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Executives

Gregory H. Lundberg - Vice President of Investor Relations and Assistant Treasurer

Mary Agnes Wilderotter - Chairman and Chief Executive Officer

Daniel J. McCarthy - President, Chief Operating Officer and Chief Operating Officer - Electric Lightwave

Donald R. Shassian - Chief Financial Officer and Executive Vice President

Analysts

Batya Levi - UBS Investment Bank, Research Division

Simon Flannery - Morgan Stanley, Research Division

Michael McCormack - Nomura Securities Co. Ltd., Research Division

Christopher C. King - Stifel, Nicolaus & Co., Inc., Research Division

Philip Cusick - JP Morgan Chase & Co, Research Division

Scott Goldman - Goldman Sachs Group Inc., Research Division

Michael Rollins - Citigroup Inc, Research Division

David W. Barden - BofA Merrill Lynch, Research Division

Frank G. Louthan - Raymond James & Associates, Inc., Research Division

Frontier Communications (FTR) Q2 2012 Earnings Call July 31, 2012 4:30 PM ET

Operator

Good day, everyone, and welcome to the Frontier Communications Second Quarter 2012 Earnings Results Conference Call. This call is being recorded. At this time, I would like to turn the conference over to Mr. Greg Lundberg. Please go ahead, sir.

Gregory H. Lundberg

Thanks, Rebecca. Good afternoon, everyone. The purpose of this call is to discuss the 2012 second quarter results for Frontier Communications. The press release and earnings presentation are available in the Investor Relations section of our website, frontier.com.

On today's call are Maggie Wilderotter, Chairman and Chief Executive Officer; Dan McCarthy, President and Chief Operating Officer; and Donald Shassian, Chief Financial Officer.

During this call, we'll be making certain forward-looking statements. Please review the Safe Harbor language found in our press release and SEC filings. On this call, we'll also be discussing GAAP and non-GAAP financial measures as defined under SEC rules. Please refer to the reconciliation between GAAP and non-GAAP provided in our earnings release.

I'll now turn the call over to Maggie.

Mary Agnes Wilderotter

Thanks, Greg, and good afternoon, everyone. Frontier's second quarter 2012 results reflect a significant 39% narrowing of our revenue loss, thus, $9 million for the quarter. This is strong progress from $31 million in the third quarter of 2010, the first full quarter of our ownership of the acquired Verizon properties.

Q2 2012 revenues represents a year-over-year loss rate of 4.8%, the lowest levels since closing. Total access line loss in the acquired properties was 8.5%, 3 percentage points below the loss rate when we took ownership. We achieved this well in advance of our stated goal of 2013.

Our revenue improvement is happening on many fronts so what is central to our strategy is focusing on broadband services. During the quarter, we extended our network reach to 60,000 more homes and will connect an additional 92,876 homes with the $71.9 million of capital from the FCC's Connect America Fund.

Another broadband initiative is our new wholesale agreement with Hughes to distribute satellite service branded Frontier Broadband. We're excited about the economics of the partnership, the sales opportunities for double and triple play bundles and the ability to extend 5 to 15 megabit service to several hundred thousand unserved and underserved customers in our existing markets.

We are also focused on dramatically improving broadband speeds for residential and business customers, bringing 20 megabits service to 42% of our residential homes by the end of the year. Dan McCarthy will discuss this in more detail.

Improved broadband reach and capacity, combined with enhancements to the customer online and off-line experience, will allow us to have better acquisition and retention rates, driving further revenue growth. Our total access line loss rate is now down to 7.6%, the lowest since closing. Our second quarter net broadband subscriber additions were 5,442, reflecting an expected increase in conversion non-pay disconnects and less robust marketing programs.

Before I continue with Q2 results, I do want to mention the great job our employees did in responding to the severe and unusual windstorm in the last 4 days of June that impacted 3 of our 5 largest states. 2 million people throughout these states were without power for days. Frontier deployed more than 300 generators to keep our service up and running.

Our Fort Wayne, Indiana market alone saw a wind gust of 91 miles an hour, the equivalent of a Category 1 hurricane. And Ohio customers were without power from June 29 to July 10th. And we deployed 91 generators in that state. In West Virginia, half the state was without electricity, and 55% of our wire centers were running on generators.

Our employees in all these states went above and beyond the call of working duty, around-the-clock restoring service to our customers, deploying and refueling generators, removing trees and debris and repairing and replacing physical damage to cables, fiber, dropped and other network equipments. I would like to thank all of our employees who kept their communities connected through these devastating storms.

As I mentioned, we completed the systems conversion activities during the second quarter, and we have all states and markets operating on one set of systems, which is a competitive advantage in this industry. During the second quarter, our call center representatives and field technicians were getting more proficient on the new systems. Our General Managers have also gained a better understanding of their markets with the new recording and measurement tools we provided. With these activities behind us, and the entire company on one set of systems, we are now moving forward focused on revenue growth, cost reductions and broadband penetration.

Several initiatives underway include: An upgrade to our Frontier websites later this summer, which will greatly enhance online customer sales, provisioning and service activities; improvements in sales and retention based on a simple and flexible pricing structure we launched in mid-July that provides customer choice on bundles, all-in pricing with no hidden fees and eliminates old promotional credits. Slide 6 shows how our new service offering leads with attractive broadband tiers, from 1 megabit per second to over 50.

In commercial, we are leading with broadband. Fee products like Ethernet, dedicated Internet access, wireless backhaul and customer premise equipment represent 50% of total business revenues and grew 4% on an annualized basis in the second quarter.

Turning to Slide 7. Frontier continued to deliver excellent expense management. Our 49% adjusted EBITDA margin for Q2 2012 is the highest since the acquisition. We reduced costs organically and recognized an additional $9 million in synergies. The completion of our systems conversion is expected to further increase cost efficiencies through simplified processes. Further network integration and real estate consolidation will enable us to continue to reduce costs.

Our expenses should also begin to reflect greater labor efficiencies in the coming quarters. In the first 6 months of 2012, we ratified 11 union contracts, representing approximately 13% of our union employees. Since July 2010, we have ratified 33 contracts, representing 33% of our union employees.

Our ratification process is a win-win for both the unions and Frontier because it maintains good jobs and benefits in an extremely competitive industry and difficult economic environment, while providing for modest wage increases. In many contracts, we have also implemented increased employee medical expense contributions, curtailed pensions for new employees and increased hour flexibility for technicians to sell and install products like Dish and Hughes. We expect to complete our full contract cycle by the end of 2013.

Overall, our improving top line, lower expenses, stable EBITDA and reduced capital expenditures helped drive $285 million of free cash flows, which has Frontier on track to achieve our 2012 guidance of $900 million to $1 billion.

Our dividend payout was just 35% of free cash flow in the second quarter, and our leverage ratio was stable. We expect free cash flow to be enhanced by all the elements of our strategy that I discussed today, driving revenue growth, meeting with broadband and delivering operational excellence.

Over the next 2 quarters, we will be leveraging our network upgrades to push for market share and penetration on our broadband buildout. We will increase our marketing focus to target win-backs for both residential and small business, and we will continue to drive operating efficiencies as we take advantage of single systems, simplified bundles and standardize processing throughout all of our markets.

We are poised to drive results through our basic business and new revenue opportunities, like Frontier Mobile, Frontier Broadband with Hughes, Frontier Secure, Frontier Energy and our Tech at Home program.

I'd like to hand this call over now to McCarthy to discuss our technology roadmap, as well as some of the operational trends, before Don Shassian gives you the financial highlights for the quarter.

Daniel J. McCarthy

Thanks, Maggie. Slide 8 shows our network enhancement plans from June 30, 2012, through the end of the year and into 2013. We're enabling a significant increase in customer speed, most notably in 6, 12 and 20 megabit per second service.

We expect our 20 meg service to move from 28% of residential households today to 42% by year-end and then 52% by the end of 2013. The 12 meg services planned to increase from 33% of homes today to 51% by year-end and 60% by 2013. And the 6 meg service is planned to increase from 57% of homes today to 74% by year-end and 80% by 2013. The ability to drive these quick increases as due to our recently-completed system conversions, which lets us utilize the advanced features of our DSLAM architecture. That is also due to the extensive investments we've made in the middle-mile transport system. Frontier will be using a mix of bonded ADSL2+ and VDSL2 technology to deliver these speeds, each of which has unique advantages depending on the market and specific deployment.

In addition, we're enhancing the network to deliver VoIP services for business and are also continuing to invest in Ethernet capabilities which, by year-end, will cover 71% of our commercial customer locations. Importantly, the cost to deliver the higher speeds VoIP and Ethernet is all within our stated CapEx guidance. And this roadmap will allow us to meet our FCC commitments in terms of timing and speeds.

Turning to Slide 9, you can see the continued improvements in our overall business and in particular, the positive impacts we've seen from running states on our own systems. Total access line loss rates for acquired properties were 8.5% and compared to our solid legacy business at 6%. West Virginia, which converted to Frontier systems on July 1, 2010, has shown a dramatic improvement from 11.2% to 4.2%. While we don't expect all the acquired properties to get to this level, we are seeing good improvements in the other converted states as the 8.5% results indicate. Residential customer churn also continues to decline and all the acquired properties are closing in on legacy at 1.4%. Broadband availability improved to 85% overall.

On our 3 meg commitment to the FCC, we are at 79% and need to be at 80% by year-end 2012, a level we expect to exceed. We're looking forward to improving these metrics and believe that our speed increases will help make it possible. With system convergence behind us, all areas of the organization are aligned to improve service and increase customer revenues. Network design and engineering, field operations and marketing are working together towards this goal.

I'll now hand the call over to Don Shassian, Frontier's Chief Financial Officer.

Donald R. Shassian

Thank you, Dan, and thanks, everyone, for joining our call today. Before I get into the operations of the quarter, I would like to mention 4 specific matters that occurred in the second quarter of 2012: The $70.8 million pre-tax loss from the early extinguishment of debt; $28.6 million integration expenses; $9.8 million gain recorded in other income related to investments in Adelphia previously written off; and $1.5 million in severance costs. Adjusting for the after-tax impacts of these 4 items, our second quarter non-GAAP adjusted EPS will be $0.08 per share.

Please turn to Slide 10 to start with our top line revenue drivers. Broadband net subscribers grew approximately 5,400 during the quarter. Our new simplified pricing structure that Maggie mentioned and our broadband-only product, coupled with improved segmented marketing and increased proficiency in our call centers, is expected to drive improvements in broadband growth over the next several quarters.

Total access line losses in the quarter were 92,725, the first time that our quarterly loss rate dropped below 100,000. We are now down to a 7.6% annual loss rate. Most importantly, the acquired properties are down to 8.5%, which is 3 percentage points below the annual loss rate at closing and is well ahead of the target we established publicly back in 2009, 2010. We are on track to drive that loss rate down to 8% as we exit 2012.

Video net adds also expanded, lead by our full quarter of selling DISH in the acquired properties. Continued files to video disconnects were offset by solid sales on the DISH Hopper service. Residential monthly churn was 1.63%, up slightly, but the trend has significantly improved from 2011, and we expect it to decline further.

Slide 11 shows our revenue composition. Total revenues fell $9 million sequentially and a 4.8% decline from Q2 2011. Again, our best results in closing. The largest component of the decline remain voice revenues, which were down 2% sequentially, while data Internet revenues grew 1%. Regulatory revenue remained essentially flat.

Segmenting our customer revenue into 2 components: Residential and Business. You can see that residential revenue was flat sequentially compared to a $9 million drop last quarter as our pricing is becoming more disciplined and our customer service representatives are selling value and upselling bundles. Business revenue was down $8 million or 1.4% sequentially due to higher volume discounts, less CPE revenue and reductions in some less profitable carrier circuits. Business remains 52% of our customer revenues, and we expect our key commercial products, coupled with residential speed increases, to drive business and broadband past the 66% of total customer revenue that they represent today.

Slide 12 is a bit more color on the customer revenue breakdown. And you can see that both residential and business ARPU improved this quarter. Residential ARPU increased due to bundled services and improved pricing discipline, while business ARPU grew sequentially be at strength in wholesale and enterprise customers, offset by a decline in small-business customers.

With the speedy capacity of returning on in our markets, combined with VoIP products for small-business and easy-to-buy bundles, we plan to start taking small-business share back.

Our cash operating expenses, shown on Slide 13, continued to decline $10 million sequentially, driven primarily by $9 million in cost synergies related to the system conversion completed in first quarter. Organic expense reduction should increase going forward as we proceed further wage and non-wage savings. I would like to reiterate that we expect to remove approximately $100 million of expenses per annum beginning in 2013.

Our synergy update is on Slide 14. The $9 million we recognized in the quarter brings our total annualized rates to $640 million. These savings are the result of the total elimination of the Verizon system maintenance costs, reductions in IT contractor and other non-wage costs, and from reductions in other corporate support functions. We expect future synergies to come from further network integration and efficiencies and from real estate consolidation.

Capital expenditures, which are on Slide 15, are 13.3% of revenues in the quarter and 13.9% on a full quarter trailing basis. Our capital investments in the second quarter included 60,000 new broadband expansion homes after building 40,000 in the first quarter.

Our trailing 4 quarter free cash flow exceeded our current annualized dividend payment at over $750 million, and our Q2 payout ratio is 35%. We have added a line to this chart, which show cash flow from operating activities less capital expenditures. These figures are derived from the GAAP cash flow savings.

The primary difference between this measure and our definition of adjusted free cash flow is that we exclude integration capital expenditures in the integration expenses. These are nonrecurring items relating to the acquisition and its integration that are not useful in truly understanding the underlying cash-generating capability of the company during the quarter, and therefore, its cash-generating strength going forward.

In order to drive that point home, I would like to reiterate that our integration operating expenses and capital expenditures will be declining through the rest of this year and will be completed this calendar year. At that point, the primary difference in the 2 definitions will be working capital changes, which will fluctuate quarterly based on seasonal activities, and our management of receivables and payables.

Our unrestricted cash balances at Q2 were up $44 million compared to the first quarter of 2012. Even though we used $60 million to buy back $58 million of our 6.25 notes due 2013 in the open market and $15 million to pay down other scheduled term loan principal.

As you can see on Slide 17, leverage stabilized based on our EBITDA performance, increased cash and the slightly -- net reduction in outstanding debt. With cash and restricted cash on hand, and our undrawn $750 million revolving credit facility, our liquidity is again very robust at $1.3 billion.

Slide 18 shows the debt profile. On May 17, we raised $500 million of debt that we structured to mature in 2021, a year on which we have no maturities. We used proceeds from the offering for a tendered bond due in 2014 and 2015. While the 9.25% coupon was above our target cost of capital. We felt that it was important to address upcoming maturities, given global uncertainties, and as well as the U.S. economic situation heading into an election.

Please note that the effective interest rate on the tendered debt was higher than the new issue coupon due to the fact that the tendered bonds have been issued at a discount back in early 2009. Our cash and restricted cash totaled $515 million as of Q2 2012. We expect our free cash flow as a dividend to build on the balance sheet and to be more than sufficient to pay off our 2013 maturities.

Our 2012 guidance remains unchanged, as shown on Slide 19. Our free cash flow puts us over the midway mark towards our 2012 guidance. Capital expenditures guidance is still $725 million to $775 million. Even with the investment to increase speed and capacity that Dan McCarthy discussed, we expect to be within this range. I would like to reiterate our 2013 capital expenditure guidance that we gave this past May in an 8-K filing of $625 million to $675 million, which is approximately $100 million below our 2012 estimate.

Please note that our Q3 results may be negatively impacted by the very extreme storms that hit West Virginia, Ohio, Indiana and Carolina at the end of June and early July. We're still quantifying the impact of these storms.

Finally, I'd like to comment on 2 other important matters: Pensions and the Connect America Fund. We expect the recently-enacted Highway Investment Act of 2012 to lower our expected cash pension contributions over the next 2 years. For 2012, our originally disclosed pension contributions estimate was $60 million. We now expect that level to be between $30 million and $40 million, each will be contributed in Q3 and Q4. As we contribute cash in the second half of the year, the noncash pension added back to adjusted EBITDA will change accordingly.

Secondly, Frontier announced last week that we have accepted of $71.9 million in Connect America Fund Phase 1, even after we accounted for -- by Frontier as a capital expenditure offset, formerly known as the contribution related to construction. They will not be accounted for as revenues. We expect to begin receiving in fund in August and deploying the capital for household expansion shortly hereafter. Our buildout plans are across from several states with a heavy emphasis on Wisconsin. We are required to fully deploy the capital within 3 years.

In summary, Frontier delivered a solid quarter on many of its key metrics: Revenue, expense, EBITDA, free cash flow, active point losses, customer losses and residential business revenue per customer. Our network enhancements, simplified pricing structure and marketing efforts will improve both residential and business results in the second half of this year.

And with increased speed, solid partnerships and a new go-to-market strategy, we look forward to reporting back here in early November with our third quarter results.

With that, let me pass the call back to Rebecca to open the call up to questions.

Question-and-Answer Session

Operator

[Operator Instructions] And your first question will come from Batya Levi with UBS.

Batya Levi - UBS Investment Bank, Research Division

These were very good results with especially revenues beating our estimates. First, can you please comment if there were any accruals or any one-time rates on the revenue side? And just looking out into the second half, can you talk a little bit more about how should we be thinking about the revenue improvement? You have ICC reform kicking in since July. And maybe if you could comment about what you're seeing in the macro environment? And you also mentioned that you expect to gain some share in the business segment, how all of that fits together in terms of revenue forecast for the second half?

Donald R. Shassian

Batya, on the first question, well, one-timers, they are really one-timers. A couple of items typically offset each other. There's nothing really significant. It was really -- it's very, clean quarter in the revenue side, both on the voice side -- the local voice side, on the data side and on the weather side. And switched had a minor negative because of our local switching support true-up that really is quite minor. So it's really a very clean quarter all around.

Mary Agnes Wilderotter

Batya, it's Maggie. Thank you for the compliment on the quarter. We agree with you. It was very solid for Frontier. Let me talk a little bit about revenue. We are, I think, very focused on that subject and with the convergence behind us, it's really enabled us to have full transparency of all the products and services that our customers are taking today, both residential and business and to start to really move out with some new products and services that we think will provide revenue lift for the company. A good example are the residential products we just launched on July 15, which is a new set of bundles. It's basically a very simple way for a customer to create their own bundle. We did not have that capability in the acquired property on the Verizon system. So this gives us full flexibility for the customers, both online and offline, in terms of very simplified bundles and a very simplified billing that goes along with that. In addition to that, as Dan talked about, we have a number of higher speeds that are available now to customers, but these bundles have tiers to them that allows us to upsell customers to an ultimate and ultra-package in many cards of our footprints. So we're very excited about that on the residential side. We'll also have the Frontier Broadband by Hughes product set, launching it in the fourth quarter throughout the country. So, we're also excited about the opportunity to reach several hundred thousand households that we weren't planning on selling to this year, that will be upside for us in that fourth quarter. If I shift over to the business side, we have a very strong pipeline for CPE. We have found that with the macroeconomic environment, we haven't seen things get better, we're not really seeing things get worse, but customers, especially in the business side, are taking longer to make decisions, so we have a knock on the pipeline that we feel very positive about continued strong CPE growth. We have a number of wireless backhaul towers we're going to be building in the second half of this year. We've also launched a new small business product called the Dash [ph] product. That is a combination of VoIP for voice and IT for small businesses, up to about 10 people in a small business. We've launched that in 4 states so far. It will be in 13, 14 states over the next several months. We've had very, very good take rates, and I think, as Don mentioned, with that new capability, it will enable us to do very good win-backs in the new market. In addition to that, we're launching a simplified pricing for small business, similar to what we've done in the residential side in the next 30 days. So there's a lot of moving pieces, but we feel very good. We have a full portfolio of initiatives that will drive revenue. In addition to, as you've seen lower churn, lower access line losses, and we really do believe we can drive broadband penetration significantly over these next couple of quarters.

Donald R. Shassian

If I can add on to that Batya, and the question about [indiscernible] in this quarter, we do not expect to see a very -- any significant impact on revenues except for the rebalancing, if you would, of regulatory revenues declining and the offset being more up in the local voice side. So we'll do some rebalancing within the income statement. We don't expect to see very significant impact in the third quarter for that.

Mary Agnes Wilderotter

Correct.

Operator

And next, we'll go to Simon Flannery of Morgan Stanley.

Simon Flannery - Morgan Stanley, Research Division

Maybe we could stay on broadband. Maggie, you talked a lot about the opportunity there. Can you just remind us of the size of the opportunity? Give us an update on where you are in terms of penetration of total households in your acquired versus your legacy properties and where you are in terms of the buildout now that now that you're taking the money from the Connect America Fund. So how should we think about that sort of untapped opportunity in a sense? And then on the Connect America Fund, there's been very different responses to the opportunity by you versus some of the other carriers. Can you just talk us through your thought process, your decision process that made you decide to take this money?

Mary Agnes Wilderotter

Simon, I'm going to let Dan talk a little bit about the broadband penetration. We actually track that on a daily basis, too. And he can give you more insight as to how we're doing in the new build areas and some of the focus areas that we're doing over the next quarters. So -- and then I'll come back to the Connect America Fund.

Daniel J. McCarthy

Thanks, Maggie. Simon, we've actually continued to open up more and more sites throughout the second quarter. So as we sit here today, our penetration of the new areas that we've opened up is about 16.4%. It varies from about 10% to 11%, up to a high of about 25% to 26%. And we continue to enjoy good results in areas that we've opened up over the last several years. In the second half of the year, we plan on continuing to upgrade on our broadband expansion with about 89,000 additional households in the second half of the year. In addition, we'll be looking at -- moving as quickly as possible on the cap-related households that you asked about. As we go forward, we're finalizing the design phase. The only thing that will hold us back from getting more of that into this year as well as the winter construction season in some of the areas especially in Wisconsin, as Maggie pointed out. So we're very bullish on that. In addition, we've moved forward, as I noted, in upgrading the speed profiles in a number of areas using the bonded ADSL2+ and the VDSL capabilities and the [indiscernible] that have been deployed to date. So we see that as one of the biggest opportunities for us, both from a cross-sell perspective and moving customers, up in speed and up in ARPU, as well as a gross activation perspective.

Mary Agnes Wilderotter

Yes, just to sort of answer what Dan said, a lot of these new households that we're turning on in the second half of the year, Simon, are not -- are noncompetition households, too. So we do think that will help drive that penetration up more so where it is today. The 16.4% average, that includes anybody we turned on yesterday, and also households that have been turned on for a 12-month window or more. So you'll see those numbers continue to rise every single quarter. Let me shift over to the Connect America Fund. When we went through the process of looking at household availability that we can build, and the costs associated with building those households, I think we all know there is the $775 amount per household that we could take from the FCC, we had ample households in our markets where we could build for that price or less. So we felt very good about taking 100% of the money because we still have several hundred thousand households to build out, and many of them still in a density area that we could afford to do it with the tax money.

Donald R. Shassian

And now we're focusing on acquired properties.

Mary Agnes Wilderotter

Right. It's all focused on the acquired properties. We're not doing it if we are in legacy at all because I think as you know, we're at like 93% reach in those markets. So we sort of had a different point of view from other carriers because we have so much rural properties that hadn't had broadband built in those areas from the Verizon acquisition. So it really gave us that opportunity to take 100% of the dollars. And to put them to work in such a way that it's a win-win for the customer, for us and also helps drive what the FCC is trying to accomplish, and that's getting broadband more quickly deployed in rural America. The other good part of going to that cap exercise is you basically had to do a lot of engineering work to figure out who could qualify or not and whether it could work or not for us. So as Dan said, I think we can move fairly quickly. We'll start to receive funds in August, and we're going to start building in August. So I think we have the opportunity to turn on some households this year that we weren't expected to do. And again, these are unserved locations that really are not competitive at all. So there's no competition in those areas. So we're pretty excited about it. We think that this is going to be good for Frontier and good overall.

Operator

And next, we'll go to Mike McCormack with Nomura Securities.

Michael McCormack - Nomura Securities Co. Ltd., Research Division

Don, maybe just a quick follow up to Batya's question thinking about the revenue. I know last quarter you identified the bad debt change on the other line, which helped boost it up, I guess. I think at 11 million sequentially. It looks like we've remained at a pretty high rate on other. I'm just trying to get a sense for what's driving that? And then data and internet, you had a bit of a headwind, I think, from billing stuff and [indiscernible] interest rate going away. You had a little bit of a boost there but I think consensus is a bit higher. I'm just trying to get a sense for what the moving parts are and how we should be thinking about that as we model forward? And then just lastly, maybe Maggie, if you could just make a quick comment on the economy. I think you mentioned something about the decision making lengthening out a bit, and I know you guys identified [ph] but you're disconnecting some non-profitable circuits, and the CPE is down a bit. How should we be thinking about business revenues as we progress through the year?

Donald R. Shassian

Mike, we really -- other is really running at a new level right now with all the moving pieces that -- DISH gross adds being very, very robust, we're getting some nice lift and a lot -- and some other whole connection revenue being very strong, bad debts having to manage through that process, we're trying to get sort of a new level right now so there was some lift last quarter, both on bad debt reversal and [indiscernible] bigger reversal and the really situation [indiscernible], early termination fees -- late payment fees, rather, but it's really running at a level that's really pretty consistent with fee going forward. That data, it's -- the difference is kicking in. We have been very good [indiscernible] appraising into our customers and really trying to make sure that we are moving the prices up in a right direction and looking at customers who are paying way below where they should be. They are not a valued customer. If we can't get them up, we're sort of let them disconnect off, if you would, and it's enabling us to be more disciplined [indiscernible]. So that data, we're hoping, is going to continue to lift, can start -- either get that moving and try to just really manage through this voice is actually [indiscernible] minimize the decline.

Mary Agnes Wilderotter

Yes, and just to add to that, Mike, on the data and Internet side, we also don't have any automated credits that we're putting on customers' accounts that happened on the Verizon systems. We didn't have visibility to that before the conversions. After the conversions, that went away. So that really helped with the pricing discipline to make sure that we are billing customers for the products and services that they are taking from us. And we don't have sort of legacy, old promotional credits that sort of hang on, on these bills that don't belong there anymore. So I agree with Don, I think you're going to continue to see lift on the data site. And we feel good about that. I think you'll continue to see acceleration in terms of penetration that will help as well. With regard to the economy, as I mentioned, the economy is stagnant throughout the United States. We are not seeing any material growth. We're not seeing small businesses going out of business like we did in 2007 and 2008. But we do see a level of caution of the commercial side. I think commercial customers are watching what they spend and how they spend it. So we also think that some of the new products and services we have for -- especially our small businesses, which is the maturity of our business customers, will really help us grab share and bring penetration over to our side. So we're not negative about it, but we're realistic to know that CPE is taking longer to get deals over the finish line. But we do have a great pipeline there. So we feel good about that, that we'll do well with CPE. It depends on which quarter the sales wind up in. And medium and enterprise are holding their own. So I think, and wholesale, again, has been strong on the wireless carrier side in terms of backhaul. So I think we have pretty good line of sight for the next couple of quarters. But who knows? It's an election year. I don't know if the economy's going to fall to the face of the earth over the next 3 months. But so far, we're cautiously optimistic that we'll continue this momentum.

Operator

And next, we will go to Chris King with Stifel, Nicolaus.

Christopher C. King - Stifel, Nicolaus & Co., Inc., Research Division

Just one quick housekeeping one first, and that is on the integration costs. Just was wondering how we should kind of model those winding down over the course of the next 2 quarters, whether we would see a little spike up in the fourth quarter as those kind of went away, or whether they should continue to trend lower sequentially as we work through the year? Secondly, just on your balance sheet, just wanted to see if, Don, you would confirm that the short-term debt position on your balance sheet, if the plans were, at this point, to just retire that upon maturities and cash on hand? And then lastly, from a regulatory standpoint, just was wondering if you guys could give your latest thoughts on special access reform and where you guys sit on that debate.

Donald R. Shassian

Well, Chris, on the integration expenses, it'll be declining sequentially the next 2 quarters. They will not be a very large item in the fourth quarter. Most of our expenses are continuing from conversion of debt. We've got some things we just continued to clean up. We've got some systems conversions that have [indiscernible] just given the finished work. We've got a couple of integration into the network and to the real estate consolidation. So I figured if they're trending down, it will not be a big hit into the quarter. On the balance sheet, short-term debt, yes, we -- our cash on the balance sheet, plus our residual cash free flow that will be generated over the next 2 quarters will be used to pay down the maturities in 2013. Okay?

Daniel J. McCarthy

Special access, Chris, I'll just add on special access reform side. At this point, we really have not taken a large public position on that. We're going to see it really impacting us as we go forward through '12 and into '13. We could see a lot of carriers actually moving forward and purchasing Ethernet services. And some of that pressure around the special access reform seems to have abated with their discussions with us.

Operator

And next, we'll go to Phil Cusick with JPMorgan.

Philip Cusick - JP Morgan Chase & Co, Research Division

Maybe a few quick ones. Can you update us on how you're thinking on cash taxes on '13? And can you give us an idea on the 2013 pension contribution as well?

Donald R. Shassian

Cash tax, I think what folks have been modeling for 2013 is between $200 million and $300 million. And so I don't think that's a range I'm going to leave out there. I going to be able to have a better handle of that as we finalize our tax returns for '11, which we'll be filing shortly. And I think the range of that, well, I'll just say, is still appropriate. And so I'll just sort of leave that range that people have of between $200 million and $300 million. Pension contributions. I think it's going to be approximately $60 million. I think that's the best [indiscernible] I think that it will be out there. We certainly -- we see that the rates are -- that the government puts out with this higher [indiscernible] came out. And I think in that zone is the proper item to be modeling off of.

Philip Cusick - JP Morgan Chase & Co, Research Division

And if I could, you're running to about right in the middle of your CapEx guidance for the year. What's the sensitivity to the high- and low-end of that at this point?

Donald R. Shassian

I think it's -- I'll start, and Dan will add in. I mean, there's an awful lot of activity that Dan and his people are doing and trying to move things in and trying to be as good -- as much as we can and make sure to obviously take advantage of a bonus depreciation this year. There's a couple of items with wireless backhaul we're looking at as well. And then there's also some IT investments that we're looking at, so there's 2 things about how much can we get done effectively and efficiently, they just spend the dollars and not be effective and efficient, [indiscernible] to be managed.

Daniel J. McCarthy

No, I was just going to add that, I think, at this point, we're shooting for right where we are from a run rate perspective. Those pressures that Don pointed out to, [indiscernible] and we're managing through those right now and I think -- the only thing that I could see that might add any other pressure is just success based capital through were -- really started to take a lot of market share back.

Mary Agnes Wilderotter

We don't foresee anything even with the pressures that would get us out of the range. So we feel very good about the capital range that's out there.

Operator

And from Goldman Sachs, we'll hear from Scott Goldman.

Scott Goldman - Goldman Sachs Group Inc., Research Division

I wanted to talk a little bit about the cost side of the business. And you guys have laid out the synergies, and I think there's about $1 million of incremental organic cost that came out. And you've laid out your 2013 expectations there. I guess a couple of questions out of this, wondering how do you think about how organic cost reductions layer in for the back half of the year and where those savings will come and the timing of that for 2013? And then also on the cost side, 2Q EBITDA is stronger than we were expecting. How much of that was driven maybe lower sales and marketing and how did that trend in the quarter?

Donald R. Shassian

Well, [indiscernible] the last piece, lower sales and marketing in the quarter? No. Our [indiscernible] relatively flat Q2 versus Q1. So that is not something that drove it. We're looking at number of initiatives. We've got some things on the synergies side that we were pulling through. We have a number of network integration items we're looking at in terms of configurations on [indiscernible] that we're looking at. We've got some real estate consolidation we're also looking at. And also now we we're trying to shift back into a real business-as-usual perspective about [indiscernible] what do we mean, we felt running this business from the wage and non-wage perspective appropriately -- in real-time to actually simplify the business and get rid of unnecessary work and so there's both wage and non-wage activities that we'll be going after later on this year if you want to be able to be in a position to get that whole $100 million offer in 2013. It's in a lot of place and throughout the business, a lot of things that heard to date, in and lot of the corporate support functions, there's probably still more to happen here. And I think it's really [indiscernible] in -- as well in the field of engineering. And in call center, how can we be more efficient? How can we deliver the right service to our customers and to do it as efficiently as possible?

Scott Goldman - Goldman Sachs Group Inc., Research Division

And how should we think about the organic cost reductions in the back half of the year as opposed to 2013?

Donald R. Shassian

It's still being worked [indiscernible] I'm going to hold off giving a significant guidance for the fourth quarter. We've got a number of things we're looking at right now. And Maggie and Dan [indiscernible] connect on some things, they're trying to figure out what we were pulling through. I would -- right now, I'd be thinking more first quarter than fourth quarter. If [indiscernible] that changes, we will certainly make that communication upfront.

Mary Agnes Wilderotter

Yes, Scott, this is Maggie. Just to sort of echo what Don has said, one of the things that Frontier has always been very good at is looking at the business on an ongoing basis and making sure we stay as efficient and as effective as possible. And with us being on one set of systems now, it gives us the opportunity to really get good at these processes, to really streamline the activities that we've had and actually doing things multiple ways, getting everything done the same way. So what we're looking at, too, is as we build the proficiency, we still have some bubble workforce in the call centers that will continue to go away. And we do have proficiency and improvements, actually in productivity that we're seeing on the tech op side. We have a number of employees, too, that are going to be retiring over these next several months. And our goal is not to replace any of those retirees either. So you're going to see us continue to manage the business from a pretty disciplined point of view. So there will be organic cost savings in the next couple of quarters. But we believe that we will continue to push those, so we'll have those $100 million annual cost savings starting in '13.

Scott Goldman - Goldman Sachs Group Inc., Research Division

Great. And then just a follow-up on the revenue side, I know it's been beaten a little bit, but just on the residential ARPU, we saw the nice uptick there. I think you talked about the bundle penetration. Can you maybe just give a little bit more granularity there and maybe talk about how higher-speed broadband tiers, the uptake for higher speed, whether that's been a factor in driving that ARPU higher as well?

Donald R. Shassian

I'll start, then give to Dan. I think the primary driver, Scott, is greater discipline in pricing. It's making sure that we're charging the right prices for the product we see, the good value product and making sure that customers that are paying below that are moved up appropriately, and that we're not giving away dollars inappropriately. And I think that's the main issue. Certainly, as we move forward with the speed changes that Dan was talking about, we're looking to do price improvements relative to the speed enhancements. But that is not a factor that I would quote in the quarter.

Daniel J. McCarthy

Yes, I would agree, it was not a factor in the quarter. I think that as we go forward in the third quarter and to the fourth quarter, it will be. And I would expect to see ARPU on the high-speed sales improve as much as $10 per customer per sale depending on the mix of the sales.

Mary Agnes Wilderotter

The only other factor I'll throw in that we did see good improvements in the second quarter is on our Frontier Secure products. This is our hard drive backup, our computer security. We launched a new product called identity theft protection and, that has done extremely well. So we have seen some lifts there. And we plan to continue to see that lift through third and fourth quarter as well.

Operator

And next, we'll hear from Michael Rollins with Citi.

Michael Rollins - Citigroup Inc, Research Division

I was wondering if you'd talk a little bit more about fiber to the tower, the size of the available towers in your region, maybe your penetration of those? And then what's layered into CapEx for this year and next year in terms of the build-out for more fiber to those towers?

Donald R. Shassian

Well, I think we've got about 7,200 towers in the footprint, Michael. We have built fiber to about 3,700 of them by the end of 2014. And that's built into our CapEx that has occurred last year, this year and I would expecting the next couple of years. And it's -- we're really looking at those on a one-off basis with the economics, bidding them on appropriately to get the right return on the capital that there is -- and working with a number of carriers that are working with us to get them built when we need to have them built. Some people want them yesterday and they really don't need them. Others want them several months from now, we're trying to make sure they're built at the appropriate time so that we can balance our CapEx spending with the ARPUs that we think we could balance with our shareholders. Hopefully that helps?

Michael Rollins - Citigroup Inc, Research Division

Okay. And can you just give us where you are today?

Donald R. Shassian

In terms of the number built today -- one second. I think it is 2,600 -- 2,300 built today.

Operator

And next, we'll go to David Barden with Bank of America.

David W. Barden - BofA Merrill Lynch, Research Division

So just first on the cap front, if I could, Don or Maggie, you guys kind of took a different more aggressive approach in terms of taking that money down and probably the most -- I don't know, the biggest criticism we've probably heard from the other carriers about the system was that $775 was just not going to be enough money to really get to a lot of households. But you guys found exactly 90, no, no, no, 2,000 households or something at $775 each. And so could you talk a little bit about how kind of did that math maybe differently than the other carriers did in terms of taking those funds. I think the second thing was also, Don, there's, I think, been a little bit more hesitation in terms of kind of embracing the Highway Bill to this point in time universally to kind of cut the pension funding because of the theory that maybe if you make even larger pension contributions this year, you could kind of hold on to the tax benefits of those contributions and there's some other trade-offs that come later. So if you could talk a little bit about your decision there will be helpful as well. And then if I could just ask one last one, just the last one was, the consumer ARPU was really strong this quarter, up like a $1. If you could talk about some other drivers behind that, it'd be great.

Donald R. Shassian

Okay. David, first on the cap, I think you really need to look it up in terms of legacy and acquired property. I think our legacy properties, as you look at the economics of legacy, it probably -- is very similar to the other carriers, they did not take the dollars. If we were just legacy, we would not have taken dollars because we're reaching 92% of the homes already to reach the incremental portion of that 8%. So $775 would not have been economically feasible for us. But the acquired properties, they make commitment to the FCC in the various [ph] states to get ourselves to 85% by a certain date. Taking the 85% up to like 92% is where we have that opportunity to get others don't have. And that's the sweet spot here where this makes sense for us and where it may be quite different from other carriers. Hopefully, that helps you get a perspective. It's not a different math, it's simply we got a different grouping of properties that are not already a huge reach up to 92% and really -- these dollars can really help us get up to that level with that kind of [indiscernible] situation.

Mary Agnes Wilderotter

And also, we can build in that sweet spot, that 85% to 92% at a lower cost, of course, than if you can build that 92% to 100%. So there's still better density in that 85% to 92% that allows us to take the cash money and put it to work and have it be a positive return for Frontier. Get broadband out faster to a bunch of customers that we would have built anyway, at some point in time. And it also accomplishes the objectives of using the funds that are available from the FCC. We actually could have taken more money, if they had one. So we felt good about it. We totally understand why the other carriers made the decisions they made because we didn't -- we're not building anything on our legacy markets. So it's the money. It's all in the acquired properties where we still had pretty low penetration with enough density to support the parameters that the FCC put in place.

Donald R. Shassian

David, does that answer your first question?

David W. Barden - BofA Merrill Lynch, Research Division

Yes, I think it cleared it up. And you guys had regulatory obligations anyway, and this money is just like a net help to kind of get there, so you took everything.

Donald R. Shassian

No, no, no, no.

Mary Agnes Wilderotter

Above and beyond that...

Donald R. Shassian

Above that...

Mary Agnes Wilderotter

Yes...

Donald R. Shassian

This subsidy is not helping us achieve the FCC and state requirements and commitments.

Mary Agnes Wilderotter

Right.

Donald R. Shassian

This is taking us above those commitments. So the commitments were already getting us to 85%. This is going to take us north of 85%, getting us closer to the 90%, 92%, if you would, where it becomes very expensive. And your second question on the tax benefits. The savings here in '12 and '13 are $20 million, maybe about $30 million to $40 million. I think there's certain tax benefits here, but it's no for us like a savings of $50 million to $100 million in the tax bill. And so I think the tax bill, which is not being that significant, but where you think interest rates are going to over the next number of years. I don't believe that interest rates are going to spike hugely in the next several years, where we are going to all of a sudden be losing out on an opportunity on this thing. And I think what the plan that does [ph] it, puts more of a smoothing mechanism in it in what predictable [ph], It's really volatility. And I think that's good for how to manage the business and for how the [ph] stakeholders have you lost? And third, on the commercial ARPU, I think we try to hit -- the customer ARPU, we try to hit this earlier. It really was, usually, the pricing discipline. And we talked about in the future calls [ph] the visibility in managing certain business -- customer accounts. And what this really has enabled us to be one [indiscernible] is really be able to analyze what's being offered to customers, what's it's already been offered to customers and to keep some disparities that have existed over the past number of years that we're cleaning up, and we're looking to ARPU and customers. It's not raising necessarily the ARPU on existing authors in the marketplace. It's being disciplined about them and that's in discounting. But it's also going back and making sure that lower ARPU customers are getting some staggered increase, if you would, and trying to make sure the value is being put on the table. So the choice is a better focus on pricing.

Mary Agnes Wilderotter

Yes, and keep in mind, too, with the type of bundles that we have in the marketplace today, which are called custom valued pricing bundles, that we don't have to run promotions to discount off of those bundles. The customer will have got a discount for taking multiple products and for being a Price Protection Plan customer, and that sort of builds into how we sell and support those bundles. But we're not giving additional promos on top of that. So that pricing discipline really does make a difference in improving ARPU.

David W. Barden - BofA Merrill Lynch, Research Division

So is this $58 kind of residential ARPU that we saw kind of up $1? Is that kind of going to be trending now in that direction? Or is it kind of plateauing in this area?

Donald R. Shassian

Well, I think -- we totally hope we are going to be going to continue a bit more. But we're -- I wouldn't start modeling significant increase in ARPU, until we start making some for those opportunities here. But I think it's a good level where it is. We're trying to be more disciplined and try to win that meaningfully.

Mary Agnes Wilderotter

But of course, we're pushing. We want to see revenue continue to go up. And we've got a lot of new products that we're putting out in the marketplace that we think will help us.

Operator

And your final question will come from Frank Louthan with Raymond James.

Frank G. Louthan - Raymond James & Associates, Inc., Research Division

Can you talk to us a little bit, just quickly, what sort of margin and revenue you get on the Frontier Secure product? And then can you give us an idea on what extent increasing rates and sort of rightsizing some of the rates on broadband sort of impacted the broadband adds? And at what point we expect to see that accelerate a bit? And can you give us an idea on your enterprise sales force, what's the number there and how is that trending as far as driving additional revenues?

Mary Agnes Wilderotter

We're just trying to...

Donald R. Shassian

Frontier Secure. I think it's about 35% to 40% margin...

Mary Agnes Wilderotter

Right.

Donald R. Shassian

On the products that we sell. It was, obviously, reaching another provider to sort of give us any assistance with a backside data storage with those. We are obviously using our own in-house people to be able to be sort of the tech support for that as well.

Mary Agnes Wilderotter

It runs about, on average, around $8 per customer who takes Frontier Secure, Frank. And we do have several hundred thousand customers on the product [indiscernible].

Daniel J. McCarthy

And Frank, on the commercial sales force side. I think, we've developed a very good competency in managing our existing talent base. We're shifting the focus now, where we're creating kind of hunter teams that are really dedicated to go after driving market share. And that's why I think a lot of the opportunities, especially with the new data products, as well as the voice products that we're going to put in the market.

Donald R. Shassian

And we have approximately 400 salespeople, Frank, in the commercial centers.

Frank G. Louthan - Raymond James & Associates, Inc., Research Division

And what is that up from, say, 12 months ago?

Donald R. Shassian

12 -- I would say -- I think that's well up about 100 -- about 100 -- maybe north of 100 -- we closed the transaction in new properties. There was no real commercial sales force that came with that. So we've been building that. And I think over the past 18 months, it's going up about 150, so it's pretty large. And really bringing most sophisticated solution selling folks into the mix. And we really -- I think they starting to hit their stride. We try to get closer, Maggie talked about sales processes and taken a little bit longer to get closed. Businesses are being more deliberate about things. The pipeline is growing. I think their proficiencies are getting a lot better. And [indiscernible] and other products should be enhanced and ethernet products are being available, I think their ability to start getting closure. As we've been saying, second half of the year, we're very excited about.

Mary Agnes Wilderotter

Yes, we also put some specific people in that number on CPE on a dedicated basis, Frank, so they could really work side-by-side with the medium and enterprise regular salespeople to get these deals over the finish line, especially when you've got big deals like 911 systems that are pretty sophisticated sales processes. So we have some experts that really do focus on the CPE side. In addition to that, we also added, in that number, there's a number of small business account executives that we put in the regions within the market that we did not have before. As we've looked at the penetration for small business, we think there are some big upside on the win-back side, as Dan said. So these are hunters that are going to go after win-backs for us in those markets. So again, these are revenue-generating headcount for us. And we've hired a number of them, and it's going to get them up to speed and getting them active in the market and starting to drive penetration.

Donald R. Shassian

Frank, did you have another question we did not answer?

Frank G. Louthan - Raymond James & Associates, Inc., Research Division

Yes, just to what extent did -- you made reference to adjusting some rates and of some -- maybe some legacy customers on broadband. And did that have a negative effect on the broadband adds? And at what point do you think we will have flushed all that out and beyond more of a normalized course?

Donald R. Shassian

I think the pricing discipline and the pricing philosophy we implemented is probably going to be going on for 6 to 9 months. We're going to see new customers coming in. We're going to see existing customers going -- pricing going up. We are going to see some existing customers not liking what we are doing, and start dropping off. But I think it's going to be, ebb and flow for the next 6 to 9 months.

Mary Agnes Wilderotter

Yes, but I'll also say to Frank, for this quarter, to me, the broadband net adds that was really more about the rest of the cleanup we had to do for the system conversions from the first quarter. I mentioned the storms, that was the last 4 days in the quarter. We didn't have anybody installing broadband in those -- in 3 of our 5 largest states. And then the cleanup continued into the first part of July. So we see a very robust pipeline for broadband. And our pricing is very competitive in the marketplace. So I'm probably a little bit more bullish than my CFO in terms of customer reception to what we're doing from a pricing perspective because we're competitive. It's not like you go someplace else and you're getting a better pricing than you're going to get from Frontier. So we feel good about what we're doing, and I think we will continue to see acceleration from a penetration perspective on broadband now that we've got all the system conversion cleanup behind us.

So in closing, I just want to say to everyone who joined us on the phone and also on the web, thank you for taking the time. We did have a very solid second quarter. We are excited about the next 2 quarters coming up. And we look forward to reporting solid results here again in November for the third quarter. Thanks, again.

Operator

Ladies and gentlemen, that does conclude today's presentation. We do thank everyone for your participation.

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Source: Frontier Communications Management Discusses Q2 2012 Results - Earnings Call Transcript
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