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Alaska Communications Systems Group, Inc. (NASDAQ:ALSK)

Q1 2008 Earnings Call Transcript

May 5, 2008 5:00 pm ET

Executives

Melissa Fouts – Director of IR

Liane Pelletier – Chairman, President and CEO

David Wilson – CFO, SVP and Treasurer

Leonard Steinberg – VP, General Counsel and Corporate Secretary

Analysts

Jonathan Chaplin – JPMorgan Securities

Frank Louthan – Raymond James

David Coleman – RBC Capital Markets

Operator

Good afternoon, ladies and gentlemen. Thank you for standing by. Welcome to the Alaska Communications Systems first quarter 2008 conference call. During today's presentation all parties will be in a listen-only mode. Following the presentation the conference will be opened for questions. (Operator instructions) This conference call is being recorded today, Monday, May 5 of 2008. I would now like to turn the conference over to Melissa Fouts, Director of Investor Relations. Please go ahead, ma'am.

Melissa Fouts

Good afternoon, and welcome to the Alaska Communications Systems First Quarter 2008 conference call. With me today are Liane Pelletier, President, Chief Executive Officer and Chair of ACS, David Wilson, Chief Financial Officer, and Leonard Steinberg, General Counsel.

During this call, company participants will make forward-looking statements as defined under U.S. Securities laws. Forward-looking statements are statements that are not historical facts and may include financial projections, estimates of shareholder returns or other descriptions of the company's plans, objectives, expectations or intentions. You are cautioned not to put undue reliance on forward-looking statements as actual results could differ materially from expectations as a result of a variety of factors, many of which are outside the company's control. We discuss these factors in our SEC filings.

Lastly, any non-GAAP measurements referred to during this call have been reconciled to their nearest GAAP measure. You may find these reconciliations in today's press release and our SEC filings on our investor website at www.alsk.com.

We will begin the call with Liane discussing the company's Enterprise strategy underpinning our recently announced acquisition. Then David will review our quarterly operational and financial performance, our recent financing transaction, and our progress in building our Enterprise book of business. Liane will then close and open the call for questions.

With that, I would like to turn the call over to Liane. Liane?

Liane Pelletier

Thank you, Melissa. Welcome and thank you all for participating on the call. At the outset, I will share a bit about our cable build and our cable buy strategy, which form part of how we will serve the Enterprise market. The demand and supply fundamentals of this market make it an ideal place to put capital to work. As for the demand side, the market served by the cable investment is the inter-state transport market, sized last year at over $200 million. Data usage in this market is growing over 40% a year and that’s before we experienced new oil, gas, and other economic development opportunities in Alaska.

As one example of the opportunity ahead of us, British Petroleum and ConocoPhillips recently announced that they will jointly develop a pipeline to move natural gas from the North Slope of Alaska to markets in the Lower 48. Their plan involves spending $600 million over the next three years to reach the first project milestone with total spending for the project estimated at more than $30 billion over more than 10 years.

As for the supply side, with our AKORN build and our Crest buy we will own two of the four cables connecting Alaska to the rest of the world and we will be one of two suppliers. As we have mentioned before, the Alaska supply market differs radically from the long haul fiber market in the Lower 48 where a glut of competing suppliers pressured return. We believe the supply market and therefore expected returns are quite different in Alaska.

As we serve this market, our pricing will reflect a strategy of differentiation, and the value customers place on our solutions. For example, the cable we are building, AKORN, leaves Alaska along the only geographically diverse route and this is key for our customers’ traffic security and business continuity. ACS will operate the AKORN and Crest cables together as a ring and connect this submarine transport system to ACS's in-state data network.

In state, we recently upgraded our Metro Ethernet network to 10 gig in order to best serve the needs of Enterprise customers. ACS's Metro Ethernet and MPLS networks offer key advantages over legacy network technologies commonly installed in Alaska. And the ACS in-state network reaches from the north, site of oil and gas fields, to Southeast Alaska, site of major tourism and fishing industries. ACS will manage customers' traffic on these two cables via two network operations control centers, one here in Alaska, and one in the Lower 48. Our approach to establishing a Lower 48 knock will minimize both our total cost of ownership and the time needed to deliver world-class capabilities to Enterprise customers.

In summary, we believe our differentiated Enterprise strategy is the key to igniting ACS's next growth engine. And in particular, the cable investments revitalize and maximize the value of our local network. Considering the AKORN cable itself has a 25-year life, and the cost of service sold on the cables are largely fixed, we expect an annual return on our investment to be north of 20%. With this Enterprise growth strategy in place, which builds on our wireless growth strategy, we have an ideal platform to reward shareholders.

I will now ask David to cover our recent financing transaction, our progress towards building the Enterprise book of business, and, of course, Q1's operating results. David?

David Wilson

Thank you, Liane. I will first start with the quarterly operational details for wireless. First with the turn down of our TDMA network and the impact of AT&T Mobility entering the market, conditions in the first quarter were unique and not reflective of future expectations. During the quarter we also undertook certain database cleanup activities. The turn down of TDMA and the cleanup of our subscriber accounts resulted in 1,300 retail disconnects impacting retail wireless subscriber net adds of 300 in the quarter. During the quarter, we also turned down 1,700 wholesale TDMA subscribers.

As you may recall, we are not allowing wholesalers to resell our TDMA service. With the turn down of TDMA service behind us, we expect to save $700,000 annually in network costs. While the entry of AT&T Mobility into our market has been impactful, we are pleased with the traction we are gaining from a range of specifically targeted initiatives that started in the consumer segment. A small sampling includes, first, realigned ACS plan designs and reduced ACS rates to match AT&T's. We further added differentiating features and then migrated existing ACS customers to the plan, they agree, best meets their needs. Between January and mid-April, over 50% of consumers had transitioned over to our new plans. In addition, recent sales volumes reflect the market appeal of the new ACS plans.

Second, we trialed new handset offers to attract new customers and to gain contract renewals of our existing customers. Third, we began providing our highest- value customers with differentiated service at stores and in the call centers. These, and many other initiatives, are having a positive impact. Mid-quarter, we saw a strong rebound in consumer postpaid net adds, which are running 20% above levels experienced in the second half of 2007.

Stage (inaudible) consumer rollout, targeted initiatives rolled out to the business segments later in Q1. By mid-April, over 20% of business subscribers have migrated to their best plans. Our advertising the fastest mobile Internet product in the state to high target industries demonstrated strong returns with 12% of all wireless activations in the quarter coming from the data card service and that in turn contributed to data ARPU for the quarter of $3.77, up 46% year-over-year, and up 16% sequentially.

On to wireline, local retail line ARPU increased to $19.75 from $19.69, while lines declined 1.8% during the quarter, the majority from consumer households. DSL customers grew by 450 during the quarter to 47,950, as DSL penetration of retail lines expanded to 26% overall and, for consumer, nearly 50% penetration, high by national standards. Consistent with national carriers, we have also been increasing the value of our embedded base by migrating them to higher speeds, partially contributing to an Internet ARPU increase of $0.92 over the fourth quarter of 2007. DSL remains a key focus of our process improvement and we are currently rolling out a number of initiatives that will radically improve the early life customer experience, including industry leading self installation software and industry leading bundles.

Now, I'll review the first quarter 2008 financial results, compared to the first quarter 2007. Revenues were $96.8 million, up 5.6% from first quarter 2007 revenues of $91.6 million. Wireless revenue was $33.7 million, up 6.4% over the prior year revenue of $31.7 million, which benefited from $700,000 in out-of-period CTC. The increase reflected retail revenue gains from increased subscribers and an increase in data ARPU and a 15.6% increase in foreign roaming revenue to $3.7 million, up from $3.2 million in the prior year.

Onto wireline, where revenues increased 5.2% over the prior year to $63.1 million from $60 million in the first quarter of 2007. Retail revenue of $23.6 million declined 5.2% from the prior year, with lower CPE sales and higher uncollectible expense accounting for half of the decline. As expected, wholesale revenue declined 11% to $5.3 million, as a 27.9% decline in wholesale and uni lines was partially offset by 17% increase in ARPU.

Access revenue increased $2.4 million, or 10% over the first quarter of 2007, with first quarter 2008 performance benefiting from access revenue reserve true-ups that were $3.1 million higher in Q1 '08 than they were in '07.

Enterprise revenue was up 53% to $7.8 million, driven by carrier wins and data sales to large commercial and government customers. The Enterprise segment is key to our renewed wireline growth and we are pleased with the traction we are gaining ahead of the launch of AKORN, with capacity now in hand following our agreement to buy Crest.

On to EBITDA, which increased 4.6% over the prior year to $34.9 million.

Wireless EBITDA margin of 40.8% was down from 50.5% in the prior year. Lower EBITDA margins were expected with the final push for TDMA conversions, the front loading of new wireless program costs designed for greater retention and ARPU, and the allocation of more ACS headcount towards wireless activities. Additionally, device subsidies have increased as the mix of devices sold shifts towards higher end data-rich devices including data cards.

Wireline EBITDA margin was 33.7%, compared to 29.1% in the first quarter of 2007. As noted earlier, wireline EBITDA benefited from favorable network access reserve true-ups.

Net income, before tax, increased by 35% to $9.9 million, while net income after tax declined by 21% to $5.8 million, reflective of book tax charge in 2008 but none in 2007. We exit the quarter with NOLs of $121 million, and we do not expect to be a full cash taxpayer until 2012.

Cash from operations was $24.9 million, compared to $28 million in the prior year. Major uses of cash during the quarter included $22.7 million in capital expenditures, inclusive of $15.1 million for AKORN build and $9.2 million in dividends.

And now, to our financial guidance, where we are reaffirming full year 2008 expectations for revenues in the range of $385 million to $395 million; EBITDA in the range of $130 million to $134 million, excluding $6 million in start-up costs for AKORN; maintenance CapEx of $42 million; and investments in our fiber facility of $82 million.

From the close of our $125 million convertible debt offering, we are increasing net cash interest expense guidance to $33 million from $30 million. Revenue and EBITDA guidance excludes contributions from our Crest acquisition, which is expected to close early in the fourth quarter.

Before handing the call back to Liane, I'll provide a quick overview of how our convertible offering and Crest acquisition support our dividend expansion plans. We believe the addition of Crest to our AKORN build improves total expected returns to shareholders. Through the acquisition and a carefully crafted financing vehicle, we have effectively managed the initial cash carry costs of our long haul fiber strategy and the dilution risk to shareholders.

Starting with the convertible, on April 8, we closed the sale of $125 million in 5.75% convertible notes due March 1, 2013. Concurrent with the notes issuance, we entered into hedged transactions that increased the initial effective conversion price to approximately $16.42 per share. Net proceeds from the offering of $110 million provide the financing necessary for both our $70 million acquisition of Crest and the $40 million of debt required to complete AKORN.

The addition of Crest brings a book of business and recurring EBITDA of $3 million and it brings $1 million in cost synergies. When combined with our new debt, the initial net carry costs of our long haul fiber strategy dropped to $9 million from the $12 million we shared in March. We are making significant progress covering this $9 million target ahead of the commercial launch of AKORN and sales exiting Q1 '08 contributing $5 million to the target and an additional $1 million already added in the second quarter. We are also positioned to benefit from IRU sales previously enjoyed by Crest that have averaged $9 million per annum.

In conclusion, we are well placed to resume our track record of increased dividends with the close of Crest, the commercial launch of AKORN, and the sales needed to cover cash carry costs. To be specific, we now have funding in place to complete the build of AKORN and to buy Crest. Crest is expected to close in early fourth quarter. AKORN is expected to turn up in early Q1, 2009. To-date, ACS has secured $6 million of the estimated $9 million target required to cover cash carry costs for the two fiber systems.

Now, back to Liane for closing remarks.

Liane Pelletier

Thank you, David. We expect to continue to enjoy strength from our first growth engine as Alaska's best wireless provider, and we are delighted to have our second growth engine, Enterprise, fully defined and funded. We look forward to sharing more as David Wilson and I will be visiting equity investors next week on the East Coast and in the Chicago area. If you would like to meet with us, please contact our investor line at 907-564-7556 or email us at investors@acsalaska.com. Thank you for your time today.

And with that, I'd like to open the call to questions.

Question-and-Answer Session

Operator

Thank you. Ladies and gentlemen, we will now begin the question-and-answer session. (Operator instructions) Our first question comes from the line of Jonathan Chaplin with JPMorgan Securities. Please go ahead.

Jonathan Chaplin – JPMorgan Securities

Hi. Just one quick question for Liane. I think when the discussion of AKORN first started, you gave us two data points. One would be that when the – you were in a position to grow the dividend again, the compound growth of over however long you didn't grow the dividend would be made up for by the increase of the dividend when you are able to grow it. And then secondly, the investments that you were considering, you would only consider if the dividend growth – once you are in a position to grow the dividend again would have been greater than they would have been before. And I am just wondering if both of those data points are still the same, given all the changes we have seen in the nature of the investment over the last few months.

Liane Pelletier

Thanks, Jonathan, for the question. So, a couple things that we have continued to reiterate time and time again that is our growth rate, top bottom line is in the mid-single digit area, and that our dividend policy of 70% to 75% payout of distributable cash fits there. And so those are the pieces that I think we've laid down from the get-go of our dividend strategy. Is there anything else you would add, David?

David Wilson

Yes, in terms of the mid-single digit, Jonathan, that's with the addition of the Enterprise business. So we think (inaudible) is certainly in a premium over the expectations we have given previously which is closer to 3% long-term. So, mid-single digit provides that additional boost from a growth standpoint. Obviously, that's very important when you think about long-term value. And as Liane mentioned, the Board has not moved away from the target payout ratio of 70% to 75%. So as soon as we cover the cash carry costs, we are very well positioned there. And obviously we have the benefit, too, of an additional source of meaningful growth for this business.

Jonathan Chaplin – JPMorgan Securities

So just following up from that, David, if I just use that mid-single digit growth rate and the 70% to 75% payout ratio, I get to a dividend in 2009 of somewhere around $1.05. Is there any reason to not think that's the right number?

David Wilson

Again, nothing has changed, Jonathan. Obviously, I am not going to comment on your model specifically, but we see long-term growth from the business and again, we maintain that 70% to 75% payout ratio. It's definitely a story around dividend growth over time.

Jonathan Chaplin – JPMorgan Securities

Awesome. Thank you very much guys.

Liane Pelletier

Thanks. Jonathan.

Operator

Thank you. Our next question comes from the line of Frank Louthan with Raymond James. Please go ahead.

Frank Louthan – Raymond James

Great. Thank you. You mentioned that you have moved 50% or so of your customers to new plans. Can you give us an idea of what impact that's going to have on ARPU? Did you lower the base and decrease people's rates? Should we look for a negative impact on the ARPU for the year? How should we think about that? And can you comment on the ETC cap imposed by the FCC last week, how you think that's going to impact you or not impact you? And I am coming up with $4.7 million for ETC revenue this quarter. Is that a good run rate and would you expect that to grow or, given the exclusions for Alaska within that ruling, or should we model that to be flat? Thanks.

Liane Pelletier

Thanks, Frank, for your questions. I'll pick up with the ARPU question and then I'll hand it to Leonard who is leading the internal analysis of the order that came out on Friday relative to this CETC cap. So on to ARPU, as we shared in the prepared remarks, with much lead time, we knew what the new competitors' price plans would be and we took proactive action to go ahead and match them on headline rates. And when you do that, there's lots of little moving parts within a wireless calling plan. Some moved up, some moved down. But we wanted to make sure from a marketing standpoint that we were very solidly positioned in the market versus the new competitor. The effect on ARPU is therefore a blend, right. So, if you take down some headline rates, you might move other things. And in fact, we use them as a very significant benchmark, overall. You know from our prepared remarks that a good 12% of total net adds in the quarter came from data card sales so we are pushing very chunky, high ARPU data, as we might see the normal industry pressure on voice ARPU. Features is also a phenomenally growing piece of our total wireless mix.

When you look at the ARPU effect, just Q4 to Q1, you can see in our statistics that there was some decline, but about a third of it’s seasonal, about a third of it is CETC, and a third of it relative to our program to convert customers to better plans. Now, when you think about kind of looking through the last part of the year, which is really where you were trying to angle your analysis, you can imagine that we marketed best plans to our customers in a priority order. And those that had sort of the most value to capture as a result of the conversion were very, very early takers of that. So in one sense, you can think that sort of the biggest adjustment to ARPU has already happened and the remaining 40 some percent of consumers are yet to pick up a new plan and I would fully expect that the ARPU effects of that last part of the consumer base would be much less than what we have already experienced. So, I'll pause with that before handing it to Leonard. Was that helpful on the ARPU side?

Frank Louthan – Raymond James

Yes. Thank you.

Liane Pelletier

Okay. Leonard?

Leonard Steinberg

Thank you, Liane. As you know, the FCC issued an order imposing an interim cap on CETCs at the end of last week and we here at ACS are still digesting that order and evaluating all of its implications. I will say, though, at first glance it appears that the FCC understands the underserved nature of the Alaskan market and has ensured continued funding for Alaska CETCs by including all of Alaska in the areas eligible for exclusion from the cap. So I hope that helps provide some guidance.

Frank Louthan – Raymond James

So can we expect ETC revenue to grow with subscribers as it has been in the past?

David Wilson

Face value, obviously, it's a positive, frank. Again, as Leonard said, there's a few things we need to understand better, so we are being very cautious, and we are looking through, making sure we understand the order in its entirety. But face value, it's certainly a positive.

Frank Louthan – Raymond James

Okay. Great. Thank you.

Operator

Thank you. (Operator instructions) Our next question comes from the line of David Coleman with RBC Capital Markets. Please go ahead.

David Coleman – RBC Capital Markets

Great. Thank you very much. Just a few questions. Looks like on the wireline business, the retail access lines actually were the highest in this quarter versus past few quarters, specifically on the retail side. Then on the – the TDMA cost savings, about $700,000 annually, was most of that reflected in 1Q results or is there any carryover into 2Q? And then finally, just on the acquisition of Crest, is there any opportunity to improve margins by grooming traffic off the GCI fiber onto Crest? Thank you.

David Wilson

Hey, thanks, Dave. I'll take them as you read them out. So, in terms of the retail decline, we were I think about 5.9% was the trailing 12 months number that you saw. What I would say is what's happening in Alaska is representative of what's happening nationally. So it's not an Alaskan specific issue. In terms of certain things that we have chosen to do, one is to push less aggressively in certain markets that are characterized by high turnover. When we were successfully reducing the write-down and, for example, through the end of March last year, we were very successful in terms of picking up share in those markets, but given the high level of turnover, it's not a smart use of cash. So we have purposely stepped away from those markets and we have definitely seen our share decline there, but that's a low value segment to be involved with and we are quite pleased to about be out of that segment. So that's a part of it.

In terms of structural decline, I'd say over half of what you are seeing is structural, and in terms of the other decline that you are seeing there, both the structural and the share that's primarily centered on the consumer space, we are clearly focused on the Enterprise space, so business lines have held up very, very well. And in terms of our long-term strategy, we are not going to try and fight things that are happening nationally. I don't think you can successfully do that and the way you are successful is working out how can you earn the best return from your previous investment. And the Enterprise strategy we are pursuing is the best way to earn a return. And it's what some of the other larger carriers are doing too, so we are following in the footsteps others there and we have a unique opportunity, given our market tools, to be successful in that space. Anything else on retail line before I move on to TDMA costs, Dave?

David Coleman – RBC Capital Markets

No, that's great. Thank you.

David Wilson

In terms of TDMA, so no, no major impact in terms of first quarter. So expect to see that benefit starting to feather in certainly by the middle of this quarter. You should start to see it really change. So really think about it for mid-Q2 onwards, seeing the full benefit of that 700K saving.

David Coleman – RBC Capital Markets

Great. Thank you. And just –

David Wilson

And then in terms of Crest, in terms of savings from GCI, we are still examining that. I think any saving opportunity is pretty modest, so not a significant move of the dial. We do currently have some capacity on the cable. Obviously when we own two, they would cease to be a required source of redundancy for us. But very modest.

Operator

Thank you. (Operator instructions) And our next question is a follow-up from the line of David Coleman with RBC Capital Markets. Please go ahead.

David Coleman – RBC Capital Markets

Sorry about that. Just one question. I see you guys, you talked about lowering pricing to compete with AT&T. Has there been any competitive response from AT&T since they have acquired the Dobson network?

Liane Pelletier

David, this is Liane. I will take that. Clearly, they are a national operator and they don't have the incentive or nimbleness to be able to operate and customize product and pricing for the state of Alaska and so there is – we are not seeing any reaction on their part to actions we have taken. They are sort of running their national game plan, with one exception. I think we shared on the earlier call that, whereas the national carrier AT&T announced an unlimited calling plan, actually in response to ACS's, they have not brought that yet to Alaska, so we remain a very solid competitor for the space of those who want unlimited voice, and, of course, we unlimited data too. So we are alone in that vis-a-vis the AT&T option and they have it in the Lower 48 but not in Alaska.

David Coleman – RBC Capital Markets

Great. Thank you very much.

Operator

Thank you. Our next question is a follow-up from the line of Frank Louthan with Raymond James. Please go ahead.

Frank Louthan – Raymond James

Just quickly, can you clarify what you said your expectations are on – for the AKORN traffic for this year and, of the traffic you say you have already made some progress toward making a dent covering the operating cost. Is any of that your own traffic that you are counting sort of that that’s where you would be saving the costs of your own traffic or is that all outside third-party customers that you have already signed up with some contracts to put traffic on that network? Thanks.

David Wilson

Good question, Frank. When we discuss it, when we think about it, we are thinking about incremental revenue, so third party, not internal, for example, saving cost in terms of ISP traffic, that's not part of the numbers we are sharing. So it's really about generating third-party revenue and driving incremental cash inflow to the company.

Frank Louthan – Raymond James

Okay. And expectations for revenue this year?

David Wilson

Oh, sorry. In terms of what we are specifically drawing out, we are specifically drawing out the target cash carry costs of $9 million. So this is an EBITDA contribution as opposed to a revenue number, Frank. So I appreciate I am mixing an apple with an orange. But we are looking for $9 million of cost to carry. We exited the quarter carrying $5 million and through April we added additional business, contributing additional $1 million. So $6 million of the $9 million is covered. I am going to shy away from issuing a revenue number, if you'll forgive me, again, EBITDA margin's a sensitive topic. But we’ll certainly continue to give you good insight in terms of how we are covering that cash carry cost.

Frank Louthan – Raymond James

Fair enough. Very helpful. Thanks.

Operator

Thank you. (Operator instructions) One moment, please. And I am showing that there are no further questions. I will turn the call back over to Liane Pelletier for closing comments. Please go ahead, ma'am.

Liane Pelletier

Well, thank you all for joining us today. I hope that if you are interested in meeting with us, that you will contact us through telephone, 907-564-7556 or that e-mail address is investors@acsalaska.com. We look forward to meeting with you and we look forward to sharing results with you on our next call.

Operator

Thank you. Ladies and gentlemen, that will conclude today's teleconference. We do thank you again for your participation and thank you for using ACT conferencing. You may now disconnect.

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