SureWest Communications Q3 2007 Earnings Call Transcript

SureWest Communications (SURW)

Q3 2007 Earnings Call

November 7, 2007 12:00 pm ET

Executives

Reid Cox - Director of IR

Steve Oldham - President and CEO

Fred Arcuri - SVP and COO

Phil Grybas - SVP and CFO

Analysts

Christopher King - Stifel Nicolaus

Tim Wang - Lakeview Investment Group

John Luciano - Private Management Group

Presentation

Operator

Good day, ladies and gentlemen, and welcome to the Third Quarter 2007 SureWest Communications Earnings Conference Call. My name is Kam, and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will be facilitating a question-and-answer session towards the end of this conference. (Operator Instructions).

Now I'd like to turn your presentation over to your host for today, Mr. Reid Cox, Director of Investor Relations. Please proceed, sir.

Reid Cox

Great, thank you. Good morning and welcome to SureWest's third quarter 2007 earnings conference call and webcast. SureWest reported financial results for the quarter this morning, which are available under the Investor Relations section of our website. The 10-Q will be filed later today. With us on today's call are Steve Oldham, President and CEO; Phil Grybas, CFO; and Fred Arcuri, our COO.

Before we begin, I'd like to remind you that some of the statements, comments, and discussions which occur during this call are forward-looking in nature and relate to future events and/or performance. These statements should not be relied on as historical or absolute facts as future performance and future events are subject to numerous risks and uncertainties that frequently cause actual results and actual events to deviate substantially from what may be anticipated today.

There are many such risks and uncertainties which could affect the economy, our industry, and our company in particular, some or all of which could affect future results. Before making any investment decisions about our company, we encourage you to review the company's most recent filings with the Securities and Exchange Commission, which contain a description of many of these risks and uncertainties under the heading Risk Factors. These reports are easily available by accessing the company's website.

With that said, I'd like to now turn the call over to SureWest's CEO, Steve Oldham.

Steve Oldham

Thanks, Reid. Good morning. [Technical Difficulty] we've seen this type of deregulation in other industries and the lessons are clear. Those companies that adapt to new environment can find tremendous growth and success in the changing landscape. Those companies that resist change and do not or cannot compete find they are unable to build their value and must explore alternatives to grow. Currently, we believe we are in a position to take advantage of, and in fact lead the changes in our industry, creating growth opportunities for SureWest.

One of our competitive advantages is our ability to offer a truly superior service and customer experience. Our fiber-to-the-premise network is the only network in our markets providing a triple-play with symmetrical data speeds of up to 50 megabits and switched high-definition IPTV along with full voice services.

Our goal is to be the bandwidth leader in every market we serve, which we believe will drive greater penetration of the homes we pass, increased RGUs from our customers and create operating efficiencies.

We are continuing our success on the measures in the third quarter of 2007. Compared to the same quarter a year ago, penetration stands at 30% and is progressing towards our goal of 35% or greater penetration in all of our markets. Broadband RGUs grew 13% over the year, which we believe supports our position that demand for hyper-speed IP services is growing. ARPU increased to $1.12 to $77.24, which indicates that customers are taking additional services from SureWest in the face of significant competition.

I'd like to take just a few minutes to recap the steps we have taken to position SureWest to thrive in this new environment and achieve the long-term success as a preferred provider of network services wherever we serve.

Several years ago, in response to an increasingly competitive environment, SureWest recognized the need to diversify our revenue stream away from a total reliance of traditional voice services. The company pushed fiber deep into our ILEC to fully enable our ability to provide DSL service to our voice customers.

After we acquired the assets of WINFirst, we chose to design and deploy an advanced fiber network capable of providing voice, video and data that will remain clearly superior to our competition over the long haul. Over the last few years, our employees have delivered on this strategy.

In 2002, after acquiring the assets of WINFirst, we began our entry into video and launched one of the first triple-play offerings in the country, when we began our IPTV service across the fiber network. Late in 2005, we became the first provider in the US to offer HD IPTV, leveraging the incredible bandwidth of our fiber network to provide what most viewers believe is a vastly superior experience.

As a result of our decision and action, SureWest has been operating the highest bandwidth network in the country. We've been selling and supporting triple-play services across our network and have effectively solved many of the problems that newer entrants into this technology are just beginning to struggle with.

For example, our employees have developed the steps necessary to wire a home as quickly and cleanly as possible in order for our customers to fully experience the benefits of our truly high bandwidth network. We have processes in place to quickly provision the customer, so that the revenues from the new service can begin as soon as possible. And we're helping to develop new IP-based products such as the high-definition digital video recorders.

In parallel with these network achievements, we've also made great strides in increasing the company's focus and efficiencies. For most of our 94-year history we operated in a price regulated environment, which provided a number of protections subsidies and cost recovering mechanisms. These protections and subsidies serve the purpose of ensuring the universal service to our customers at affordable prices.

Over the last couple of years, the historical cost of service method of setting practice has been replaced by a system in which prices were determined by the very competitive marketplace. We support the deregulation of our industry and have undertaking numerous steps that focus and streamline our operations in response to it.

Over the past year, we've made a number of changes designed to provide lower cost of doing business and incentives for our employees to excel at their jobs. These changes relating to our employees compensation structure include freezing our defined benefit plan and encouraging our employees to participate in the 401(k) program for their retirement needs, as well as a complete review of our sales and compensation structures, including the mix of benefits, cash payments and cash payments to our employees.

Early results indicate we have increased employee satisfaction, lower turnover and improved performance. We believe these changes will enable us to continue to attract and retain talented employees who help us grow the company.

As you know, earlier this year we completed the divesture of our directories business for $110 million. We continue to evaluate all of our businesses to ensure they are supporting our strategy and are on our path to contributing cash flow to the company.

We have launched five outsourcing projects in an effort to both reduce costs and provide the flexibility to scale the business. We estimate that these initiatives will save the company about $1 million a year annually without sacrificing customer service, while allowing us to concentrate management efforts on growing our network business.

From the liquidity perspective, we have $100 million credit facility with CoBank at attractive rates. We have drawn $40 million on this facility with $60 million remaining available. We also carry about $63 million in cash and short-term investments from the after-tax proceeds of the sale of the directories business and we have other non-core assets that could be monetized.

Late last year the state enacted a state video franchise law which provides for a streamline process to obtain a franchise necessary to expand our video offering outside of our existing franchise areas. Also, the company has successfully resolved the issue of the ongoing access to approximately $10.3 million in California High Cost Fund payments based on our drawdown over five years.

All of these efforts have been undertaken in order for the company to excel on a highly competitive environment and to diversify away from a total reliance on voice by designing and deploying an advanced fiber network capable of bundled voice, video and data services, and to build a network capable of delivering more products and services across it than any competitor in our markets.

I'll turn the call over now to our Chief Operating Officer, Fred Arcuri to discuss the operational accomplishments in the third quarter. Fred?

Fred Arcuri

Thanks, Steve. First, I'd like to discuss what effects competition is having on our core full services telephone voice business. In the past few years, all ILECs have seen a loss of access lines. Early on, this was due to wireless substitution primarily for second access lines. Then, as customer's desire for higher bandwidth access to the Internet has grown, those customers converted their secondary access lines used for Internet dial-up to DSL lines.

The pressure on secondary access lines converting to wireless and DSL continues today albeit at a slower pace than in the past. Now, however, there is additional pressure on total access lines we serve in the ILEC. At SureWest we are seeing some loss of primary access lines to wireless substitution. This occurs primarily in MDUs where many of the occupants have never had a primary land-based access line, but have relied solely on wireless for telephone service.

Now beginning in the second quarter of this year, we began to lose both primary and secondary access lines to competition. We observed the ramp-up of access line loss peaking in July and August of this year and tapering off in September and October. The historical reasons for access line losses coupled with recent competition have accelerated our line losses to levels in excess of our recent history.

As Steve mentioned, SureWest has long anticipated the loss of access line revenues to various forms of competition and in changes to how we price our products and services. Years ago, the company began the design and deployment of our ultrahigh bandwidth network in order to capture voice, video and data customers from our competitors. That strategy is proving to be successful with growth in total broadband revenues of 15% year-over-year and 16% year-to-date over last year's year-to-date.

We've also reduced staffing to historical low levels of less than 800 fulltime employees at the end of October and less than 20 temporary employees at the end of October. As Steve mentioned, we have greatly improved the ways we compensate our employees in order to reduce costs and improve productivity.

In addition to changing how we operate our system and manage our employees, we are continuing to build out the advance fiber network to reach more potential customers and to upgrade the copper-to-fiber in the ILEC in order for us to more effectively go after video customers and defend against losses to our competitors.

The company intends to spend between $60 million and $80 million in 2008 on our basic capital needs, fiber network build and upgrades to ILEC plan. This year we project spending approximately $53 million in capital dollar to meet our basic capital needs, expand the fiber network and continue the fiber upgrades in the ILEC.

As Steve will elaborate on at the end of the call, we believe we have two to three years remaining on our current CLEC plans to install our all fiber network in identified neighborhoods in Sacramento Metro and to upgrade the ILEC from copper-to-fiber in targeted areas.

This is based on our estimate of marketable homes close to our CLEC network or in our ILEC that meet the demographic requirements of our marketing and sales plan. We can accelerate or decelerate this plan if needed, but it is our current plan based on real estate development, available demographics and maximizing the resources available to us. Of course, we will continue to look for opportunities to deliver our superior network to ideal demographics when available.

Customer penetration on existing homes passed is an important measure for us. We are working to increase overall penetration at the same time, as we increased the number of new homes passed. In the past year, our total marketable homes penetration increased to 30% from 27%, which can be taken as evidence that we are selecting the right markets to build into and/or offering compelling service to capture an increasing share of customers.

Total broadband subscribers, defined as the total number of homes that take either our DSL or fiber services, increased 14% over the past year with an 11% growth in DSL subscribers and 20% growth in fiber subscribers. We are pleased with both of these numbers.

The 11% growth in DSL indicates that we are continuing to drive growth in our ILEC territory despite competition from cable. It is also a demonstration of the desire for customers to increase the speed with which they access the Internet. The demonstrated growth in customer demand for a higher Internet access speed is a trend we think will continue. The 20% growth in fiber subscribers shows that bandwidth in our network differentiates us from our competitors.

Broadband growth stands out from an RGU, or revenue generating unit, perspective as well. Over the last year, total RGUs grew by 13% with data RGUs increasing 15%, voice RGUs 12% and video RGUs by 8%. Of note in those numbers is the fact that we were able to achieve 8% video RGU growth despite the fact that an IP-based HD DVR is not available, which has clearly hampered our sales.

We believe there are two services critical to competing for video customers. The first is the ability to provide high-definition programming. Televisions that support HD are becoming mainstream, and the picture quality is so superior that it becomes undesirable to watch non-HD programming. We recently announced expanding our HD channel lineup from 26 channels to nearly 40 channels by the end of this month and now anticipate being able to increase this total even higher by the end of the year.

We believe this is a very important differentiator for SureWest. HD channels take up five to six times as much bandwidth as a regular channel. The virtually unlimited bandwidth capabilities of our fiber network combined with our switched video technology enable us to offer many more HD channels than our competitor networks are able to support.

The second device is an HD DVR. Once a customer has enjoyed the ability to record programming to watch at their convenience, they are reluctant to do without. To-date, an IP HD DVR has not existed for us to provide our customers. Utilizing a test group, we currently have deployed DVRs from two different manufacturers that we anticipate having available to our customers and our sales forces for this holiday season.

We believe our video RGU growth of 8% over the past year is particularly impressive in light of not having this critical functionality, and should have strong upside when we are able to offer this critical service to our video offering.

In the wireless segment, we experienced a 3% decline in subscribers and 5% decline in revenue compared to the third quarter a year ago. The wireless segment remains a challenge for us as industry customer penetration rates have begun to plateau, which means fewer new customers and increasing competition for existing customers.

We are taking steps to stabilize our customer base. We've been investing in our dealer channel and new marketing promotions to add new contract subscribers and have been reducing costs through efforts like outsourcing our wireless call center.

In closing, we continue to focus our resources on expanding our leading-edge broadband network and services. We believe we have the best broadband network in the country today and are working to push that advantage by increasing the number of customers that can access that network and increasing the revenue generating services that we can provide across that network.

I'll now turn the call over to our CFO, Phil Grybas, to discuss the financial results of the quarter.

Phil Grybas

Thank you, Fred. As we've mentioned on previous calls, our goals are to grow revenues by selectively growing the network into areas with the greatest potential for selling multiple revenue generating units, or RGUs; achieve penetration in the areas we serve, which will increase revenues across the existing network assets; increase the average revenue per user, or ARPU, across the customer base; pursue cost efficiencies, while enhancing our customers experience.

Our results in the quarter show we're making steady progress toward these goals. For example, broadband revenues grew 15% compared to the same quarter last year. Marketable home penetration increased to 30% from 27%. ARPU has grown $1.12 as compared to last year. Decreases in insurance, operating and tax expenses and labor costs among others has allowed us to effectively manage expense growth.

We report revenue in three segments. The broadband segment consists primarily of digital voice, digital video and high-speed data services provided across an advanced fiber platform, and DSL within the ILEC copper network. Telecom segment primarily includes residential, small, medium sized enterprises and network access services to commercial enterprises and other telecommunication carriers. The wireless segment includes digital wireless, voice services, sale of handsets and related accessories.

Broadband revenues grew 15% in the third quarter of 2007 compared to the same quarter a year earlier as a result of a 13% increase in data, voice and video RGUs combined with an increase in average revenue per customer of $1.12 to $77.24 per customer.

As Fred mentioned, we will be launching our HD DVR in the fourth quarter and are confident that this addition to our product line will add fuel to what already is a strong growth trajectory in broadband RGUs. We are very focused on the broadband segment as a primary growth engine of the company.

With that goal in mind, we are very pleased to report a second consecutive quarter of positive broadband EBITDA and $76,000 in positive EBITDA year-to-date. This achievement marks a net $3.7 million EBITDA improvement over the same nine-month period last year.

In our telecom segment, although voice access lines declined 7% compared to the same period last year, this decline was offset by a 12% increase in broadband voice RGUs. Overall access lines declined almost 5%. Long distance penetration increased from 45% to 49% last year to this year.

As Fred mentioned, there are two primary drivers for the telecom segments access line decline. The first is an industry-wide reduction in secondary access lines to replacement technologies, namely wireless and DSL substitution. Second, is the introduction of competition for voice customers in our ILEC territory.

We are aggressively responding to these trends by upgrading our copper infrastructure in ILECs to fiber where it is cost effective in order to go after triple-play revenues and specifically to capture new video revenues. While we may not be able to stop the overall industry trend of declining access lines, we are working to replace those revenues with data and video services.

During the period telecom segment revenues declined 10% as compared to last year due mainly to a combination of a decrease in net revenue, the decline in access lines and the decline in the California High Cost Fund revenues.

Wireless revenues declined 5% in the third quarter of 2007 as compared to the third quarter of 2006 with a $0.20 in ARPU only partially offsetting a 3% reduction in subscribers. As Fred mentioned earlier, we are exploring a number of ways to grow subscribers and increase margins in this business.

As a result, consolidated revenues decreased 2% compared to the third quarter of 2006 with strong broadband revenue growth substantially offsetting the anticipated declines in telecom and wireless revenues. We believe we are successfully diversifying our revenues across the wider variety of services, thereby reducing revenue concentration risk, and consequently, creating new growth opportunities.

Operating expenses, excluding depreciation and amortization increased by 4% in the third quarter of 2007 from the same quarter a year earlier primarily due to the incremental cost associated with growing our broadband customer base and network, as well as additional brand advertising to stimulate further revenue growth.

We realized the benefits of some of our cost efficiency programs in the third quarter, including the benefits of freezing our defined benefits pension plan, which is expected to save the company up to $5 million annually, as well as the outsourcing of non-core functions, which we discussed at some length on our last call.

As a result of the 2% year-over-year revenue decrease and 4% increase in expenses, EBITDA declined by 12% to $16.2 million in the third quarter of 2007. It is worth reiterating that over that same period broadband EBITDA has turned positive, which we believe is a significant achievement.

Depreciation decreased by 7% in the third quarter of 2007 from the second quarter of 2006. This reduction resulted primarily from the extension of the useful lives of some of our broadband assets, which was partially offset by an increase associated with new network investment to increase the size of our footprint and homes passed.

Income from continuing operations net of taxes was $736,000 in the third quarter of 2007, a decrease from $812,000 in the third quarter of 2006. From a dollar perspective, income from continuing operations is essentially flat as the company replaces declining telecom profits with increasing broadband performance.

Net income for the third quarter of 2007 of $736,000 decreased from $2.2 million a year earlier, due primarily to the impact of discontinued operations of $1.3 million from the directory operations.

Capital expenditures totaled $12 million in the third quarter, a 6% decrease from a year ago and consistent with the second quarter of this year. Our annual CapEx is projected to be $53 million, which is roughly in line with 2006.

I will conclude with the summary of key success indicators, which are the metrics we utilize to measure our success in growing the business, controlling expenses and increasing shareholder value. These metrics include EBITDA margin, customers per employee and revenue per employee. I will be comparing these metrics to our previous second quarter 2007.

Including the impact of net adjustments in both periods, EBITDA margin was 32%. We closed the third quarter with 810 employees, down from 825 employees the previous quarter as a result of our cost reduction efforts, including the initial efforts to outsource some of our non-core functions. Revenue per employee increased to approximately $63,800 per employee from approximately $63,600 in the second quarter.

In summary, we are encouraged by the financial results and operating metrics for the third quarter as they reflect our progress toward replacing declining profitability in the telecom segment with increases in broadband performance resulting from triple-play services as well as business services.

I'll now hand the call back to Steve.

Steve Oldham

Thanks, Phil. I wanted to wrap-up by elaborating on some of the topics raised by Fred and by Phil. First in the topic of capital expenditures, as we have previously mentioned, we believe we have a two to three-year remaining build out on our current schedule with capital expenditures in the $60 million to $70 million per year range.

This will complete our immediate edge out opportunities and overbuild targeted ILEC areas, adding over 40,000 new homes passed in addition to approximately 190,000 homes passed today. Renewed strength in the construction industry is likely to expand the pool of homes that we can economically connect to our network.

This two to three-year plan will fill in our targeted markets in and around Sacramento, where we believe we can achieve greater than 35% penetration and triple-play ARPU in excess of $100 per customers, which will increase overtime. It is important to note that we can modify this plan reducing the capital spend and increasing free cash flow, if necessary, or accelerate the spend to build out and expand for footprint sooner.

In addition to regional growth opportunities, we have been actively assessing acquisition opportunities. We would be a strategic buyer of assets which we believe would leverage our experience in building networks that provide triple-play services, improving the revenue potential of the purchased assets, along with achieving economies of scale on our existing business infrastructure.

While there may be some advantages to acquiring and integrating assets that are close to Sacramento, our primary interest is in the financial potential of an asset and the incremental improvements we would bring to bear. We believe our business model can be replicated elsewhere and it doesn't require that the networks be physically integrated.

With the recent activity in the capital markets, we believe that the acquisition valuation may come down to be more in line with what we believe to be rational levels. Our current underlevered cap structure provides us with the opportunity to take advantage of asset purchases that may become available.

In summary, our current growth plan for the Sacramento area is likely to be completed in two to three years spending at $60 million to $70 million per year. Spending could be higher. We have significantly greater level of acceptances and corresponding success base capital expenditures. We continue to assess acquisition opportunities where we believe we are able to create significant incremental value to accelerate our growth and take advantage of our balance sheet to increase shareholder value.

We are expanding our product line, launching our HD DVR, which alleviates a significant hole in our offering, expanding the number of HD channels, which our network can uniquely support, and benefiting from the adoption of bandwidth-intensive services that increase the appeal of our network.

With that said, we'd be happy to answer any questions you may have. Operator, any questions?

Question-and-Answer session

Operator

(Operator Instructions). And the first question comes from the line of Christopher King from Stifel Nicolaus. Please proceed.

Christopher King - Stifel Nicolaus

Hi, guys. Two quick questions for you. One, I was wondering whether you could give us a little bit of information regarding your price points for the HD DVR as well as for your general high-definition package right now that you're offering in the marketplace.

And secondly, just had a bit of a house keeping question on your income tax rate that's been bouncing around over the last several quarters. I was wondering, specifically, I guess, historically, what was going on with your corporate tax rate and how we should look at that going forward? Thanks.

Fred Arcuri

Chris, this is Fred Arcuri. On the price point issue, when it comes to our HD, as we increase our HD channel lineup, we will look at how much price flexibility we have combined with the rest of our video offering, including DVR, having to stay relatively competitive even though we increased the number of channels we've.

Right now, we're running at about $11 a month on our HD channel lineup, and we haven't picked a price point yet for our DVR. But going out the gate, it will be highly promoted. We're going to want to put customers on as fast as we can, and then we'll look at pricing flexibility.

Steve Oldham

This is Steve. Needless to say, we know we have to be competitive with the existing offers out here. But we think, we'll have a superior offer with the IP DVR.

Chris, on the tax issue, from time to time, as you know, we've had tax reserves that are put into place until various reviews have taken place. And once the various tax years are closed, those reserves come back into this income stream. And so, it does have an impact on our effective tax rate, and we're seeing a little bit of that in the recent past.

Christopher King - Stifel Nicolaus

Thank you.

Operator

(Operator Instructions). The next question comes from the line of [Tim Wong] from Lakeview Investment Group. Please proceed.

Tim Wang - Lakeview Investment Group

I just had a question about continued weakness on the wireless side. You guys mentioned that you had some non-core assets you were considering divesting, will the wireless segment be something that you would consider divesting going forward?

Steve Oldham

This is Steve Oldham. There is little question that we are looking at all of our assets very aggressively, and we're working hard to come up with a wireless asset resolution in the near future.

Tim Wang - Lakeview Investment Group

Okay. All right. Thank you.

Operator

(Operator Instructions).

Steve Oldham

If there are no more questions, I want to thank you all very much for participating in the call.

Operator

And the next question comes from the line of Tom Luken from Private Management Group. Please proceed.

John Luciano - Private Management Group

Yes. It's [John Luciano], Private Management Group. Can you give me a quick sense in that area what kind of consumer CapEx will be expected for the HD rollout, whether it would be more competitive with satellite or in our cable as far as what the consumer might have to spend? Thank you.

Steve Oldham

We see some prices in $10 to $11 a month range for DVRs, for example. There is little question though that there is an art to how you package your HD video package. For example, you could up the price on the total HD option and throw a DVR into it, or you could have a standalone DVR option available to the customer. We haven't worked that exact detail out. We know this. We have to be competitive with the people we're going head-to-head for those video customers. But it clearly is a value adder to our total video package, and we see increased ARPU and RGUs as a result.

John Luciano - Private Management Group

Okay. Thank you.

Operator

And there is no more further question.

Reid Cox

Okay. Again, we'd like to thank you for your attendance on our third quarter earnings call and your continued interest in SureWest. Thank you.

Operator

This concludes your presentation for today. Ladies and gentlemen, you may now disconnect. Have a wonderful week.

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