You may now disconnect.

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