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Time Warner Telecom (NASDAQ:TWTC)

Q3 2007 Earnings Call

November 8, 2007 11:00 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 third quarter 2007 conference call. Today's call is being recorded. With us from the company is Chairman, Chief Executive Officer, and President Larissa Herda; and Senior 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 me start by directing you to our website at TWTelecom.com where you can find our press release and supplemental quarterly information.

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

Time Warner Telecom, Inc. is under no obligation and expressly disclaims any obligation to update or alter its forward-looking statements, whether as a result of new information, future events, or otherwise.

In conjunction with SEC Regulation G, I want to point out we report several financial measures that are non-GAAP, including modified EBITDA. Our non-GAAP measures are not intended to replace our GAAP disclosure, rather they merely are presented to provide additional insight into our performance. Please see our press release and information posted on our website for more details 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 has been one of consistent growth and this quarter's no different. It was another great quarter. Our performance is based on strategic choices we have made over many years with long-term growth and profitability in mind which has culminated in more than five years of consecutive quarterly enterprise revenue growth. We continue to grow enterprise revenue on a larger and larger base, with this segment now representing 70% of our total revenue.

Also for three years, we have achieved total revenue growth each and every quarter and we have sustained our organic growth trends while successfully integrating a significant acquisition. Last year, we made a strategic choice to expand our footprint with the acquisition of Xspedius. We are well on our way to achieving our goals for that acquisition, and our progress is impressive.

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

Just to remind you, that means as of August we achieved the following milestones, including: a unified organization for our sales, customer care, field operations, marketing and headquarter functions. Additionally, we have 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 a phenomenal set of accomplishments in a relatively short period of time and we have continued to deliver strong performance throughout this effort.

We have probably made the integration look easy given our success, but I don't want to kid you; this was not without some degree of pain for 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 our synergies are on target.

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

As planned, our modified EBITDA margin was diluted by this acquisition. Through our strong execution, we have seen our margins continue to improve as we move through our integration. Remember, at the same time we are gaining synergies we are also investing in the business for the acquired markets, which adds cost in the short term but will facilitate our continued growth.

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

Our acquired operations are evolving to look more like our core model and are gaining momentum. We have seeded the markets with additional bench strength for serving customer demands in term of sales, support, and technical 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 at the same time, we are growing our business with medium to large customers. Our recent rollout to ten acquired markets is complete, and the markets are staffed and sales are occurring. We are starting to see quality customer wins in these markets, so let me just touch on a few.

In Louisville, we have seen strong initial sales activities, including these three customer wins. We made a sale to a major health care company which included connecting their primary data center to other corporate sites with highly secure OnNet OC192 service solution. We also sold a 13-site IP VPN and Ethernet solution to a large consumer goods retailer, and we sold IP VPN and Internet services to a computer support company who is a service provider to a leading PC manufacturer. In addition, this win also drove sales for this customer's Dallas operations.

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

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

These are just a few of our wins but they evidence additional success from the acquisition, and demonstrate why we made this investment 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 pleased with our results to date, which will contribute to our growth platform for 2008 and beyond.

The momentum in our acquired business also continues throughout the company. Business is good, demand remains strong and pricing continues to be relatively stable for our market, which is local metro services on a national level.

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

Demand in our sales funnel remained strong. We are doing more of just about everything for medium and large enterprises. This includes receiving more and more requests for complex data solutions to serve our sweet spot, which is medium to large enterprises. Customer demand continues from the technology transitions, from frame and ATM services, to IP VPN-based solutions. This is driven by customers' need for more bandwidth and lower maintenance costs.

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

Additionally, continued bandwidth demand in Internet-based applications are resulting in ongoing sales of highly scalable Internet access services. Also, specialized requests for private high capacity network services such as DWDM are driven by the demand for the highest level of network security which we are seeing across our enterprise vertical markets.

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

As a side note on disaster recovery, I want to share a recent example of how valuable our services are and our ability to respond rapidly to our customers. The San Diego Sheriff's department has been a customer of ours with Ethernet services for several years. Recently, we received a call from the Sheriff's department data and services division, who was anticipating a significant increase in demand for their Internet capabilities. This was due to the fires on the West Coast, and they were requesting more bandwidth as a precautionary measure. In less than an hour, we were able to more than double their bandwidth, and we were able to do so by just a phone call and the use of our remote provisioning capability --now that is powerful.

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

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

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

So I'll close with one word: consistency. Consistency in our strategy, our performance, our execution on integration and consistency in our enterprise growth. This consistency, which we have demonstrated in our continued 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 a bit of our departure from the format in previous calls, I will direct you to the press release for all the financial details, and I will instead focus on some trends and general comments on the quarter.

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

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

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

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

Finally, we continue to attract a wide variety of enterprise customers. Our highly diversified revenue stream is demonstrated by the 70% of our revenue comes from the enterprise segment with no enterprise customer representing more than 2% of total revenue. Our enterprise revenue is diversified over many vertical market segments with no enterprise segment representing 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 and significant acquisitions. These metrics demonstrate a very solid and diverse customer base.

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

If you recall in our first quarter call, we had mentioned a record sale completed in March that was our largest single sale to date. This first full quarter for that customer complemented our overall enterprise strength, leading to our 5% sequential quarterly revenue growth on an enterprise 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 some pressure all year as a result of consolidation-related grooming from Cingular and others as well as normal grooming and contract renewals to current market prices. We expect that carrier grooming will continue.

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

Now let me turn to margins. Sequentially, our gross margin remained virtually unchanged and modified EBITDA margin expanded slightly to 31.5%. The increase in modified EBITDA was primarily due to strong revenue growth and integration cost synergies. This increase was partially offset by increased access costs due to additional sales as well as fluctuations in contract settlements, increased costs for additional field and sales personnel for the new product rollout to ten acquired markets, and a slight increase in bad debt expense for mortgage-related customers.

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

Looking to the longer-term margin trends, as our business continues to grow and as we realize more cost synergies and become more efficient, we continue to expect to reach mid-30% modified EBITDA margin during the summer of 2008. We expect the network cost synergies, which as a majority of our expected integration synergies, will be primarily realized in the next few quarters.

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

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

Let me sum up by saying we delivered another quarter of strong revenue, margin and cash flow performance, and we have done this while continuing to move efficiently through a large acquisition. We will remain focused on growing the business, leveraging our acquired operations, and growing our enterprise business. In short, this quarter we continued our consistently strong performance.

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

Question-and-Answer Session

Operator

Your first question comes from Vance Edelson - Morgan Stanley.

Vance Edelson - Morgan Stanley

Thanks a lot, and congrats on the results. Could you just comment a little bit on what you're seeing at the margin on enterprise spending strength, just given the results from Cisco last night? What are you seeing on the front lines there, any signs of a slowdown? Thanks.

Larissa Herda

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

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

Vance Edelson - Morgan Stanley

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

Larissa Herda

I would characterize it as going through a process right now and we're not expending a whole lot of branding dollars until we make the final decision on what direction we're going to go in. We do have some legal process that we're going through that are costing some money. A lot of the creative processes we actually spent a lot of the money on earlier so it's not on hold, it's ongoing; it's just not racking up a whole lot of dollars right now.

Vance Edelson - Morgan Stanley

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

Larissa Herda

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

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

Operator

Your next question comes from Tom Sykes – Deutsche Bank.

Tom Sykes - Deutsche Bank

You did take down CapEx a little bit. Do we read anything at all 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 the second one.

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

Mark Peters

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

Larissa Herda

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

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

It's really the Ethernet capability that there's some upfront costs associated with that that the market has to bear. We need to make sure that we're going to get our returns before we put additional CapEx for those types of products in those other markets. I'm sure that will happen over time. It just hasn’t been the highest priority for us. You have so many people, and you have so many resources, and you want to focus them on the places where you're going to get the biggest bang for your buck in the shortest period of time. That's what we've chosen to do. It seems to be reaping the rewards that we've been expecting.

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've seen a slowdown in volume growth. It's probably more consumer related, but are you 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 pretty strong quarter. Would there be any reason that this quarter would be down a bit or some volatility in the next few quarters?

Mark Peters

We're loathe to give any kind of guidance other than we've already given which is where we really expect to be during the summer of next year, which is the mid-30%. So any particular quarter is going to be dependent on customer sales.

Larissa Herda

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

Tim Horan - CIBC World Markets

But it's not seasonal other than just adding to customers that you were talking about. There's no seasonal 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 think the 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. How do you feel about that going forward in terms of maybe being the leverage what you have a little bit more and lowering the CapEx below 20% of revenues? Thanks.

Mark Peters

I'm not sure if looking at CapEx as a percent of revenues is the right way to look at it. It's where you're investing those capital dollars. Larissa mentioned that we're very disciplined in how we deploy our capital. As you know, we don't build it and they will come. Rather we look at the majority of our capital spending is to spec up new customer locations.

We have a stringent internal rate of return threshold that is a 30% bogey over the life of that customer contract with no assumption on renewals. So there's no residual on that equipment and that's after tax. As long as we keep finding those opportunities, it really makes a lot of sense for our 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 low and there might be opportunity to upsell existing buildings that you're in, I guess is what I'm implying.

Mark Peters

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

Larissa Herda

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

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

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

So it is a combination of things going on. We don't have 100 years of investment like the Bell companies 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 question comes from Donna Jaegers - Janco Partners.

Donna Jaegers - Janco Partners

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

Mark Peters

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

Larissa Herda

I'll also note that in the past quarter, in the results where you saw the 5% sequential enterprise growth, we had mortgage-related disconnects. They were on the larger side. So, it's a larger size for those types of customers. So, we're going to have some of that. But you may or may not notice it. It will just depend on what occurs.

Donna Jaegers - Janco Partners

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

Mark Peters

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

Operator

Your next question comes from Frank Louthan - Raymond James.

Frank Louthan - Raymond James

I noticed you had an uptick in the sales force in the quarter. Can you give us an idea of where those folks were going? Is that more on the national side or the local? When can we expect to see, I would assume maybe second quarter, start to see a lot of that productivity really come in as far 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 your synergies coming from? Is that coming out of cost of good or G&A? How should we be thinking about that as we're trending toward mid-30s as EBITDA margins next summer?

Larissa Herda

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

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

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

Mark Peters

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

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

Frank Louthan - Raymond James

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

Mark Peters

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

Having said that, we track that pretty closely and we're people are accountable for that internally. However, to report it out publicly really isn't what we think is the right way to go, rather focusing you all towards 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, that we should be thinking about mid-next year as sort of a stopping point, or is this just a milestone along the path? Obviously you've got synergies helping out, integration costs coming down. But you guys are improving margins organically, as well. So is this something that continues progression, or is that a goal post that you think is important for us?

Secondly on the pricing environment. I know you mentioned demand continues to be great. There's been some press releases by I guess some of your lesser peers out there that have been very aggressive positioning around provisioning as well as pricing. Is there anything on the pricing side we should be thinking about?

Mark Peters

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

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

But as a function of the mix and the product base as we sell to the OnNet customers with the complex service offerings, there could be opportunity for that expand. Obviously offset to a degree by customers that have 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 has demonstrated, real opportunity to leverage our operating costs.

Larissa Herda

And obviously there's the tradeoff. So, the more OnNet-type of business we spend more CapEx to get that higher margin business, whereas the off-net business is a lower CapEx model, 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 press releases you're talking about so I don't know how to respond to that. But we have not really seen any changes generally. You always see pockets, but we've always seen pockets of pressure on a market-by-market basis and I suspect it's more a function of if it's a national company we're competing against, I suspect it's more a function of their local management or their regional management that may have a way of attacking that local market that's different than what they may be doing in other places. So there's not necessarily consistency there.

That's no different than what we've seen before. We've always seen on the wholesale side, the reality is that, transport-type services, dedicated services, are a fairly highly commoditized service. Unless you're going to the customer buildings for the carriers, and that's obviously where our strength is because we've got over 8,000 buildings and there's nobody even 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 that we go through on the carrier side, and that's been something that we've always dealt with in our business, as carrier contracts expire and you need to re-rate them, you generally are re-rating them down.

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

If you go to some of the other industry players that may be focused 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 IP VPN services and where the core infrastructure is fiber, we have a tremendous competitive advantage from both a technology standpoint, network standpoint, as well as a pricing standpoint.

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

Mike McCormack - Bear Stearns

Larissa, on the wholesale stuff, you mentioned some re-rates on contracts. Are you seeing any carriers coming into overbuild some of those local access points?

Larissa Herda

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

Mike McCormack - Bear Stearns

Is that impacting you guys at all, or is that just minimal?

Larissa Herda

No. It's minimal.

Operator

Your next question comes from Rai Archibold - Kaufman Brothers.

Rai Archibold - Kaufman Brothers

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

Larissa Herda

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

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

Rai Archibold - Kaufman Brothers

Relative to the new markets, particularly the ten that were opened in June, I think you cited two or three wins that came as a consequence of that. How's the pipeline building going there, and how should we look for the 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. I talked about a couple of them in markets like Louisville, where when we get those customers that are billing in the $30,000 to $80,000 per month, those types of customers, that's a sweet spot of our business. We can do everything for that size customer. These are markets that have never had a fiber-based carrier that went after the market like we go after the market.

Because remember, most of the fiber-based carriers that are out there, in fact all of them that I'm aware of -- and I think I'm aware of most of them -- have taken the strategy of building fiber but primarily connecting up carrier pops and maybe a few major customers, but this is a capital- intensive business, as we all know. It requires a significant investment, a lot of discipline, and most fiber-based carriers have gone with a small business strategy, which is what Xspedius did, because they didn't want to spend the CapEx.

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

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

As many of you know, one of the markets that we acquired with Xspedius were markets that we were planning on eventually trying to figure out how to get into anyhow. We were going through a decision of buying versus build, some markets like Fort Worth, in Texas, for instance, which is adjacent to Dallas. It has tremendous pull from our other Texas markets. And so we had major customers in that market that we had been talking to who wanted our services, and we were getting ready to build in there, and with 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 to see 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 far are 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 we think about your M&A strategy going forward from this point?

Larissa Herda

Well, our integration is basically complete. What that means is from the perspective of bringing networks together, the people side of it has been done for a while, the systems side is -- in this business, if you look at most of the companies, if you really 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 systems integration that we've completed and certainly they've never done it in the timeframe that we've done it in. It's a really hard thing to do.

There's fallout from that type of activity obviously because once 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 at on their computer screens than they did before. So there's training issues associated with the integration, and it takes time because people are fundamentally inefficient for a period of time until they learn it. We've been going 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 integration continues. It's really more process improvement, right? Streamlining, and tweaking because, again, when you bring systems together, things fall out. Data falls out, because it's not perfect. They did their data differently.

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

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

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

Obviously the costs associated with getting those synergies are dwindling, as well and that's where you start to get the combination of getting those synergies combined with spending less on getting those synergies is 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&A strategy at this point, going forward?

Larissa Herda

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

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

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

With that said, we're always looking at opportunities to continue to grow our capabilities, to grow our market reach. There are very few places where we're not, honestly. So we don't have to be in any place. If the right opportunity comes along and it's the right price, you know, there's been some rather inflated prices out there in our opinion for assets that are non-operationally where we are and so if you find the right price, the right opportunity, the right combination of things, certainly we will seriously take a look at it. But right now, we're really focused on execution and obviously that'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 EBITDA margins by next year, it sounded like the majority of that is coming from the gross margin side. Although you mentioned some things lower in the income statement. Is that fair to say that more than half of it will come from gross margin improvements?

Mark Peters

Really the bulk of it's going to come from the network grooming activities as well as the growth in the business. So I think up on the gross margin and the operating expense side 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 markets where you're going in, that most of the potential customers for the full product suite hadn't had an opportunity to have a fiber-based network from a competitive provider. What is the typical competitive situation as you're going in these new markets? Is it all the left-wing-haul carriers that are serving them, 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 that the local exchange carrier that's there in some of the markets they obviously have smaller incumbent carriers there. But that they're basically telling us that they're unresponsive, and they are not offering them advanced services. There's legacy services.

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

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

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

Tom Watts - Cowen

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

Larissa Herda

Sure. It takes some time. In some cases the only thing they have to really hang their hats on is price. So you'll see them selectively, if there's a customer they really want to go after, they'll go after them. They don't do it across the board. They seem to do it in a spotty way. Maybe it's to send a message, I don't know. But what 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 these customers in these markets. The consolidation has changed their status within the carriers that they were in, that they were buying from. If they used to be a 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 changed because there are no longer in some cases served by a local rep.

So they don't have local relationships. As I travel from market to market to market around the country and talk to customers and I talk to a lot of them, I'm continually told by customers that one of the most important things that they value in their relationship with Time Warner Telecom is the local relationship that we have created with them and there's a partnership there. It's meaningful. It has been a very powerful I think competitive advantage for us. As we go into these newer markets, this is something that's been refreshing for them, as well.

Tom Watts - Cowen

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

Larissa Herda

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

What I'm finding and what it also helps me do is find out the caliber of the people that we're bringing to the company, and we're bringing in people who have tremendous credentials, who may have been part of just an overall downsizing that occurred, that wasn't based on anything other than you happened to be in the wrong place at the wrong time. I'm very impressed with the people that we've brought into the company. We are the place that 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 probably feel a bit overworked honestly. Because they have a complex job in this company because we have a complex set of services. It's different from a lot of other places. So no, recruitment is actually a pleasure at this point, so no problems there.

Mark Peters

Thanks, Tom and thanks 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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Source: Time Warner Telecom Q3 2007 Earnings Call Transcript
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