Time Warner Telecom Q3 2007 Earnings Call Transcript

Nov. 8.07 | About: tw telecom (TWTC)

Time Warner Telecom (NASDAQ:TWTC)

Q3 2007 Earnings Call

November 8, 200711:00 am ET

Executives

Carole Curtain - IR

Larissa Herda - Chairman, CEO, President

Mark Peters - CFO

Analysts

Vance Edelson - Morgan Stanley

Tom Sykes - Deutsche Bank

Tim Horan - CIBC World Markets

Donna Jaegers - Janco Partners

Frank Louthan - Raymond James

Mike McCormack - Bear Stearns

Rai Archibold - Kaufman Brothers

Tom Watts - Cowen & Co

Operator

Good morning, and welcome to Time Warner Telecom's thirdquarter 2007 conference call. Today's call is being recorded. With us from thecompany is Chairman, Chief Executive Officer, and President Larissa Herda; andSenior Vice President and Chief Financial Officer Mark Peters.

At this time, I will turn the call over to Carole Curtain,Senior Director of Investor Relations. Please go ahead.

Carole Curtain

Welcome to Time Warner Telecom's conference call. Let mestart by directing you to our website at TWTelecom.com where you can find ourpress release and supplemental quarterly information.

Before we begin, I'll read our Safe Harbor statement. Issues discussedon today's conference call include certain forward-looking statements withinthe meaning of the Private Securities Litigation Reform Act of 1995. Thesestatements are based on management's current expectations and are naturallysubject to uncertainty and changes in circumstances. Actual results may varymaterially from the expectations contained herein due to the risks disclosed inthe company's annual and quarterly filings with the SEC, especially the sectionentitled risk factors, in our annual report on Form 10-K for the fiscal yearended December 31, 2006,and our supplemental materials posted on our website.

Time Warner Telecom, Inc. is under no obligation andexpressly disclaims any obligation to update or alter its forward-lookingstatements, whether as a result of new information, future events, orotherwise.

In conjunction with SEC Regulation G, I want to point out wereport several financial measures that are non-GAAP, including modified EBITDA.Our non-GAAP measures are not intended to replace our GAAP disclosure, ratherthey merely are presented to provide additional insight into our performance.Please see our press release and information posted on our website for moredetails on these and other matters.

Now I'm pleased to introduce Time Warner Telecom's Chairman,CEO and President Larissa Herda.

Larissa Herda

Thanks, Carole. Hi,everyone and thank you for joining us today. Time Warner Telecom's story hasbeen one of consistent growth and this quarter's no different. It was anothergreat quarter. Our performance is based on strategic choices we have made overmany years with long-term growth and profitability in mind which has culminatedin more than five years of consecutive quarterly enterprise revenue growth. Wecontinue to grow enterprise revenue on a larger and larger base, with thissegment now representing 70% of our total revenue.

Also for three years, we have achieved total revenue growtheach and every quarter and we have sustained our organic growth trends whilesuccessfully integrating a significant acquisition. Last year, we made astrategic choice to expand our footprint with the acquisition of Xspedius. Weare well on our way to achieving our goals for that acquisition, and ourprogress is impressive.

Clearly, integration is a complex, extensive task,especially in our business, and a challenge for any company. To add to thechallenge and complexity, we used the integration of the two companies as acatalyst to further improve our operating platform for even greater scalabilityand to optimize our entire business.

Just to remind you, that means as of August we achieved thefollowing milestones, including: a unified organization for our sales, customercare, field operations, marketing and headquarter functions. Additionally, wehave a common data and systems infrastructure serving all customers nationwide;and, we have fully integrated our networks.

Just to lend some perspective to those milestones, that's aphenomenal set of accomplishments in a relatively short period of time and wehave continued to deliver strong performance throughout this effort.

We have probably made the integration look easy given oursuccess, but I don't want to kid you; this was not without some degree of painfor our team. I couldn't be more proud of our people and their accomplishments.I'm pleased to say that our integration is substantially complete and oursynergies are on target.

That said, there is still a lot of work ahead of us as wecontinue to optimize and streamline our operations, including further pursuingour network synergies. Given our integration success, we have been able toaccelerate various activities. Completing our systems and product integrationahead of schedule as well as successfully integrating our 12 overlap marketsallowed us to accelerate the rollout of our full product suite to ten acquiredmarkets, which we did this summer. And now, with the progress in the first ten marketsunderway, we're planning to roll out another four markets in the fourthquarter, which is also ahead of schedule. Over time, we will continue to investin the balance of the acquired markets on a success-based basis, which hasalways been our model.

As planned, our modified EBITDA margin was diluted by thisacquisition. Through our strong execution, we have seen our margins continue toimprove as we move through our integration. Remember, at the same time we aregaining synergies we are also investing in the business for the acquiredmarkets, which adds cost in the short term but will facilitate our continuedgrowth.

Again, this is an example of us making long-term strategicdecisions to continue our future growth platform. So the bottom line here is,even with these additional costs margins still expanded, which points to thesuccess of our integration and strong growth.

Our acquired operations are evolving to look more like ourcore model and are gaining momentum. We have seeded the markets with additionalbench strength for serving customer demands in term of sales, support, andtechnical people systems and processes.

As part of that change, we are managing churn of smaller,less profitable customers, in concert with our normal product evolution and atthe same time, we are growing our business with medium to large customers. Ourrecent rollout to ten acquired markets is complete, and the markets are staffedand sales are occurring. We are starting to see quality customer wins in thesemarkets, so let me just touch on a few.

In Louisville,we have seen strong initial sales activities, including these three customerwins. We made a sale to a major health care company which included connectingtheir primary data center to other corporate sites with highly secure OnNetOC192 service solution. We also sold a 13-site IP VPN and Ethernet solution toa large consumer goods retailer, and we sold IP VPN and Internet services to a computersupport company who is a service provider to a leading PC manufacturer. Inaddition, this win also drove sales for this customer's Dallasoperations.

So just these three sales came to nearly $90,000 in monthlyrecurring revenue -- still yet to be installed, by the way, over the nextcouple of quarters -- with a total value over their contract terms which varyfrom three to five years of nearly $5 million.

We're just getting started. In Birmingham, we sold asix-site IP VPN including Internet and voice services to a major automotiveretailer, and in Jacksonville and Nashville we're seeing growth with Ethernet Internetservices leading the way for enterprise customers.

These are just a few of our wins but they evidenceadditional success from the acquisition, and demonstrate why we made thisinvestment which was clearly revenue synergies, greater reach and expanded opportunities.We have work ahead of us to continue to grow the markets, but we're pleasedwith our results to date, which will contribute to our growth platform for 2008and beyond.

The momentum in our acquired business also continuesthroughout the company. Business is good, demand remains strong and pricingcontinues to be relatively stable for our market, which is local metro serviceson a national level.

We view the world from a local perspective as opposed tothat of a long-haul services provider, which is an important distinction,frequently overlooked by those not familiar with Time Warner Telecom. So fromour perspective, we continue to experience a relatively stable pricingenvironment, especially for our more differentiated and complex services. As always, there continues to be some pocketsof stronger price competition such as wholesale Internet services, but thatdynamic is no different than before.

Demand in our sales funnel remained strong. We are doingmore of just about everything for medium and large enterprises. This includesreceiving more and more requests for complex data solutions to serve our sweetspot, which is medium to large enterprises. Customer demand continues from thetechnology transitions, from frame and ATM services, to IP VPN-based solutions.This is driven by customers' need for more bandwidth and lower maintenancecosts.

Ethernet products are another area of continuing demand.This product suite includes bigger pipes and more complexity to servemultipoint solutions to accommodate our customers' growth, efficiency andscalability beyond current private line solutions.

Additionally, continued bandwidth demand in Internet-basedapplications are resulting in ongoing sales of highly scalable Internet accessservices. Also, specialized requests for private high capacity network servicessuch as DWDM are driven by the demand for the highest level of network securitywhich we are seeing across our enterprise vertical markets.

Demand for services supporting our customers' disaster recoverycontinues, including colocations and data center connectivity to meetregulatory, Sarbanes-Oxley and other compliance-type requirements.

As a side note on disaster recovery, I want to share arecent example of how valuable our services are and our ability to respondrapidly to our customers. The San Diego Sheriff's department has been acustomer of ours with Ethernet services for several years. Recently, wereceived a call from the Sheriff's department data and services division, whowas anticipating a significant increase in demand for their Internetcapabilities. This was due to the fires on the West Coast, and they wererequesting more bandwidth as a precautionary measure. In less than an hour, wewere able to more than double their bandwidth, and we were able to do so byjust a phone call and the use of our remote provisioning capability --now thatis powerful.

This was an extreme solution for our customer, requiring arapid response from us and is a great example of the scalability andflexibility of our network architecture, which is a big differentiator forTime-Warner Telecom. For many customers like the San Diego Sheriff'sdepartment, we continue to see strong demand and win market share in the Ethernetspace.

We continue our Ethernet leadership position based on thequality of our products and our service. This is evidenced by Atlantic ACM'sissuance of nine awards to us last week for excellence as an industry-leadingmetro carrier, which was based on feedback from business customers.

The bottom line on demand for telecom services is there isincreasingly fewer companies capable of doing what we do and that puts us in avery favorable position to serve our sweet spot of medium to large enterprisecustomers. We believe that we are on the front end of some very positive demandtrends, which we are not only benefiting from today, but expect to benefit fromfor some time to come.

So I'll close with one word: consistency. Consistency in ourstrategy, our performance, our execution on integration and consistency in ourenterprise growth. This consistency, which we have demonstrated in ourcontinued strong execution, is what positions us for ongoing future growth.

With that, I will hand the call over to Mark.

Mark Peters

Thanks, Larissa. As abit of our departure from the format in previous calls, I will direct you tothe press release for all the financial details, and I will instead focus onsome trends and general comments on the quarter.

We achieved another quarter of solid results. We continuedour long-term trend of consistent enterprise growth and strong modified EBITDAmargin, reduced our already low revenue and customer churn, and deliveredlever-free cash flow for the quarter. Net-net, we continue to demonstrate oursuccessful business model with our solid results.

I want to touch on the following topics relative to ourperformance, including the diversification of our revenue base, trends inenterprise and carrier sales, our margins and ongoing dynamics of our business,and our strong liquidity.

The quality of our growing recurring revenue base isdemonstrated by several factors. First, our strong product portfolio andcustomer service is causing existing customers to purchase additional servicesfrom us. Our customer retention efforts are also a factor as demonstrated byour lower churn.

Additionally, we have an impressive 30-day sales outstandingwith bad debt expense as a percent of revenue of only 0.5%.

Finally, we continue to attract a wide variety of enterprisecustomers. Our highly diversified revenue stream is demonstrated by the 70% ofour revenue comes from the enterprise segment with no enterprise customerrepresenting more than 2% of total revenue. Our enterprise revenue isdiversified over many vertical market segments with no enterprise segmentrepresenting more than 9% of total revenue.

Additionally, our single-largest customer, AT&T,represents only 7% of our third quarter revenue, even after their numerous andsignificant acquisitions. These metrics demonstrate a very solid and diversecustomer base.

Enterpriserevenue continues a steady upward climb with 5% sequential growth and thelargest and fastest-growing segment of our customer base, now representing 70%of our total revenue. The enterprise segment, driven by our data and Internetproduct portfolio, remains our growth engine.

If you recall in our first quarter call, we had mentioned arecord sale completed in March that was our largest single sale to date. Thisfirst full quarter for that customer complemented our overall enterprisestrength, leading to our 5% sequential quarterly revenue growth on anenterprise base that is now 60% larger than one year ago; so we generated 20%annualized organic growth on a much larger base.

Carrier revenue continues to be an important revenue stream,representing 26% of revenue this quarter. We have continued to see somepressure all year as a result of consolidation-related grooming from Cingularand others as well as normal grooming and contract renewals to current marketprices. We expect that carrier grooming will continue.

On the sales front, we are continuing to generate new salesfrom large and small carriers alike, as they look for quality providers toconnect their network into the metro area, to reach their customers, otherpops, and cell sites.

Now let me turn to margins. Sequentially, our gross marginremained virtually unchanged and modified EBITDA margin expanded slightly to31.5%. The increase in modified EBITDA was primarily due to strong revenuegrowth and integration cost synergies. This increase was partially offset byincreased access costs due to additional sales as well as fluctuations incontract settlements, increased costs for additional field and sales personnelfor the new product rollout to ten acquired markets, and a slight increase inbad debt expense for mortgage-related customers.

We are also incurring higher access and other costs as aresult of continuing integration activities as we continue to achieve ournetwork cost synergies and overall operational efficiency.

Looking to the longer-term margin trends, as our businesscontinues to grow and as we realize more cost synergies and become moreefficient, we continue to expect to reach mid-30% modified EBITDA margin duringthe summer of 2008. We expect the network cost synergies, which as a majorityof our expected integration synergies, will be primarily realized in the nextfew quarters.

That said, I want to remind you that our quarterly marginsalways have been and will be impacted by the timing of sales, installations,seasonality and other normal business fluctuations, as well as integrationsynergies and costs. While margins are very important to us, it is equallyimportant to balance all key financial metrics. We will continue to keep theproper focus on balancing revenue growth, modified EBITDA margins, and cashflows.

Now let me turn to our balance sheet. We are in an extremelystrong liquidity position. We reported $307 million in cash and equivalents andinvestments. That means that even after funding $31 million of integration andbranding costs, we only had a $2 million net use of cash, year-to-date. Inaddition, we have only $6 million of annual debt maturities until 2013, and wehave strong leverage ratios. We were able to deliver $9.1 million in leveredfree cash flow this quarter, which included $7.6 million of integration andbranding expenditures.

Let me sum up by saying we delivered another quarter ofstrong revenue, margin and cash flow performance, and we have done this whilecontinuing to move efficiently through a large acquisition. We will remainfocused on growing the business, leveraging our acquired operations, andgrowing our enterprise business. In short, this quarter we continued ourconsistently strong performance.

Thanks for joining us, and we will now take your questions.

Question-and-AnswerSession

Operator

Your first question comes from Vance Edelson - MorganStanley.

Vance Edelson - Morgan Stanley

Thanks a lot, and congratson the results. Could you just comment a little bit on what you're seeing atthe margin on enterprise spending strength, just given the results from Ciscolast night? What are you seeing on the front lines there, any signs of aslowdown? Thanks.

Larissa Herda

We've certainly beenlooking for it, but we're not seeing it. We've been talking extensively to ourfolks in the field, in the sales organization, and just had a call two days agoin preparation for this call with all of our regionals. The word was that ourcustomers that we're selling to are all going through a lot of growth, with theexception of maybe some of the mortgage-related type of customers, we're notreally seeing any change in customer demand. It's been very consistent.

Now some of it could also be, keep in mind, we're sellingservices that make customers moreefficient and provide them with a lower total cost of ownership. So althoughthey may stop doing some more discretionary types of things, I think what we'redoing is helping them run their businesses more efficiently. So even if otherthings are slowing down, I would expect that since we're saving them moneywe're probably going to continue to see that growth.

Vance Edelson - Morgan Stanley

The latest on the branding initiatives, I guess the expenseassociated with that dropped a lot this quarter. Is that a sign that it'salmost over, or is the branding change just on hold for the time being?

Larissa Herda

I would characterizeit as going through a process right now and we're not expending a whole lot ofbranding dollars until we make the final decision on what direction we're goingto go in. We do have some legal process that we're going through that arecosting some money. A lot of the creative processes we actually spent a lot ofthe money on earlier so it's not on hold, it's ongoing; it's just not rackingup a whole lot of dollars right now.

Vance Edelson - Morgan Stanley

The number of offline buildings, I didn't see that in thepress release. Is that something we'll be getting going forward?

Larissa Herda

We're working on that. Obviously when we want to providedata to our investors we want to make sure that it's completely accurate. Goingthrough the integration we recognize that there's just a lot of puts and takesand different ways that the Xspedius folks were counting their buildings andthere's obviously a lot of overlap too in buildings. So it's going to take ussome sometime to scrub through that.

I would say more to come. We'll talk about what we're goingto do with those buildings in the first quarter. The reality is that, we hatetaking metrics away from investors because they are so few as they are outthere, but I'm not sure that it's a particularly relevant metric. At the sametime, we're working on providing more clarity around those numbers. Suffice tosay, they continue to grow.

Operator

Your next questioncomes from Tom Sykes – Deutsche Bank.

Tom Sykes - Deutsche Bank

You did take down CapEx a little bit. Do we read anything atall into the demand environment, because most of your CapEx is success-based?We are usually complaining on the other side I realize.

Larissa Herda

Damned if you do, damned if you don't, right?

Tom Sykes - Deutsche Bank

That’s right. So before I get mocked more, let me ask thesecond one.

You're rolling out four additional markets from the acquiredproperty in the fourth quarter. Is that a good run rate to look at? I think you'renow at roughly one-third of the acquired markets. But is four a quarter orsomething around that a good way to look at it?

Mark Peters

Let me just touch thefirst one on CapEx. I wouldn't read anything into the narrowing of the guidanceon the CapEx. As we get closer to the end of the year, we just refined thenumber a bit. As Larissa mentioned earlier, the sales funnel remains strong.Everything that we see of the business remains strong looking forward. Iwouldn't read anything into the reduction there. Just really a narrowing of theguidance.

Larissa Herda

I wouldn't call four markets any kind of an ongoing run rateon the market expansions. We're starting to get into some smaller markets thatwe're not going to put major product capabilities in until we see the resultsfrom sales efforts and opportunities there. We're really not into that build itand they will come type of philosophy. So as you know, we're very successbased. It will come in fits and starts. If we see six new markets that we wantto enter into, then we're going to put product capability in those markets.

In the meantime, we're selling the existing productportfolios in those markets. Over time, you'll start to see us sell some moreas well. We're selling voice and Internet and dedicated services and we'regoing to continue to do that in those markets.

It's really the Ethernet capability that there's someupfront costs associated with that that the market has to bear. We need to makesure that we're going to get our returns before we put additional CapEx forthose types of products in those other markets. I'm sure that will happen over time. It just hasn’tbeen the highest priority for us. You have so many people, and you have so manyresources, and you want to focus them on the places where you're going to getthe biggest bang for your buck in the shortest period of time. That's whatwe've chosen to do. It seems to be reaping the rewards that we've beenexpecting.

Operator

Your next question comes from Tim Horan - CIBC.

Tim Horan - CIBC World Markets

We've had some of the IP backbone providers saying they'veseen a slowdown in volume growth. It's probably more consumer related, but areyou seeing any slowdown in traffic, through your routers at the edge?

Larissa Herda

Not at all.

Tim Horan - CIBC World Markets

Margins, I know they can be lumpy quarter to quarter.Historically, it looks like your fourth quarter margins are usually a prettystrong quarter. Would there be any reason that this quarter would be down a bitor some volatility in the next few quarters?

Mark Peters

We're loathe to give any kind of guidance other than we'vealready given which is where we really expect to be during the summer of nextyear, which is the mid-30%. So any particular quarter is going to be dependenton customer sales.

Larissa Herda

Timing. Some of thebiggest gyrations in any given quarter is simply timing. We can install theexact same number of customers with the exact same amount of revenue and if youhappen to install a lot of them in the beginning versus the end it can have animpact on the quarter which is why we have consistently said over many yearsthat we think it's important to look at the overall trends in the revenue asopposed to the quarter-to-quarter gyration, which as you clearly recognize, wehave some lumpiness in that over a quarter-to-quarter basis based on a wholelot of different things.

Tim Horan - CIBC World Markets

But it's not seasonalother than just adding to customers that you were talking about. There's noseasonal reason it would be up or down in the fourth quarter?

Larissa Herda

No.

Mark Peters

No, no.

Tim Horan - CIBC World Markets

CapEx, you're narrowing the range a little bit. But I thinkthe focus may be going forward and obviously you're running a great business,would be to leverage your existing assets a little more. You're still spending 21%of revenues on CapEx, which is quite high on this type of services model. Howdo you feel about that going forward in terms of maybe being the leverage what youhave a little bit more and lowering the CapEx below 20% of revenues? Thanks.

Mark Peters

I'm not sure iflooking at CapEx as a percent of revenues is the right way to look at it. It'swhere you're investing those capital dollars. Larissa mentioned that we're verydisciplined in how we deploy our capital. As you know, we don't build it andthey will come. Rather we look at the majority of our capital spending is tospec up new customer locations.

We have a stringent internal rate of return threshold that isa 30% bogey over the life of that customer contract with no assumption onrenewals. So there's no residual on that equipment and that's after tax. Aslong as we keep finding those opportunities, it really makes a lot of sense forour model to keep investing in our business and extending our reach.

Tim Horan - CIBC World Markets

It seems like your customers per building is relatively lowand there might be opportunity to upsell existing buildings that you're in, Iguess is what I'm implying.

Mark Peters

That's where Icontinue to go. We have specific programs that obviously we know where ourbuildings are, and we analyze those buildings and look at opportunities there. Wehave specific programs that targets those buildings that are already lit to doexactly what you're speaking about, which is leveraging our existinginfrastructure. That's why we are able to generate the nice cash flow thatwe've been generating for a very long time.

Larissa Herda

Tim, one of the other things to keep in mind is that we arereally one of the last companies left in the telecom industry that can do whatwe do and that is targeting with the strategy that we're targeting that has theassets that we have. As a result, we are getting a lot of demand fromcompanies, and we've been seeing this in the results, clearly, demand fromcompanies who may not have considered us, two or three years ago. We're in anice spot there.

So there's investments that we make and that we continue tomake in those customers. What we find is that these are the kinds customers werefer to internally as the gift that keeps giving. So once you build for themor once you do something for them, we're constantly mining ongoingopportunities with them.

As you know, several years ago, we started a national salesforce which we didn't have five years ago. We've seen great traction in thatgroup. Those are often customers that require a lot of CapEx, as well. We'redoing all of those things. At the same time we're still buildinginfrastructure, right, so we're still building out the newer markets that wejust acquired and making those investments. So you're seeing a combination ofstill being a rather young growth company that's still making investments inour business.

So it is a combination of things going on. We don't have 100years of investment like the Bellcompanies do. We're a 13-year-old company, which in this type of a business,building the kind of infrastructure we have is still rather young.

Operator

Your next questioncomes from Donna Jaegers - Janco Partners.

Donna Jaegers - Janco Partners

Congratulations on a good, consistent quarter. As far as themortgage business being a little soft, I know your enterprise customers yousaid were no more than 2% of revenues for any one customer. Can you sort ofballpark how much you might have in that mortgage sector?

Mark Peters

The financial sector is not our largest sector and ourlargest one is over 9%. So we've done analysis broadly speaking as far ascompanies and institutions that could have some exposure to the mortgageindustry, it's not just financial institutions, it's broadly speaking. Thatnumber, again, they're not all at risk obviously. So I think that number wasprobably around 5% or less. That's really broadly looking at large and smallinstitutions alike that don't have much risk to them either.

Larissa Herda

I'll also note that in the past quarter, in the resultswhere you saw the 5% sequential enterprise growth, we had mortgage-relateddisconnects. They were on the larger side. So, it's a larger size for thosetypes of customers. So, we're going to have some of that. But you may or maynot notice it. It will just depend on what occurs.

Donna Jaegers - Janco Partners

You have a strong balance sheet with all that cash, plusyou're starting to generate free cash flow. How do you think about how muchcash you need to keep on the balance sheet going forward?

Mark Peters

It's kind ofsituational, isn't it? From a perspective standpoint, I think everybody feelscomfortable having a large cash balance. It gives us a lot of flexibility as welook for investments in our business. I'mnot going to give you a specific number. Obviously our financial ratios, ourdebt ratios are very strong. Like you point out, we have strong, unlevered freecash flow. We have positive levered free cash flow. But having that flexibilityto make investments in these additional markets, the four new markets, not bigdollars, but having that comfort on the balance sheet right now is a good placeto be. I think longer term, as all things being equal, I think eventually we'llbe taking those cash balances down one way or another.

Operator

Your next questioncomes from Frank Louthan - Raymond James.

Frank Louthan - Raymond James

I noticed you had an uptick in the sales force in thequarter. Can you give us an idea of where those folks were going? Is that moreon the national side or the local? When can we expect to see, I would assumemaybe second quarter, start to see a lot of that productivity really come in asfar as sales? In the meantime, is that going to put pressure on SG&A?

Remind us as far the margins go, where are most of yoursynergies coming from? Is that coming out of cost of good or G&A? How shouldwe be thinking about that as we're trending toward mid-30s as EBITDA marginsnext summer?

Larissa Herda

I'll answer the salesforce question and we'll leave theSG&A and synergy question to Mark. So most of the sales folks are in thelocal markets, the new markets. We also added obviously a lot of technicians. Ithink we had a net increase of about 60 people or so quarter-over-quarterchange. So we've been adding people in a number of places to support the newmarkets.

They're focused on really the medium to large customers, thesalesforces that were in those markets when they had salespeople in thosemarkets were focused on the small business that Xspedius had. So we've beenrefocusing them, and as you know, there's a long selling cycle. Now we've hadsome nice quick hits, but we've been working on some of those for quite awhile, too.

Some of the positive sales momentum we've had both come fromother markets selling into those markets, too. We're already seeing somemomentum, but the newer salespeople obviously, as you know, it takes about ayear for a sales person to get to quota. Which is why we wanted to start thisprocess earlier, and start hiring these people over the summer because wewanted to position ourselves going into '08 with some sales momentum and we'realready starting to see that.

Mark Peters

On the synergies piece, as you know, the largest expectedsynergies, cost synergies is from the network cost. Grooming the network, bothlocal and the IP backbone, rolling all our purchasing on to common contracts sowe get our most favorable pricing. That's going to come out of the operatingcosts, which obviously feeds into the gross margin. So that's where we expectto see the biggest lift especially going forward from a synergy standpoint.

But also, there were some headcount synergies that werealized since closing, and those were spread both across operating andSG&A. Obviously the executive levels and the administrative levels came outof the SG&A. So going forward, though, I would expect the bulk of thefuture ones to come out of the operating costs.

Frank Louthan - Raymond James

Where are we right now on the synergy run rate and remind uswhat we have left for next year?

Mark Peters

We haven't disclosed what the specific achievement of thosesynergies are because, frankly, it's nearly impossible because our business isgrowing so strongly that we're adding capacity into the company, as well astaking those costs out with the synergies.

Having said that, we track that pretty closely and we'repeople are accountable for that internally. However, to report it out publiclyreally isn't what we think is the right way to go, rather focusing you alltowards our trends as we go toward our margin objective next year, the mid-30%EBITDA margin.

Operator

Your next question comes from Mike McCormack - Bear Stearns.

Mike McCormack - Bear Stearns

First one is on the margins. Is there a reason, Mark, thatwe should be thinking about mid-next year as sort of a stopping point, or isthis just a milestone along the path? Obviously you've got synergies helpingout, integration costs coming down. But you guys are improving marginsorganically, as well. So is this something that continues progression, or isthat a goal post that you think is important for us?

Secondly on the pricing environment. I know you mentioneddemand continues to be great. There's been some press releases by I guess someof your lesser peers out there that have been very aggressive positioningaround provisioning as well as pricing. Is there anything on the pricing sidewe should be thinking about?

Mark Peters

Let me just touch onthe margins first. Really our objective as you stated was for us to hit themid-30% EBITDA margins during the summer of next year. Really look at that as amilestone. That's kind of putting it all together with the acquisition, thegrowth in the business to get to that level.

Now beyond that level, can we get additional growth in theEBITDA margin? Well, obviously, time will tell. Once we hit that milestone,frankly, you're not going to see us giving any more guidance around EBITDAmargins other than speaking to trends.

But as a function of the mix and the product base as we sellto the OnNet customers with the complex service offerings, there could beopportunity for that expand. Obviously offset to a degree by customers thathave off-net connectivity because that requires a higher component of type 2 costs.So, we'll talk more about that when the time comes. But I think our model hasdemonstrated, real opportunity to leverage our operating costs.

Larissa Herda

And obviously there'sthe tradeoff. So, the more OnNet-type of business we spend more CapEx to getthat higher margin business, whereas the off-net business is a lower CapExmodel, but also a lower margin business. So they both contribute to cash flow,but just in different ways.

The pricing environment, I'm not familiar with the pressreleases you're talking about so I don't know how to respond to that. But wehave not really seen any changes generally. You always see pockets, but we'vealways seen pockets of pressure on a market-by-market basis and I suspect it'smore a function of if it's a national company we're competing against, Isuspect it's more a function of their local management or their regionalmanagement that may have a way of attacking that local market that's differentthan what they may be doing in other places. So there's not necessarilyconsistency there.

That's no different than what we've seen before. We'vealways seen on the wholesale side, the reality is that, transport-typeservices, dedicated services, are a fairly highly commoditized service. Unlessyou're going to the customer buildings for the carriers, and that's obviouslywhere our strength is because we've got over 8,000 buildings and there's nobodyeven close to that. So when we provide those types of services for carriers,we've got a bit more pricing strength.

But we haven't really seen, there's obviously re-rates thatwe go through on the carrier side, and that's been something that we've alwaysdealt with in our business, as carrier contracts expire and you need to re-ratethem, you generally are re-rating them down.

But on the enterprise side, again, we're selling a differentset of products and I use the word loosely, than our peers do because there'sgenerally selling if you go with the part of the industry that's selling to thesmaller business customers, they're using a type 2 circuit to get to thosecustomers, and it's a different sale than we're making.

If you go to some of the other industry players that may befocused more on really high bandwidth, high commodity, long haul type stuff,that's a bit different business than we sell. We're selling these multi-city IPVPN services and where the core infrastructure is fiber, we have a tremendouscompetitive advantage from both a technology standpoint, network standpoint, aswell as a pricing standpoint.

So I think we're in a little bit of a different categoryperhaps than some of the other companies that you're referring to.

Mike McCormack - Bear Stearns

Larissa, on thewholesale stuff, you mentioned some re-rates on contracts. Are you seeing anycarriers coming into overbuild some of those local access points?

Larissa Herda

Yes. There's at leastone national carrier that has been national RBOC, a global RBOC, who's beenaggressively building in a few markets out of region, just a couple of them. Idon't think they're doing it for the carrier business, I think they're doing itto reduce their local access costs over time. But it's not a consistent thingthat we're seeing, and that's been going on for quite a long time. In somecases I think they're just augmenting some of the out-of-region CLEC networksthat they already have. But otherwise, no, I'm not seeing a lot of that. Butthere is at least one that we've seen some of that.

Mike McCormack - Bear Stearns

Is that impacting youguys at all, or is that just minimal?

Larissa Herda

No. It's minimal.

Operator

Your next question comes from Rai Archibold - KaufmanBrothers.

Rai Archibold - Kaufman Brothers

On the new markets that you turned on, the ten in June andthe four this quarter, can you size the incremental market opportunity you'repursuing is terms of the mid to large enterprise business?

Larissa Herda

I can't. I'm sorry. Idon't have that data to give to you now. We haven't talked publicly about themarket opportunities. But they're primarily tier 2 markets, there's one tier 1 marketbut our tier 2 markets, when you look at our business model, it works in boththe tier 1 and tier 2. But tier 2 is really powerful for us because we canreally go in and have a major impact on a large swath of the customers in thosemarkets.

Today, with the acquisition of Xspedius, we have 900,000customers that are in our target sweet spot that are within one mile of ournetwork. So we have a large untapped market opportunity in both our existingmarkets and the new market, as well.

Rai Archibold - Kaufman Brothers

Relative to the new markets, particularly the ten that wereopened in June, I think you cited two or three wins that came as a consequenceof that. How's the pipeline building going there, and how should we look forthe lift in revenues from those markets over the next several quarters?

Larissa Herda

As I said in my script, we've had great success there. Italked about a couple of them in markets like Louisville, where when we getthose customers that are billing in the $30,000 to $80,000 per month, thosetypes of customers, that's a sweet spot of our business. We can do everythingfor that size customer. These are markets that have never had a fiber-basedcarrier that went after the market like we go after the market.

Because remember, most of the fiber-based carriers that areout there, in fact all of them that I'm aware of -- and I think I'm aware ofmost of them -- have taken the strategy of building fiber but primarilyconnecting up carrier pops and maybe a few major customers, but this is acapital- intensive business, as we all know. It requires a significantinvestment, a lot of discipline, and most fiber-based carriers have gone with asmall business strategy, which is what Xspedius did, because they didn't wantto spend the CapEx.

These markets are untapped from the potential of these typesof business customers. These business customers have never had the opportunityto buy services from a competitive carrier that can give them their coreinfrastructure over fiber. It's very compelling for them.

So they're getting used to that, and they're starting to getmore familiar with us. In time as we build our reputations in those markets, Iwould see the momentum building and so we're very excited about that. This iswhat we do well and we've chosen really good markets.

As many of you know, one of the markets that we acquiredwith Xspedius were markets that we were planning on eventually trying to figureout how to get into anyhow. We were going through a decision of buying versusbuild, some markets like Fort Worth,in Texas, for instance, which isadjacent to Dallas. It hastremendous pull from our other Texasmarkets. And so we had major customers in that market that we had been talkingto who wanted our services, and we were getting ready to build in there, andwith Xspedius, we got that network. There's a lot of that going on, too.There's a lot of synergistic traffic between those markets that we bought.

We're very bullish on those markets. We think we're going tosee great stuff coming out of them in the next several years.

Rai Archibold - Kaufman Brothers

On the integration, can you kind of give us a sense how farare we completed, are we 90%, 70%? Following on that and related to the cash,as we kind of get into the homestretch with the integration here, how should wethink about your M&A strategy going forward from this point?

Larissa Herda

Well, our integrationis basically complete. What that means is from the perspective of bringingnetworks together, the people side of it has been done for a while, the systemsside is -- in this business, if you look at most of the companies, if youreally look at and you really ask the questions of the companies this business,large and small, very few of them have ever completed the kind of systemsintegration that we've completed and certainly they've never done it in thetimeframe that we've done it in. It's a really hard thing to do.

There's fallout from that type of activity obviously becauseonce you integrate systems, you figure all the people in our O'Fallon NOC,which was the Xspedius NOC, now have a whole set of different things to look aton their computer screens than they did before. So there's training issuesassociated with the integration, and it takes time because people arefundamentally inefficient for a period of time until they learn it. We've beengoing through that since the change.

We will continue to get more and more efficient over time.We're not there yet. In that sense, I guess you could say integrationcontinues. It's really more process improvement, right? Streamlining, andtweaking because, again, when you bring systems together, things fall out. Datafalls out, because it's not perfect. They did their data differently.

So, for instance, their circuit identifications haddifferent circuit identifications than our company. So now when our people in Denverare provisioning services in the new markets, they're dealing with data thatlooks different that they have to accommodate and look at differently. It's avery complex thing that I'm not going to get into here. But, suffice it to saythat aspect of integration is extremely, extremely difficult.

But the hard stuff is essentially done. What we're doing nowis getting the efficiencies that come from doing all of that hard work, andit's a combination of process improvements, software enhancements, to continueto bring the systems to where we want them to be and network grooming, which iswhere the real cost savings is going to come in.

That is just slogging away circuit after circuit aftercircuit, and remember you've got customers associated with these circuits. Soit's not like you can just go well gosh, why can't you just disconnect allthese right here? It doesn't happen that way. It takes time. At the beginningwhen we announced this acquisition, we said it was going to take 12 to 18months, and by golly that's exactly what it's going to take. It's going to endup taking us to the 18-month part to get to where our run rate synergies arewhere we want them to be so we can get the benefits of that. We're obviouslyseeing a lot of those benefits now but we'll continue to see more and more overtime.

Obviously the costs associated with getting those synergiesare dwindling, as well and that's where you start to get the combination ofgetting those synergies combined with spending less on getting those synergiesis where you're going to see the pop in our cash flows next year.

So I can't give you a 70% or 90%. It's just too precise.

Rai Archibold - Kaufman Brothers

On the M&A outlook. How should we think about your M&Astrategy at this point, going forward?

Larissa Herda

The good news is from our perspective is first of all, wedidn't enter into this acquisition having to make an acquisition because wealready had some really impressive organic revenue growth as it was. We wentinto this acquisition, it was opportunistic for us. As I said earlier, we werelooking to expand. We were trying to figure out whether we did it organicallyor through acquisition, and this fell into just perfect for us in terms of thenetwork assets that were there particularly.

So we feel like we've got a lot of opportunity in themarkets that we're in today to continue to grow from where we are. I meanagain, if you just take the carrier segment of our business and put it over tothe side, since it's been fairly flat to somewhat down business, and you lookat our enterprise, we're growing that at 19% to 20% compounded annual growthrate, is an extremely impressive number.

Again, I don't know anyone in our industry that's growingtheir enterprise business at that rate. So we've got really good, stronggrowth, we were really focused on continuing to accelerate our growth. That's afull-time job around here.

With that said, we're always looking at opportunities tocontinue to grow our capabilities, to grow our market reach. There are very fewplaces where we're not, honestly. So we don't have to be in any place. If theright opportunity comes along and it's the right price, you know, there's beensome rather inflated prices out there in our opinion for assets that arenon-operationally where we are and so if you find the right price, the rightopportunity, the right combination of things, certainly we will seriously takea look at it. But right now, we're really focused on execution and obviouslythat's working well for us.

Operator

Your next question comes from Tom Watts - Cowen and Co.

Tom Watts - Cowen

You had mentioned on your target of making mid-30s EBITDAmargins by next year, it sounded like the majority of that is coming from thegross margin side. Although you mentioned some things lower in the incomestatement. Is that fair to say that more than half of it will come from grossmargin improvements?

Mark Peters

Really the bulk ofit's going to come from the network grooming activities as well as the growthin the business. So I think up on the gross margin and the operating expenseside is where we really expect to see the bulk of the cost synergies.

Tom Watts - Cowen

You also mentioned that when you're in these new marketswhere you're going in, that most of the potential customers for the fullproduct suite hadn't had an opportunity to have a fiber-based network from acompetitive provider. What is the typical competitive situation as you're goingin these new markets? Is it all the left-wing-haul carriers that are servingthem, or who are you seeing that you come up against?

Larissa Herda

The large RBOCs --AT&T and Verizon. What we are finding from these customers in their views,and I've been out to a number of these markets now and talked to them is thatthe local exchange carrier that's there in some of the markets they obviously havesmaller incumbent carriers there. But that they're basically telling us thatthey're unresponsive, and they are not offering them advanced services. There'slegacy services.

What we have found is that when we show up and thecompetitors are there, it's generally the incumbent, whoever the incumbentcarrier is, when they find out we're there is when they go to the customers andoff them the new advanced services. But even then a lot of them are having ahard time doing that because they just don't have the product capability.

So for instance, Ethernet services, if you look at thevertical systems slide that we generally have on our website, we're the thirdin the terms of our Ethernet port share in the United States at 13.7%, just a few percentage pointsbehind $120 billion companies that obviously aren't out there aggressivelyselling those services.

So when we come into a market, it's refreshing for customersbecause we're out there selling services that they haven't seen before thatthey weren't aware were even available before and so we're really stimulating alot of new thinking with those customers and so it's fun.

Tom Watts - Cowen

Have you seen competitive responses from RBOCs that theywill launch some of these products in your market after you come in?

Larissa Herda

Sure. It takes sometime. In some cases the only thing they have to really hang their hats on isprice. So you'll see them selectively, if there's a customer they really wantto go after, they'll go after them. They don't do it across the board. Theyseem to do it in a spotty way. Maybe it's to send a message, I don't know. Butwhat we find is that it's not all about price. I mean, at the end of the day,customers are looking -- a lot of the relationships have changed with thesecustomers in these markets. The consolidation has changed their status withinthe carriers that they were in, that they were buying from. If they used to bea big fish in a small pond, they're now a really small fish in a very big pond.So the accountings has changed. The way they're even serviced has changedbecause there are no longer in some cases served by a local rep.

So they don't have local relationships. As I travel frommarket to market to market around the country and talk to customers and I talkto a lot of them, I'm continually told by customers that one of the mostimportant things that they value in their relationship with Time Warner Telecomis the local relationship that we have created with them and there's apartnership there. It's meaningful. It has been a very powerful I thinkcompetitive advantage for us. As we go into these newer markets, this issomething that's been refreshing for them, as well.

Tom Watts - Cowen

Has the ability tohire people as you go into each market and train them been much of animpediment or are you able to find good people?

Larissa Herda

Not at all. We're findinggreat people. From the sales side, it's been a habit of mine, maybe it'sbecause I'm a salesperson at heart and I love talking to salespeople, but Igenerally get in front of most of the salespeople who come in through Denverfor training, and I do that for a number of reasons. It's a very effective wayfor me to find out what the competition is really doing because they've allcome from the competition and I get to ask what's actually going on. So I havereally fresh, real-time information, and this is every few weeks or so I'mgetting it.

What I'm finding and what it also helps me do is find outthe caliber of the people that we're bringing to the company, and we'rebringing in people who have tremendous credentials, who may have been part of just an overall downsizing thatoccurred, that wasn't based on anything other than you happened to be in thewrong place at the wrong time. I'm veryimpressed with the people that we've brought into the company. We are the placethat people want to be. We're a stable company. We've got a great reputation.We've got a good growth platform. We've got fun products.

So the salespeople love it, the technical people probablyfeel a bit overworked honestly. Because they have a complex job in this companybecause we have a complex set of services. It's different from a lot of otherplaces. So no, recruitment is actually a pleasure at this point, so no problemsthere.

Mark Peters

Thanks, Tom andthanks to everyone.

Larissa Herda

Thank you, everyone. I think we ran a little over time here.Thank you for talking to us today and for your support of Time Warner Telecom.

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