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Cbeyond Inc. (NASDAQ:CBEY)

Q1 2008 Earnings Call Transcript

May 1, 2008 5:00 pm ET

Executives

Kurt Abkemeier – VP of Finance and Treasurer

Jim Geiger – Chairman and CEO

Bob Fugate – EVP and CFO

Analysts

George Sutton – Craig-Hallum

Frank Louthan – Raymond James

Jonathan Chaplin – JPMorgan Securities

Jurgan Usman – Wachovia

James Breen – Thomas Weisel

Eric Kainer – ThinkEquity

Erin Schmitz – Citigroup

David Dixon – FBR Capital Markets

Donna Jaegers – Janco Partners

Jonathan Schildkraut – Jefferies

Operator

Good day, everyone, and welcome to the Cbeyond Inc. first quarter 2008 earnings results conference call and webcast. As a reminder, this call is being recorded. At this time, for opening remarks and introductions, I'd like to turn the call over to the Vice President of Finance and Treasurer, Mr. Kurt Abkemeier. Please go ahead, sir.

Kurt Abkemeier

Thank you, operator, and thank you, call participants, for joining us today. I'd like to begin today's call by reminding you that this call contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements include, but are not limited to, statements identified by words such as believes, expects, anticipates, estimates, intends, plans, targets, projects, and similar expressions. Such statements are based upon the current beliefs and expectations of Cbeyond's management and are subject to significant risks and uncertainties. Actual results may differ from those set forth in the forward-looking statements.

Factors that might cause future results to differ include, but are not limited to, the following: The risk that we may be unable to continue to experience revenue growth at historical levels, changes in federal or state regulations or decisions by regulatory bodies that affect the company, periods of economic downturn and the resulting inability of certain of our customers to meet their payment obligations, the timing of the initiation, progress or cancellation of significant contracts or arrangements, the mix and timing of services sold in a particular period, competitive factors, our ability to recruit and maintain experienced management and personnel, rapid technological change and the timing and amount of startup costs incurred in connection with the introduction of new services or entrance into new markets, our ability to maintain or attract sufficient customers in existing or new markets, our ability to respond to increasing competition, our ability to manage the growth of our operations, changes in estimates of taxable income or utilization of deferred tax assets which could significantly affect the company's effective tax rate, pending regulatory action relating to our compliance with customer proprietary network information, and general economic and business conditions.

You are advised to consult any further disclosures we make on related subjects in the reports we file with the SEC, including the risk factors in our most recent annual report on Form 10-K, together with updates that may occur in our quarterly reports on Form 10-Q and current reports on Form 8-K. That discussion covers certain risks, uncertainties, and possibly inaccurate assumptions that could cause our actual results to differ materially from expected and historical results. We undertake no obligation to correct or update any forward-looking statements, whether as a result of new information, future events, or otherwise. On the call today we have Jim Geiger, Chairman, President and CEO, and Bob Fugate, Executive Vice President and CFO. With that said, I'll turn it over to Jim Geiger.

Jim Geiger

Thank you, Kurt. And I'd also like to welcome you and thank you for joining us today. The purpose of the call today, as Kurt mentioned, is to review financial and operating results for the first quarter of 2008. I know that investors are paying close attention to the remarks of companies as to the effect of the economy on their business. In our case, while we wouldn't want to overstate the significance of the economic downturn, we have certainly felt some impact, mainly in the areas of receivables and churn last quarter, and to a lesser degree, in the areas of churn as well as customer additions this quarter. Despite the economic pressures, I believe that our business has performed very well, and I am pleased with our performance and as optimistic as to any time in our history about our continued organic growth.

In the first quarter, we grew customers by 25.7% year over year, revenues by 27.7%, adjusted EBITDA by 20.1%. We recorded strong adjusted EBITDA margins across our markets, turned Los Angeles free cash flow positive on schedule–our sixth market to become free cash flow generating–saw concrete results in our efforts at reducing both customer churn and bad debt expense; maintained stable ARPU; grew applications use per customer to 6.4, with 26% mobile penetration as a customer base; and a continued mobile attach rate of over 40% of new sales. We launched hosted Microsoft Exchange to our Atlanta customers, began serving customers in our tenth market–Miami–and we also prepared our eleventh market–Minneapolis–for launch this summer.

On our last call, we spoke at length regarding the increase in customer churn and bad debt expense that we experienced in Q4. We noted that the challenging economic environment had increased the number of our existing customers who were unable to pay us, and we described the steps we were taking to address this situation. As you may recall, we tightened customer credit and flushed 300 of our weakest credit customers from our base in Q4 and forecast that we would flush another 300 in Q1, resulting in 1.4% churn for each of those two quarters.

Today I'm pleased to report that the steps we took in the customer credit area have been successful so far in improving the health of our receivables and customer base. We had anticipated that with the continued disconnect of non-paying customers, the Q1 monthly customer churn would remain at the Q4 level of 1.4%; however, we saw it reduced to 1.3%. As in the past, our elevated churn rate above historical levels is solely due to what we call uncontrollable churn, which is due to customer non-payment and other factors beyond our control. Our controllable churn rate has remained unchanged at our historical low levels of 0.4%.

In addition to this positive result in the area of churn, our credit tightening resulted in immediately positive results in the area of bad debt expense. We reduced bad debt expense from 2.7% of revenue in Q4 to 1.8% in Q1, a reduction of $500,000 in expense. The credit and churn issue that arose last quarter was approached the way we approach any challenges that arise in our business, with an intense focus and drive for excellence. Our current visibility into churn indicates that churn is trending lower in Q2, and our goal is to return to more historic levels of churn over the next several quarters.

Now I'd like to turn to sales and marketing. I believe that our expertise in selling to small businesses is an essential core strength. We now operate in 10 major markets and employ nearly 500 direct sales reps who are focused on acquiring new customers, plus we have additional teams of reps who upsell to our customer base, and we have account managers supporting our indirect channel partners. The backbone of this organization is our sales management, which we largely develop and promote from within. It's a difficult job, and we expect a lot from these young managers. They're a talented group of men and women selected for their energy and leadership skills. We've often talked about the consistency of our performance across our markets and how our internally developed management is a key part of that. We're proud of our 28% organic growth in revenue, and we're as convinced as ever of the long-term potential for sustained growth rates.

But we did experience lower net customer additions than planned in several cities during Q1. Externally, we report net customer additions, which are the number of customers installed in the period net of those that disconnected or churned. While net additions were lower than we'd hoped at 1,633 in the quarter, remember that we had extra disconnects in the quarter from the credit tightening purge. Although our Q1 gross installs–and therefore our net additions–were lower than we wanted, our gross sales were 8% higher in Q1 than our Q4 level, and most of these Q1 sales will be installs or net additions to our customer base in Q2. So the trend is positive.

So given what we're seeing currently, we expect net additions to return to higher levels in Q2, probably around the 2,000 figure and growing from there in subsequent quarters. In addition to our continuing focus on new customer acquisitions, as you know, we have been building our capabilities in the area of upselling over the last year. We have been steadily building our staffing in this area, which we call our Solutions Advisors, or in the vernacular, I've heard them referred to as either farmers or miners, mining our customer base for more opportunity-generating application usage. This function has contributed meaningfully to our growth in application use and our stability in ARPU.

On the marketing side, we continued to support our sales force in Q1 with the tools they need to excel at their jobs. As I mentioned before, we launched hosted Microsoft Exchange during Q1 in our Atlanta market and gained experience with this important new offering in the quarter. With Exchange, our customers can enjoy the benefits of advanced email and messaging services, including Common Calendar and Contact function, and over-the-air synching for their Blackberries and Windows mobile devices. We are very careful and deliberate in rolling this product out. Most of our customers don't have any experience with Exchange. The launch of hosted Microsoft Exchange has introduced a number of new support requirements, including desktop installation support for the popular Outlook 2000 messaging clients.

We wanted to make sure we had a good handle on the complexities of our new infrastructure, as well as the customer support resources needed in one market, before rolling it out more broadly. While it's still early, we're very pleased with the results it's offering. We had a 40% attach rate of Exchange on new customer sales in Atlanta in the quarter. And 25% of those customers upgraded to our premium offering, which was double what we had expected. We also had a strong pull-through of Blackberries with that Exchange, and the number of mailboxes purchased per customer was also encouraging. Based on our success in Q1, we are rolling out Exchange to our other markets over the next several months.

Exchange is a great example of how we are delivering on our mission to bring big business tools to small businesses at prices they can afford and we can deliver profitably. Only 7% of our customers already have this upgraded Microsoft Exchange capability, so we feel this is a great opportunity to provide our customers the benefits of Exchange without the large upfront investment on their part. In addition, the updates and the related pull-through of more Blackberries will help bolster ARPU over time.

Our mobile offering continues to be a steady success for us, with our attach rate on new customers remaining at over 40%, and a large percentage of Blackberries added. Other application usage is strong, especially fax to email, network storage, voicemail, and VPN. In addition to existing applications, we continue to add other new services of value to our customers. In Q2, we are rolling out Secure Desktop.

Secure Desktop provides antivirus and spyware protection for the desktop and manages security updates for our customers' PCs. Secure Desktop is another big business application that we have made simple for our small business customers. Rather than managing multiple standalone software licenses and expiration dates, our customers can easily manage the security of their PCs through Cbeyond Online, our online customer portal, with the confidence that their computer will receive the latest antivirus updates on a regular and ongoing basis.

Adding new computers, replacing existing ones, and monitoring their security is all within their control through the easy-to-use, web-based portal. In addition, we believe that Secure Desktop service will have a positive effect on our overall network quality. By increasing the security of our customers' computers, we will reduce the amount of malware and bandwidth consumed by infected customers, resulting in increased network quality and reliability for all customers. We believe that desktop security is a service that our customers are very interested in obtaining from us, and we expect a very successful introduction. Moving to our market highlights.

In Los Angeles, we posted positive free cash flow in the quarter, on schedule, less than 24 months from launch. L.A. led all markets in net revenue, growth, and adjusted EBITDA margins climbed rapidly to 19% in the quarter. Late in Q4, we launched service in the San Francisco Bay area. We are on track in San Francisco and ramping up our staffing and sales and expect solid success in this vibrant small business market. We began installing customers in our newest market, Miami, in mid-Q1. As in San Francisco, Miami is on track in its early days, and we believe it represents an exciting opportunity. Similarly, on our next call we expect to describe the launch of our business in Minneapolis.

Finally, one of the best indicators of the success of our business model is the profitability of our markets. Looking at our first six markets, the cash flow positive markets of Atlanta, Dallas, Denver, Houston, Chicago, and Los Angeles, all of them achieved the level of EBITDA results that we were looking for in the quarter. Together, these six markets recorded $37.5 million in adjusted EBITDA, or an annualized $150 million. To summarize, the first quarter was a successful one for us. It saw us tackle our consumer credit and churn challenges head-on while posting strong financial results in our markets. Now I'll turn the call over to Bob to provide more detail on the numbers. Bob?

Bob Fugate

Thanks, Jim. I'll now go over the detailed operating metrics and financial results for the quarter ended March 31, 2008, starting with our customers. We ended the quarter with 36,674 customers, compared to 29,166 customers in the last year's period, representing a growth rate of 25.7% year over year and 4.7% quarter over quarter compared to Q4's customer count of 35,041. Net customer additions for the quarter were 1,633. Customer additions were more uneven in the first quarter across all our markets than they have been in the last few quarters, but based on what we're seeing so far in Q2, we believe that net additions will be growing going forward.

Moving on to revenues, we recorded $80.5 million in the first quarter of '08 versus $63 million in the first quarter of last year and $76.9 million in the fourth quarter of 2007. Our revenue growth rate was 27.7% year over year and 4.7% sequentially. Previously, Jim mentioned our expectations for higher net customer additions in Q2. We expect that the impact on revenue of that increase in net customer addition will be an acceleration in sequential revenue growth from Q1 to Q2. ARPU, or average revenue per customer location, was $748 during the quarter compared to $750 in Q4 '07 and $744 in Q1 '07. As we have stated before, we see the general trend in ARPU as flat to moderately increasing as we increase the value of what we include in our bundle and increase our application penetration with our customers.

In the first quarter, a variety of factors impacted ARPU, and probably the most prominent one was that we discounted mobile handsets a bit more in order to drive Blackberry and laptop usage. Like all wireless providers, we discount or subsidize the cost of handsets to our mobile customers. All of that discount is reflected in the month of sale. In the first quarter, we drove more mobile sales with higher discounts, and this was the primary factor in the decrease in ARPU of about $2.00. On our last call, we mentioned that terminating access rates would be declining in Q1 and Q2. Although the access rates did decline, we did not see a negative impact on ARPU from this factor due to an overall increase in volume.

Moving on to expenses, our cost of service was 31.1% during the first quarter compared to 30.9% in Q4 '07 and 29.8% in Q1 of '07. Cost of revenue was primarily impacted by increased mobile usage as mobile penetration of the customer base reached 26% of the customer base. But we expect recurring mobile charges to consume an increasing portion of our revenue as we add mobile subscribers to our base. Also, as mentioned in our discussion of ARPU, we continue to sell more mobile handsets with the full cost of the handset subsidy flowing through our cost of revenue line in the month of sale. Keep in mind that we continue to see cost savings in other parts of cost of revenue as we regroom our network and reduce the costs from other vendors.

Offsetting the pressure on costs from our success with mobile, we continued to post high levels of access and other cost recoveries from our telecom suppliers in Q1. These access cost recoveries totaled $1.4 million during Q1 '08 compared to $900,000 in Q1 '07 and $900,000 in Q4 '07. The cost recoveries in Q1 '08 primarily benefited our Atlanta, Dallas, and Houston markets. Telecom cost recoveries represent the result of our efforts to correct the complex and erroneous bills that we routinely receive from our telecom suppliers, principally the Bells. They're an ongoing operating activity in each period but fluctuate in volume from quarter to quarter.

Last year we averaged about $1.1 million in cost recoveries per quarter. As we stated in the past, we expect that gross margins will decline modestly over time, primarily due to the success of our mobile offering and its growing impact on the business, and also due to the larger number of startup markets operating at early-stage gross margins. SG&A expense as a percentage of revenue was 54.6% in Q1 '08, flat compared to 54.4% in Q4 '07 and 54.4% in Q1 '07. The three market launches from 2007 and the recent launch of Miami during the first quarter of 2008 have made it difficult to realize SG&A leverage currently because of the significant upfront SG&A investments required to get a market to scale. Furthermore, the first quarter of every year is when our employees receive annual raises and when the cost of benefits and taxes is heavier.

All of this is consistent with prior year's results, and we're confident that as our markets continue to grow, we will see significant improvement in SG&A as a percent of revenue. As Jim mentioned, bad debt expense was a success story for us in the first quarter. During the first quarter, we reduced bad debt expense as a percent of revenue from 2.7% in Q4 to 1.8% in Q1, which represented a decrease of $500,000 in expense while the revenue grew by $3.6 million. In addition, we reduced our customer receivables that are past 60 days from 13% in Q4 to 9% in Q1 and dropped our days sales outstanding on customer receivables to 26. We believe that this rapid improvement in bad debt expense as a percent of revenue–back to historical norms–is evidence that we made the right decision in tightening credit and improving the quality of our customer base in uncertain economic times. Our renewed focus on this area has given us a better understanding of how to handle delinquent customers and how to spot them earlier in the process.

Next I'll speak briefly about non-cash share-based compensation expense. Non-cash share-based compensation expense was $3 million in the first quarter of 2008 versus $2.7 million in Q4 '07 and $2.1 million in Q1 '07. Although we exclude non-cash stock compensation expense from our reported adjusted EBITDA, we record this item as part of our SG&A expenses. With respect to this expense going forward, it's impacted by a number of factors, so it's not entirely easy to project, but our present guidance for 2008 is an expense of $13 million to $14 million.

You might recall that we provided guidance of $15 million on the last call, but since Cbeyond realized the significant decline in its share price prior to our most recent equity grants, stock-based compensation expenses related to the recent grants are lower than was initially expected. Excluding the effect of non-cash compensation on SG&A, as a percent of revenue SG&A was 50.9% in Q1 '08 compared to 51% in Q4 '07 and 51.1% in Q1 '07. Moving on to EBITDA, our consolidated adjusted EBITDA was $14.5 million in the first quarter versus $14 million in the fourth quarter of '07 and $12.1 million in the first quarter of '07. And just briefly to touch on the definition of adjusted EBITDA, the exclusions include non-cash share-based compensation expenses, loss on disposal of property and equipment, and other income and expense. The full detail of the reconciliation is included in our press release.

A variety of factors impacted the direction of adjusted EBITDA in the quarter compared to the fourth quarter of 2007. On the positive side, we had solid, profitable growth in revenue. Lower bad debt expense provided a lift of approximately $500,000, and increased cost recoveries provided an additional benefit of $500,000 compared to Q4 '07. On the negative side, our gross margin was slightly lower, and the launch of Miami increased the losses by $800,000 in the quarter. In fact, the aggregate drag from all negative EBITDA markets in the quarter was $4.2 million, an increase from $3.8 million in Q4 '07 and $2.1 million in Q1 '07, all as planned. Annual compensation increases, new hires, and the increased cost of payroll taxes and benefits increased our corporate adjusted EBITDA losses by $1.5 million.

On prior calls, we have gone through our segment results in detail. This information is available to you in our press release, and since we have discussed much of this already today, in the interest of time I will not go through this, and instead refer you to the table in the press release. Our depreciation and amortization came in at $9 million in Q1 '08 compared to $8.4 million in Q4 '07 and $7.1 million in Q1 '07. In the first quarter, we recorded an income tax expense of $1 million.

Income tax expense increased as a percentage of income before taxes as a result of our having begun to accrue federal income taxes at the full corporate tax rate and due to an increase in the Texas State Margin tax, both of which occurred in the first quarter of 2008. As we have stated before, although we're not currently managing to net income, we have posted positive net income in each quarter since we went public in November of 2005. We posted net income of $1 million in the first quarter compared to $12.5 million in the fourth quarter of '07, which included a $9.6 million tax benefit, and $2.7 million in the first quarter of 2007.

Next, capital expenditures. Our capital expenditures were $15.6 million in the first quarter compared to $18.1 million in Q4 of '07 and $13.9 million in Q1 of '07. Once our markets have been in operation over three years, we target CapEx to be at 5% to 10% of revenue, and in the first quarter, our CapEx was 5.1% of revenue for our first five markets combined, which supported a year-over-year revenue growth rate of 18.9% in those same markets. Our corporate capital expenditures were $5.3 million in the first quarter compared to $7.8 million in the fourth quarter of '07 and $4.2 million in the first quarter of '07. The corporate CapEx reflects a normal run rate for us and includes spending on software development, product development, OSS enhancements, and data center expansion.

Regarding the balance sheet, we had a cash, cash equivalents, and marketable securities position of $46 million at March 31 versus $56.2 million at December 31. The decrease in cash during the first quarter is due to a handful of planned factors, as was forecast on the last call. (inaudible) payments in connection with a favorable resolution of significant billing disputes with telecommunication suppliers, payment of annual bonuses in February, prepayment of a variety of annual expenses, and payment of some capital expenditures that were incurred and recorded in the fourth quarter but paid in the first quarter. We do not expect to see significant cash declines in subsequent quarters, and we anticipate that we will continue to maintain a strong cash position going forward. We have no debt outstanding and a $25 million credit facility in reserve which we do not currently expect to borrow under.

Lastly, I'll touch on our guidance for 2008. At the time of our last call, we provided guidance of revenues $355 million to $360 million, adjusted EBITDA of $60 million to $62 million, and capital expenditures of $65 million to $70 million. Our guidance assumed economic conditions similar to those we're currently facing, strong growth sales reflecting sales rep productivity levels comparable to those seen throughout 2007, churn levels between 1.4% and 1.1% throughout the year, a modest impact from renewed credit screening on new sales, stable to modest ARPU growth, and declining gross margins. At this time, we are reiterating our guidance, although it appears at this point that revenues may be closer to the lower end of our range. The outlook for adjusted EBITDA and capital expenditures is unchanged. And now I'll turn it back to Jim for a few concluding remarks. Jim?

Jim Geiger

Thanks, Bob. In summary, we're pleased with our accomplishments in the first quarter, which include 28% organic growth in revenue year over year, solid improvement in customer churn and receivables, free cash flow in Los Angeles in less than 24 months from launch, and strong profitability across our markets. So at this time I'll turn the call over to our operator for question. Andrea?

Question-and-Answer Session

Operator

Thank you. (Operator instructions) We'll go first to George Sutton with Craig-Hallum.

George Sutton – Craig-Hallum

Thank you. Hi, guys. I hopped on late, so if I ask a dumb question, I apologize in advance. As you look out through the rest of the year and you look at your guidance, do you feel you're building more or less caution than you were three months ago?

Jim Geiger

Boy, that's a tough question, George.

George Sutton – Craig-Hallum

That would be the longest non-response I've ever heard.

Jim Geiger

If you're asking whether we feel better about our guidance, because we're, you know, the Rule of 78 can be your best friend, or it can be tyrannical. But as you get more, each month into a year, I think you feel much more comfortable about guidance that you give. And I think the progress that we made on receivables and churn buoys us. We have good momentum in sales. We had 8% more gross sales in the quarter than we did in the fourth quarter. So I think there's a lot of reasons for us to be, feel some wind at our back here, George, related to guidance.

Bob Fugate

I'd say we feel more confident around today's guidance, as Jim said, because we're farther into the year.

George Sutton – Craig-Hallum

That makes perfect sense. Now, with respect to, and since Bob spoke, can you discuss your pipeline for disconnects? You talked a lot about that last quarter.

Bob Fugate

Yes. We are, we're seeing confidence around churn being, for Q2 and beyond, declining from Q1. How far and how fast is not, that's really not possible to state at this point. But as we mentioned in our prepared remarks, Jim mentioned that at this point in time, we have some confidence in the visibility from our churn pipeline that it should be, we're expecting it to decline.

George Sutton – Craig-Hallum

Okay. The last question from me. You're consistently state that cable competition's not materialized, CLEC competition's been lessened by consolidation. Can we just update those thoughts today?

Jim Geiger

We don't really see any change in the competitive environment. It is consistent with prior quarters, and in our opinion, one of the better environments that we have operated within.

George Sutton – Craig-Hallum

Super. Thanks, guys.

Jim Geiger

Thank you.

Operator

And we will go next to Frank Louthan with Raymond James.

Frank Louthan – Raymond James

Great. Thanks. Just want to clarify one thing. With the rate of churn, if you exclude the 300 customers, which one, was it exactly 300 customers or so, roughly, still that number, that you forced off, and excluding that, did churn decline, let's say, declined by 10 basis points in the quarter. And then I just wanted to get an idea on the timing of the market launches. Were Miami and Minneapolis launched when you had originally scheduled them, or have you slowed down that rate of sort of when you launched the markets in the year? Thanks.

Jim Geiger

Yes. As it relates to churn, our prediction was around 300. It may have been in the 250 range, Frank, that we actually achieved, but it's hard to parse exactly which customers. I think it was an estimate, and it was a pretty good estimate at the time. And as it relates to Miami, I think that those are launched on time.

Bob Fugate

They're on schedule.

Jim Geiger

On the track that we intended to have that.

Bob Fugate

Minneapolis is, we're expecting to launch that in the summer, early summer, and that's on plan.

Frank Louthan – Raymond James

Okay, great. And with the hosted Exchange, can you give us some, a little more color on that? What do you, when do you think you're going to have that available to launch to other markets? What are you charging? Is that on a per customer basis or per user basis? And of the customers that have taken it, what's sort of the average number of customers that have–or average number of users that have been, that have taken the service when they signed up?

Bob Fugate

The 40% attach rate that we spoke to gives a basic Exchange experience to the customer. And that, it's hard for us to talk to you about what that does to uplift an ARPU, but there are a number of seats that are available within the basic package, and then customers can buy more beyond that. The complete package that I spoke to, the upgraded package that 25% of those customers have attached, or 10% of total, that we charge $10 a seat for. And I'd rather not get into, Frank, some specifics on the number of seats per attached client, because I think it's early, and I'd just rather not give that information, because I'm not sure that it would be a predictable metric to build a model off of.

Frank Louthan – Raymond James

Okay. Fair enough. And then just the last thing. With the churn, looks like it's moving back in the right direction and you're still fairly–so you're fairly comfortable with it being steadier through the end of the year–when do you think you get back towards sort of your 30% targeted top line growth rate that you sort of had in the model all along? Do you think we'd get back to that in '09, or is that something we could see more towards getting to that run rate towards the back end of the year?

Jim Geiger

'09, Frank.

Frank Louthan – Raymond James

Great. Thank you.

Jim Geiger

And I didn't answer the last part of your question. We'll be rolling out that Exchange product through the second quarter to all of our markets. We've had a good operational experience with it so far.

Frank Louthan – Raymond James

Great. Thank you.

Jim Geiger

Thank you.

Operator

We'll go next to Jonathan Chaplin with JPMorgan Securities.

Jonathan Chaplin – JPMorgan Securities

Hey, guys. Just a quick clarification on churn. So the 250 or so disconnects, I think, are, should be 250 bits of churn, more or less. So is it safe to assume that without that disconnects and the–in the second quarter you should be somewhere close to 1% or somewhere in between 1% and 1.1% churn? And then I'm wondering if you could give us a little bit more color on, it looks like gross adds slowed down a little bit sequentially. I know that the first quarter is always seasonally slightly slower for gross adds, but beyond just seasonal impacts, have you seen a slowdown in your existing markets, or have new markets been slow-ish around? Thanks.

Jim Geiger

The newest markets have not. In sort of our medium-tier markets, we're seeing some inconsistency of performance that we generally don't see. And we think that it's seasonal. There's an impact of seasonality. We think there's some small impact of the economy that–customers need to, our growth comes at other people's expense, largely. So we're out taking market share. And it's a commitment. There's an investment, and it's a commitment. We sign up most of our customers on multi-year deals. So we think there's some small piece of that that has been affected by people not wanting to commit and invest in switching to Cbeyond. We think there's also an element of execution, where we have had a little choppy performance in some of our markets. And then finally, a small piece–less than we thought–but the screening upfront is also taking a little bit of a bite out of the gross sales.

Jonathan Chaplin – JPMorgan Securities

Thanks. On the churn?

Jim Geiger

One, yes.

Bob Fugate

Yes. It isn't as easy to cut it, I guess, that finely, and I think I'd just stick to, Jonathan, that we see the trends going down.

Jonathan Chaplin – JPMorgan Securities

Okay. Thank you.

Bob Fugate

And that we think that we will, toward the last quarter in the year, we will return to more traditional levels. But it is still a bit of a choppy economy for some of our customers, so we think that there will be a bit of a soft landing.

Jonathan Chaplin – JPMorgan Securities

Got it. Thanks, guys.

Jim Geiger

Thank you.

Operator

And we will take our next question from Jurgan Usman with Wachovia.

Jurgan Usman – Wachovia

All right. That's probably me. Thank you. How are you, guys? Nice to see churn is better than expected here. A couple of questions. First of all, even that churn is actually better than your expectation of 1.4%, and keeping in mind the Rule of 78, why is your revenue, why are you expecting your revenue to come at the lower end of your guidance? And then the second one is that it looks like wireless is competing to build up there. Do you still stick to your target of 33% by the end of this year in terms of penetration?

Jim Geiger

We do still think we will get to 33%, Jurgan. There is a seasonal production of wireless that we see that where the fourth quarter tends to be a little bit stronger. So if you do a straight line, I understand we might miss by a point on your math, but we think we will make it up throughout the year. And–.

Bob Fugate

Why are we at the lower end of our guidance range for revenue? I think is really, we would have liked to have been a couple hundred higher in net adds in the quarter, and if you, you've got that 200 throughout the rest of the year. It has a rather major impact. And so we had a little more confidence around revenue at the lower end of the $5 million range of revenue. But these are big numbers, and there's some things that could change going forward, so hopefully we will do a little bit better than that.

Jurgan Usman – Wachovia

Right. And then going back to the gross adds question again, obviously, look, at least based on my math, maybe because of seasonality as well here, that your gross adds only declined slightly in the first quarter, which is kind of surprising, I suppose, given that you're tightening your credit checks. So I was just wondering. Did you turn down more potential customers than you have been in the past because of this?

Jim Geiger

The past is only a quarter long, but yes, related to other quarters, that would be true. But not at the level we had predicted, at 3% to 5%, however. Less than that.

Jurgan Usman – Wachovia

All right. So I guess your expectation for gross adds will continue to maybe move up, then, from this level?

Jim Geiger

We do.

Jurgan Usman – Wachovia

All right. Thank you.

Jim Geiger

We do. Yes. And the strong sales relative to the fourth quarter gross sales, 8% increase in Q1, gives us confidence. We have a pretty visible pipeline.

Jurgan Usman – Wachovia

Okay. Thank you very much.

Jim Geiger

Thanks, Jurgan.

Operator

We'll go next to James Breen with Thomas Weisel.

James Breen – Thomas Weisel

Thanks. Just a couple of questions. One, as you look across the credit policy tightening, does it affect you in any certain markets more than in others? And then secondly, someone asked about cable competition. AT&T made some comments in their call about some price they're offering their small and medium business markets. I don't know if you're seeing any impact there. I think they just launched in this quarter, but some comment there would be great. Thanks.

Jim Geiger

Sure. As to your first question about the credit policy, there is no discernible difference between markets. And as to AT&T's bundles, these are stuff that we're just learning about. They announced two bundles for business, Business Talk, which is, I guess, a wireless sharing with their employees. And I don't think that's going to have much of an impact on us. We already do that. Our product already allows employees to share their minutes across an account.

The other one, Business in a Box, I guess it's called, James, and we're aware of that. We haven't seen any impact from that. It seems that they're trying to jump on the VOIP bandwagon and include, by the way, they intend to, I believe, include hardware with that product. We very specifically don't include the sale of hardware in our bundle, because it competes with about 20% of our net adds each quarter coming from our indirect channel partners (inaudible) and equipment vendors. So we are more symbiotic with them and get customer additions from them. But, I guess the whole thing is back to they don't really market to our customers. AT&T won't send somebody out with a tie on to talk to these small businesses. They just don't, simply, it isn't a worthwhile economic decision on their part. They don't go to direct selling. And you aren't going to sell against us effectively, selling to new customers over the telephone. Our entrepreneurial customers, as I've said many times before, they sell their goods and services people-to-people, and they buy their goods and services people-to-people. So I'm not cavalier, but they have come up with other products and bundles in the past, and unless you're going to get out there in the trenches with us and our people, I don't think they'll be terribly successful. And they're also alienating, which is for us, about 20% of our new additions through our indirect channels.

James Breen – Thomas Weisel

Great. Thank you very much.

Jim Geiger

Thank you, Jim.

Operator

And we will go next to Eric Kainer with ThinkEquity.

Eric Kainer – ThinkEquity

Thank you very much. Nice work on bringing down the churn and the bad debt. Very important, obviously. Let's see. The first question is really about the upselling process, clearly with rolling the Exchange across the base here in the second quarter. The team that you've built to do the upselling is going to be more important. Can you talk about, give us some color as far as what the upselling process looks like and kind of how you assess the success of that team?

Jim Geiger

Yes. We target that team on our customers, and as you might suspect, many, many more resources focused on our older markets with larger customer bases. But we target them very specifically on customers who are coming up for contract renewal, customers in certain SIC codes that we know our other customers are using effectively our applications. And when we do that, there is–a part of our thesis has always been there's a deflationary pressure in the pricing of our core services. And while that occurs, we will replace that revenue with other revenue that is largely software-based and of a high margin in nature. And so what we're doing is rolling these people off of their old contracts and pricing and rolling them onto, and getting them to adopt our new services and applications, and doing so at or slightly above existing ARPUs for those customers. And that's really been our goal, and we think it's a pretty nifty trick, that we have been able to achieve that over the past several years.

Eric Kainer – ThinkEquity

Okay. So I guess that at least partly explains why, with a rising number of applications per customer, we don't see rising ARPUs?

Jim Geiger

That's right. And as we think there are some that will begin to move as we predicted, ARPU remains stable to slightly increasing. And it's a very dynamic measurement. But we're very pleased with continuing to have a stable to increasing ARPU with our customer base.

Eric Kainer – ThinkEquity

Okay. And when you get somebody to upgrade or to add new applications, to add some mobile or to add storage or security, what have you, do you generally put them on a new contract which then kind of renews everything?

Jim Geiger

Absolutely. Everything is coterminous.

Eric Kainer – ThinkEquity

Okay.

Jim Geiger

And with the addition of mobile, it's a minimum of two years.

Eric Kainer – ThinkEquity

In order to pay for the subsidy, sure, I'm sure that's the case.

Jim Geiger

Yes. And most of our customers, in fact, in the first quarter, 98% of our customers signed a three-year deal.

Eric Kainer – ThinkEquity

Wow. Okay. Thank you very much, and good luck going forward.

Jim Geiger

Thank you, Eric.

Operator

And we will go next to Erin Schmitz with Citigroup.

Erin Schmitz – Citigroup

Thank you. I was wondering if you could talk a little bit more on the growth side of things and particularly on the sales force productivity. It looks like it was down in the quarter. I'm wondering if you could provide some color around that, whether it was turnover of the sales force or if it's longer sales cycles, or just (inaudible) credit policy working in that front?

Jim Geiger

Yes. We had an overall increase in our gross sales for the quarter, quarter over quarter. But we weren't pleased with that, as we said, because it wasn't necessarily the productivity of the sales organization. It was the number of people we had in seats, productively selling. So that was for us the biggest concern, and we felt that that was an execution miss on our part.

Erin Schmitz – Citigroup

But can you identify any reasons for why it was less productive this quarter than others?

Jim Geiger

I can't, Erin.

Erin Schmitz – Citigroup

Okay. Okay. And then I was wondering, also, if you could talk just a little bit on the cost of the subscribers, as well. It looks like it's coming up a little bit for each new gross add. Is that just a factor of some of the productivity issues as well that are playing into that?

Jim Geiger

Yes.

Bob Fugate

It's really, I think what you're seeing there is the impact of having more early-stage markets contributing to the total SG&A than we have ever had in the past. And that's really a factor that you're going to see throughout 2008, abating going forward as more of those start to become profitable over time. But this year, we will have a greater proportion of negative EBITDA cities to the total number of cities than we have had in the past, and that gives you the effect of that trend. But our cost per gross add within a city is not going up.

Erin Schmitz – Citigroup

Okay, great. Thank you.

Operator

And we will go next to David Dixon with FBR Capital Markets.

David Dixon – FBR Capital Markets

Thanks, gentlemen. Good quarter. Just a few multi-part, or a multi-part question here. Really looking at the revenue picture going forward, I just wanted to clarify that the revenue guidance towards the low end of the guidance range does imply perhaps a more modest than 3% to 5% decline in gross adds. That's the first question. And then I just wanted to understand the basic, the assumptions that underlie a return to 30% revenue growth in 2009. And then just a couple of follow-ups. Thanks.

Bob Fugate

David, I wasn't clear on the first part of your question about 3% to 5%. What, can you repeat that?

David Dixon – FBR Capital Markets

Sure. So what I want just to clarify was with the revenue guidance to the lower end of the guidance range implies perhaps a more modest assumption on the decline in gross adds that what I think has been previously conveyed, the 3% to 5% reduction in gross adds.

Bob Fugate

Okay. Yes. There was, I think we're talking about a couple of different things here. We spoke in the past about an expected impact of our new credit screening on gross adds of about 3% to 5%. That was a projection. That did not really occur. The impact from credit screening was well less than that level in Q1, and we don't think it will have a significant impact on sales going forward. As Jim mentioned in the prepared remarks, we are seeing an expected acceleration in gross adds and revenue as we move into Q2. So I think you'll see a good increase in sequential revenue growth in Q2 above the sequential revenue growth you saw from Q4 to Q1. So that's good. Now, why do we see projected revenue for the year at the lower end of the range? Just simply getting back to the fact that we're a few hundred customers early in the year less than where we thought we would be. So we have a little more confidence at the lower end of that range, but you know that we have got some time to work with, and hopefully, we will do a little better than that. I hope that answers your question.

David Dixon – FBR Capital Markets

It does very well answer. Thanks very much, Bob, on that. Also, just stepping back to–well, actually just on the outlook for 2009, if you perhaps could just give me some sense of the basic assumptions that underlie a return to the 30% growth rate?

Bob Fugate

You know, really a big factor in increasing the growth rate from here is just simply having more sales reps and more cities out there that are productive. And we will have more as we move through the year than we have currently. So that's a factor of it. There's bigger scale, bigger volume that you'll see several quarters out from now than today. We had a change in our original expectations when we had that disconnect of several hundred customers at the beginning of the year. That sort of depresses the near term, and against that level, it means that as we're back at normal levels of productivity going forward, you can expect to see that percentage rates will increase, even at current levels of productivity per rep, but because we have got greater volumes of reps out there selling. So that's why we think that what we're seeing today, moving forward, gives us that kind of confidence that next year we should be a little bit higher in our year-over-year revenue growth than we're experiencing now.

David Dixon – FBR Capital Markets

Okay. Terrific. And then just the follow-up really goes to the mobility (inaudible), which is an area where you've had some great success. I wanted to get a sense of the traction on mobility between the direct and indirect sales channels, Jim, and also just what's your outlook for sales coming from the indirect and direct channels going forward looks like?

Jim Geiger

David, I'm going to ask you to please repeat that because I was distracted during that.

David Dixon – FBR Capital Markets

No problem. So just looking at the success that you've had on mobility and just whether you've seen any differences and any opportunities for traction between the direct and indirect sales channels?

Jim Geiger

Primarily all of the mobility success we have had comes out of our direct channels and also our Solutions Advisors that sell into the customer base.

David Dixon – FBR Capital Markets

Okay. And the outlook going forward in terms of the composition of sales from indirect and direct? Any changes there, Jim, that you see?

Jim Geiger

I don't see any. It hasn't changed for years.

David Dixon – FBR Capital Markets

Right.

Jim Geiger

So it's been 80% and 20% for years, doesn't matter if we throw in new markets into the mix. It just seems to stick at that level. And the apps generally are lower on the indirect sales than they are through our direct sales. The pull-through of apps. And whether that means that we're competing with people for apps that they might want to be selling to the customer on-premise versus in a network that we provide would probably be a good thesis.

David Dixon – FBR Capital Markets

Terrific. Okay, great, gentlemen. And just lastly, on the first quarter results, comparing those to how we saw the business in Q4, obviously a lot of hesitation around the operating outlook for the company in Q4. How far do you think the needles moved, just in a qualitative sense, as you look at the business here in Q1 '08?

Jim Geiger

I hesitate to say it feels better. Qualitatively, we're more optimistic. Again, as you get closer in these kinds of businesses, as more months tick off through the year, you get a lot more visibility, and the good news is it's hard to change the dial, and the bad news is it's hard to change the dial. But we feel the sentiment is different today than it was on our fourth quarter call.

David Dixon – FBR Capital Markets

Right. Okay. That's great, gentlemen. good luck for the rest of the year. Thanks very much for the questions.

Jim Geiger

Thank you very much.

Operator

And we will go next to Donna Jaegers with Janco Partners.

Donna Jaegers – Janco Partners

Thanks for taking my questions. Two quick ones. You mentioned 98% of your new subs took the three-year contract. Can you sort of, in '05 and '06, were your three-year contract percentages that high?

Jim Geiger

No, they weren't. In '07, I think we migrated up to about a 90% rate. Probably the year before that, Donna, we were down in the 80s on a three-year deal. I think it speaks to, that it's a lot, it's better pricing at that lower level and it's more attractive to the customer, and apparently that means something to them at this time.

Donna Jaegers – Janco Partners

And then the other quick question. On the tax rate, should we expect sort of 50% to 51% for the rest of the year, given the change in the Texas rate?

Bob Fugate

No, it should decline moderately over time. That 50% income tax rate was really a function of the fact that in the first quarter, we started the addition of that Texas margin tax. But really, as we scale through the year, that will slightly decline as a percentage over time. It's–the main part of this is that we're at the full corporate federal tax rate for most of that piece, and the difference was, of course, made up by that Texas margin tax we mentioned. But really, I guess I'd say that as we get into next year, it should be a more noticeable decline going forward after that.

Donna Jaegers – Janco Partners

Okay, and the federal, the full federal rate you're referring to is about what? 38%-ish?

Bob Fugate

Yes.

Donna Jaegers – Janco Partners

Okay, great. Thanks, Bob.

Bob Fugate

Thank you, Donna.

Jim Geiger

And we're going to take one more question, please.

Operator

And our last question, then, will be from Jonathan Schildkraut with Jefferies.

Jonathan Schildkraut – Jefferies

Great. Thanks for fitting me in. I've a couple of questions about guidance. And I just wanted to get a better understanding here. If I back out the 250 customers that you have forced out this quarter, and even if I take a look at last quarter and forcing out 300 customers, their churn is coming in between 1.0% and 1.1%. Yet you're saying that you think you can get back to historical levels by the end of the year. So as we enter the next quarter, should we be thinking that the churn in the traditional base is going up, or there are more people that you're forcing out through your tightened credit policies? And then I'll follow up with that.

Bob Fugate

Yes, I think the risk that we run in saying 250 out loud is that there are these bright lines, and it's not quite that crystal clear. Okay? I mean, there are a number of people that may also fall prey to our tightened credit in the second quarter as an extension of the first quarter and ongoing. So I guess the best thing that we could do to guide you is that we think that it will have a soft landing. We think that they'll return to normal levels and historical levels, and the 1.1% range is what we said by the end of the year. And we see the trending getting better.

Jonathan Schildkraut – Jefferies

Okay. In terms of the revenue, as I look out over the year, you exit this quarter at a $322 million annualized rate. At the bottom end of your range, you're talking about $355 million. That's $33 million that you need to get to get to the bottom of the range, because you have only three quarters left. I guess we'd be using a Rule of Six as opposed to a Rule of 78, but it implies about $5.5 million of incremental revenue growth in each quarter. You've indicated that you think net adds for next quarter could be around 2,000. And without a serious jump in ARPU next quarter, that would indicate you'd come in lower than $5 million or $5.5 million of incremental revenue growth and that we'd see a bigger spike in the back half of the year. Is my math right here, or are you expecting acceleration in each of the quarters as we move through to the fourth?

Jim Geiger

Yes. We will have an acceleration towards the fourth quarter.

Jonathan Schildkraut – Jefferies

Okay.

Jim Geiger

In gross adds as well as sequential revenue, absolute sequential revenue increase.

Bob Fugate

And we're–I'm sorry.

Jim Geiger

We're opening new markets, the business is growing.

Jonathan Schildkraut – Jefferies

Okay. Finally, just a question here. I'm trying to understand if there's a relationship between total acquisition costs for customers and the number of gross adds that you have. For example, in a wireless business, there's certainly a relationship there. Do you pay a one-time landing fee or anything like that to your sales force that would have your costs scale with the number of gross adds that you get in a quarter, or do you have a cost that's just associated with your sales force that is going to be relatively stable regardless of the number of gross adds that they generate?

Jim Geiger

I think that maybe some of the difficulty, because I know what you're trying to do, is that we have a mixture of markets and of the maturity of each of those markets. What I can tell you is in an existing market–one of our older markets, say, our cash-generating markets, six of them today–each incremental new add of a homogenous customer, those rates are actually very stable. The cost of acquisition, the investment to get a new customer on. Some things go up a few bucks, some things come down a few bucks, but it's been relatively stable to declining over the past several years. And we try and manage the business that way. But when you mix in on a gross basis what you're looking at in SG&A, I think there's a bunch of inefficiency that occurs early in a market's life that makes it probably very difficult for you to get in–there's a big fixed fee upfront when we start those markets, and there's a tremendous amount of inefficiency in the operating costs in the early markets. So I think one of the other questioners was getting at this too, and I think it's difficult to give you a single answer on that point.

Jonathan Schildkraut – Jefferies

Okay. I think we're actually going down the wrong path. Does generating fewer gross adds in this quarter help your, does it help decrease your total cost of customer acquisition?

Jim Geiger

Yes. It does but not materially.

Jonathan Schildkraut – Jefferies

Okay. Listen, great quarter. Thanks for taking the questions.

Jim Geiger

Thank you. With that, I want to thank you all for joining us. And we look forward to reporting more results to you next quarter. Operator?

Operator

This does conclude today's Cbeyond Inc. first quarter 2008 conference. We thank you for your participation and ask that you have a wonderful day.

Jim Geiger

Thank you, operator.

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