Embarq Corporation Q2 2008 Earnings Call Transcript

| About: Embarq Corp. (EQ)

Embarq Corporation (EQ) Q2 2008 Earnings Call July 29, 2008 4:30 PM ET


Trevor Erxleben – Investor Relations

Tom Gerke – Chief Executive Officer

Gene Betts – Chief Financial Officer

Harry Campbell – President, Consumer Markets Group

Tom McEvoy – President, Business Markets Group


Michael McCormack - J.P. Morgan

Michael Nelson - Stanford Group Company

David Coleman - RBC Capital Markets

Frank Louthan - Raymond James

Jason Armstrong - Goldman Sachs

Michael Rollins - Citigroup

Simon Flannery - Morgan Stanley

David Barden - Banc Of America Securities


Welcome everyone to the Embarq second quarter earnings conference call. (Operator instructions) Mr. Erxleben, you may begin your conference.

Trevor Erxleben

Thanks for joining us for Embarq Corporation's second quarter 2008 investment community update. With me today are Chief Executive Officer, Tom Gerke, and Chief Financial Officer, Gene Betts. In addition, Tom McEvoy, President of our Business Markets Group and Harry Campbell, President of our Consumer Markets Group will join us for the Q&A session at the end of the call.

Before we get started there are a few items I would like to bring to your attention. First, if you have downloaded the second quarter presentation from our website, please turn to the cautionary statement on Slide 2. As that slide indicates, our comments today will include forward-looking information and expectations involving a number of risks and uncertainties that could cause actual results to differ materially from our expectations. With that in mind I would strongly encourage everyone to review the detailed discussion of risks and uncertainties that is included in our SEC filings, in particular the risk factor section of our annual report on form 10-K.

Second, during our remarks today, we will be referring to certain non-GAAP measures. In the appendix of the presentation as well as in the definition section of our press release we have included reconciliations of these measures to the appropriate GAAP measures and I again want to encourage everyone to take a look at those reconciliations.

That, believe it or not, is all I have to cover this quarter, so I will go ahead and turn the call over to Tom at this time.

Tom Gerke

Looking back on the second quarter, the highlights are similar to Q1 in many ways. We again delivered solid income and cash flow results and were able to repurchase a significant number of shares at attractive prices. On the economic front we again saw both positives and negatives, the net of which led us to increase our cash flow outlook for the year. And to help maintain a solid cash flow profile over the long term we continue to take steps to improve our performance in a number of different areas.

Turning to Slide 4: Our revenue for this quarter was down a bit from the prior year with Telecom segment revenue declining 2.9% to $1.44 billion. The 2.9% rate of decline is a little higher than what we’ve seen recently, in part because wireless revenue growth has slowed, as we’ve stopped actively selling the service. However, as expected, wireless dilution has begun to improve with second quarter dilution declining to just over $3.0 million. Over the remainder of the year, we expect to see continued improvement with perhaps a positive contribution in Q4.

Voice continues to be the biggest area of revenue pressure, driven in the second quarter by a loss of 170,000 access lines. Although line losses increased by 22,000 compared to last year, that is an improvement from the year-over-year comparison in Q1. Similar to last quarter lower gross additions in consumer markets were the primary driver of the driver of the year-over-year increase in net line losses. In fact, on an absolute basis, the number of household disconnects was again below the prior year level.

Gross additions were also down in our business markets group. In contrast to consumer, though, business disconnects increased a bit this quarter. As we have indicated in the past, the negative, cyclical impact on access lines comes with an offsetting benefit in the form of reduced capital expenditures. As Gene will discuss in more detail, CAPEX was better than last year again this quarter and we’ve improved our full-year outlook by a considerable amount.

Moving to the data revenue line, we continue to see solid growth in both wholesale special access and high-capacity business data services. As a result, second quarter data revenue grew 5.9% year-over-year to $190.0 million. Although our capital expenditures are coming down as we fill fewer new service addresses, we continue to make prudent investments to help drive data growth.

For example, to accommodate the demand for wireless backhaul we are expanding the number of cell towers in our footprint we serve with fiber. This expansion is targeted based on the level demand at a given site, which helps us generate good returns on the investments. Fiber expansion also contributes to the award-winning service quality we provide to our wholesale customers.

Another area of targeted investment is the expansion of IP in both our network and our product and service portfolio. As data traffic grows, we are expanding our IP core in the areas of greatest demand, which allows us to handle the growth more cost effectively. We are also deploying IP-based DSLAMs on a targeted basis to support our upper end high-speed Internet service offerings.

From a product and service standpoint, IP-enabled functionality offers a variety of benefits for our customers. For example, we recently introduced IPsmartSuite, which enables small and medium businesses to streamline a variety of processes using touch screen display on their Cisco IP phone system. IPsmartSuite offers easily configurable applications designed for a number of different industries, including the healthcare, legal, and retail verticals, which we will be targeting.

For example, in healthcare offices the product can automate the process of reminding patients about upcoming appointments. Instead of having an employee to call each patient individually to remind them about their appointment the employee can simply an icon on their phone’s display screen and the system automatically dials each patient and provides the reminder.

We also launched a product called Embarq Smart IP Enterprise, which is similar to the Smart IP Bundle for small businesses we introduced in the fourth quarter of last year. Like the small business product, Smart IP Enterprise is economical, Embarq hosted, and it’s an alternative to CPE-based systems and offers Internet access, voice service, IP-enabled calling features, and easy to use web-based administration tools. Certain features, such as click-to-dial, which allows you to initiate a call from your contact folder in Microsoft Outlook, are unique to Smart IP Enterprise. In addition, the web administration tools are more sophisticated in order to meet the more robust requirements of Enterprise users.

Other major areas of growth include high-speed Internet revenue, which increase 13% year-over-year to $137.0 million this quarter. Although net subscriber additions were below the recent trend, at 24,000, HSI RPU was stable sequentially at $34 a month. Last year the 768kb service we introduced put some pressure on HSI RPU, which is now being largely offset by upgrades to higher speeds. Our new 10mg speed tier, although not a high-volume product is also having a positive RPU impact.

With respect to subscriber additions, Q2 results tend to be low due to seasonal factors and as with access lines, gross HSI additions were below the prior year level this quarter. In addition, we saw a year-over-year increase in economic disconnects that largely offset improvement and other categories of churn.

Going forward, we expect to see seasonal improvement in HSI additions and we’re planning to operate new, extended-reach service beginning in the third quarter. The new service should expand our addressable market by roughly 130,000 potential subscribers, raising HSI-capable lines to almost 85% of total access lines.

Delivery of this service is enabled by the use of smart coils, which will increase average installation time. As a result, an installation fee will be required to initiate service and the monthly recurring charge for consumers will be $10 higher than our standard 768kb service.

Shifting from the top line to the bottom line, our results this quarter, and frankly, over the last two years, reflect our ongoing emphasis on operational excellence. As in prior quarters, we took steps in Q2 that over time should contribute to further improvement in both our effectiveness and our efficiency.

The first of those steps I will highlight is the recent announcement that Nokia Siemens Networks will assume responsibility for our voice network operations center. That responsibility includes the monitoring of voice switching, transport, and signaling, as well as technical assistance functions. Under the agreement, approximately 265 Embarq employees will move to Nokia Siemens Networks where they will have access to tools and processes that wouldn’t make economic sense for us to develop and implement on our own. Leveraging those capabilities, along with their scale and global expertise, we expect NSN to meet or exceed current service levels and to do so at greater efficiency.

Another step we took this quarter was a call center consolidation in our consumer markets group. We closed three call centers and distributed the load among the other eight consumer centers we operate. This consolidation was driven by a combination of the reduced size of our customer base and the success we’ve had in reducing the need for our customers to call us with questions or complaints.

We have simplified our products, simplified our bills, and addressed a number of the other items that in the past have triggered service calls. The result has been a consistent decline in calls per access line over the last two years, with year-over-year improvement in some quarters exceeding 10%. In addition to improving our efficiency, I think it is reasonable to conclude that these results are positively impacting customer satisfaction.

Along with our efforts to improve satisfaction and retention, customer acquisition remains an area of emphasis. For example, over the last two years we’ve added 21 retail locations, which gives us 54 stores in total. Although we’ve slowed the rate of expansion recently, we have been able to improve our retail productivity. Sales per store have increased as has the value we realize from each sale, while costs have decreased on both a per store and a per sale basis.

As we consider further expansion, we are evaluating several innovative retail concepts. One example is a mobile store that is equipped with many of the things that you would find in our traditional retail locations. Our first Embarq Mobile Store actually started its life as a technician van but it has since been retrofitted with high-speed Internet displays, a slide-out tray for home phones, and other equipment, as well as a 42-inch television that shows product demos, dish network information, and some of our TV commercials. In the first few weeks after it hit the road the mobile store visited ten events and proved effective at both generating sales and providing positive exposure for the company.

Another factor that drives customer acquisition is a set of offers we have in the market place. In late June we began trollying a new consumer offer that includes free dish network satellite TV for a year. The bundle, which requires a two-year contract, also includes high-speed Internet service, unlimited local and long-distance calling, and popular calling features. Although given the timing of the roll out, this offer didn’t materially impact Q2. Our decision to de-emphasis wireless and increase the emphasis on video resulted in 22,000 video additions, our highest level since the second quarter of 2006.

In summary, I am pleased with the solid income and cash flow results we posted again this quarter. Growth in data and high-speed Internet revenues continues to mitigate the impact of the decline in voice and we’re making significant gains in expense and capital efficiency. Perhaps more importantly, I believe, there are still sizeable opportunities to improve efficiency throughout our business. Among the things Gene will discuss are several business process improvement initiatives we currently have underway.

So, with that, I’ll turn it over to Gene.

Gene Betts

I will begin with a brief overview of revenue for our three Telecom market groups. As you can see on Slide 7, modest revenue declines in consumer and wholesale were offset somewhat by year-over-year growth in business markets. In consumer, 4.8% growth and average revenue per household serve to mitigate the impact of access line attrition. As a result, consumer revenue declined 4.2% this quarter to $641.0 million.

Wholesale revenue declined at a similar 4% rate to $412.0 million in Q2. Within wholesale, declining switched access revenue is being partially offset by special access growth, which has been relatively steady in both the wireless and wireline segments.

Finally, business markets revenue increased slightly on a year-over-year basis to $386.0 million in Q2. Although business access line attrition was a bit higher this quarter the impact was more than offset by increases in data and equipment revenues.

Turning to Slide 8, gains and efficiency are helping offset top line pressure and contributing to strong operating income and earnings per share results. Although down a bit sequentially, second quarter operating income surpassed every other quarter since the spin and diluted EPS matched the record level we established in Q1.

Operating income in the quarter was $428.0 million, which was aided by a $9.0 million non-recurring gain on the sale of property in New Jersey. Even after adjusting for non-recurring items, Q2 operating income was above the prior year level. Year-to-date operating income is totaled $862.0 million, up from $771.0 million in the first half of 2007. First half operating margin is also much improved from the prior year level, again, with or without the impact of non-recurring items.

Looking at expenses in more detail, the $9.0 million gain was recorded in the SG&A line item which offset an increase in bad debt. At 1.8% of total revenue, bad debt this quarter was consistent with the second half of 2007 and we expect it to remain in the same range over the second half of this year.

As Tom noted earlier, we were able to capitalize on our relatively low stock price again this quarter by repurchasing a significant number of shares. From the beginning of the year through July 25 we repurchased 11.3 million shares, or more than 7% of the total outstanding. The total cost of the buybacks was $479.0 million, or a little over $42.00 per share. Among the benefits of our declining share count is that it enabled us to match the record diluted EPS of $1.38 we reported in Q1.

Along with solid income results, we generated strong cash flow this quarter, which is shown on Slide 9, and was helped by lower capital expenditures. CAPEX was $179.0 million in Q2 and totaled $356.0 million in the first half of the year, representing just 12.3% of telecom revenue. The year-over-year improvement in capital expenditures is largely a function of new service addresses, which we call NSAs as an acronym, which continue to decline from the very high levels we saw a couple of years ago.

Although our prior outlook for 2008 anticipated lower NSA requirements, our most recent analysis indicates they will be lower still. In total, we now expect CAPEX to be less than $740.0 million, down significantly from our prior outlook of $780.0 million. Within that total we expect NSA requirements to be more than $100.0 million below the level we saw in 2006 when CAPEX, excluding spin off requirements was nearly $900.0 million.

Lower capital requirements combined with solid profitability resulted in cash flow before dividends of $274.0 million in Q2 and a total of $560.0 million for the first half of the year. As with income, prior year cash flow comparisons were helped by non-recurring items, but even without those items, we’ve achieved solid year-over-year cash flow improvement.

Of course, measures of cash flow and CAPEX are key elements of return on invested capital, or as an acronym, ROIC, which when you do the calculation further highlights the efficiency of our operations. Although we’re making ongoing improvement, our operating margins in the past have been lower than some other companies in the industry, partially due to our relatively low level of regulatory subsidies. Our asset turnover, however, is relatively high, which implies a more efficient use of capital, historically. As result, our ROIC is in the top quartile among our peer group, which is true whether you include or exclude the impact of goodwill.

To help maintain strong cash flow and ROIC profiles, we are focused on continuous operational improvement. I will walk through a few brief examples to give you a sense to what we’re working on in this area. One very important aspect of these projects is that they’re designed to fundamentally improve business processes. This kind of discipline approach to process improvement is essential to making sustainable long-term progress.

In the first project, we’re looking across internal organizational boundaries to improve our end-to-end delivery of high-speed Internet service. This includes ensuring information about our physical plant is accurate to reduce truck rolls for installations of speed-up rates. We are also improving processes around modem inventory to reduce support costs. Additionally, we are increasing visibility of port utilization and transport capabilities to improve network planning and performance.

In our wholesale group, we are automating processes for ordering, provisioning, and service assurance that today involve a great deal of manual effort. In addition to significantly improving information accuracy and our internal productivity, we expect these efforts to benefit our customers as well.

Another project we believe will improve the customer experience involves streamlining our contracting processes. Enhancing our ability to create, implement, and manage contracts has a number of potential internal and external benefits, including reducing cycle time, billing adjustments, and the complexity and cost of contract support.

In our supply chain organization we are increasing the visibility of asset utilization to reduce inventory levels, particularly for equipment that doesn’t impact service. In addition, we are improving forecasting processes and the level of partnership with our suppliers to reduce lead times and to avoid over- and under-stock.

Finally, a project we’ve mentioned before is an overhaul of the workforce management systems and processes utilized to dispatch technicians in our network organization. The goal is to improve routing efficiency, which in turn we expect to increase productivity and customer satisfaction as we’re able to more precisely estimate arrival times for installation and service work. Internal work on this project started late last year and we recently began our first service pilot in the field. By late this year, or early 2009, we expect the new system to manage standard scheduling and assignment tasks for all of our field technicians.

Although individually none of these projects is transformational, collectively we expect these and other initiatives to contribute to marked operating improvement over time. In addition, we continue to pay very close attention to a number of load and productivity metrics. With the exception of depreciation, our expense structure is a lot more variable than I think is commonly perceived. Accordingly, as we have done in the past, we will continue to reduce variable or step-function variable expenses as we see reductions in related load drivers.

In closing, our results this quarter and the various initiatives we have under way give us confidence in our cash flow outlook for 2008 and beyond. On Slide 10 is a summary of our current and previous expectations for the year. Our outlook for access lines is unchanged from the last quarter because we continue to believe Q1 was the peak in terms of the year-over-year increase in absolute line losses. Although second quarter losses were still above the prior year, the gap narrowed considerably, which we think is an encouraging sign for the future.

Our outlook for revenue in the Telecommunications segment also remains unchanged at $5.72 billion-$5.80 billion. In light of the improvement in wireless dilution this quarter we are maintaining our expectation that full-year dilution will be in the $20.0 million range as well. I noted earlier that we have improved our outlook for capital expenditures to $740.0 million or less, which would be less than 13% of telecom revenue. As we’ve seen recently, the housing environment can have a material impact on our level of capital spending but unless we experience another surge in construction, we don’t expect to exceed 13% of telecom revenue over the longer term.

Finally, given the reduction in capital spending, we have increased our expectations for cash flow before dividends to a range of $1.0 billion-$1.04 billion. In light of the competitive and economic environment, reaching $1.0 billion in cash flow would be a very notable achievement and a solid improvement from last year.

That concludes our prepared comments today. I will go ahead and turn the call over to Trevor again so he can facilitate the Q&A session.

Trevor Erxleben

While the operator opens the line for questions, I would as always, ask everyone to limit to the extent possible the number of multiple and multi-part questions that you ask. We have 20-25 minutes available for Q&A so we should be able to, and would like to, get to at least one question from everyone in the queue.

Question-and-Answer Session


(Operator Instructions) Your first question comes from Michael McCormack with J.P. Morgan.

Michael McCormack - J.P. Morgan

On the margin side, you talked about some flexibility there on the variable costs. Can you give us, I don’t know if it’s easy to quantify, but you’ve got revenue, sort of core revenue, 2/3 of your revenue from voice declining at 7.2%. Maintaining margins there must be some flexibility, but at the same time DSL adds, obviously tougher seasonally, but it seems like DSL has got to be the future of the company. Is there some pressure there to spend and perhaps some pressure on margins overall?

And secondly, just on cash use, any thoughts to dividend payout ratio versus reloading a stock repurchase?

Gene Betts

First, on the margins, while certainly the parameters you mentioned are directionally accurate, we continue to expect to continue to improve our margins. We’ve talked before about the 300 basis point margin improvement of which would actually improve more than that, some of which reflects the fact that some of the spin-off costs have receded. But on the 300 basis points that we’ve articulated before, we have delivered I think about 200 basis points. There is a little more than that.

We expect, going into next year, to deliver another 100 basis points on that and we really think that we still have a number of process improvement options to help take costs out of the business. So, as I think about it, we basically have two things. If you have a reduction in access lines, there’s load that goes away in terms of service calls, operator calls, etc. But in addition we still have a real opportunity in front of us on just unit cost productivity business process improvement. So I think for the next year or so that we ought to be able to continue to improve those margins, even in what’s a difficult economic environment.

On your second question, I would just say that on dividends and use of cash generally, I think we’ve established a clear track record since spin-off of articulating an algorithm which we have consistently followed. I’ve probably bored some of you this but just to restate it, our first objective is to generate as much cash flow as we can, which as we said, we’re targeting over $1.0 billion this year, which we’re delighted with.

And then in terms of how that cash flow is deployed, we said if we have a very good, strong business case for something within the business, presumably our shareholders want us to reinvest, you know, above the cost of capital if we feel strongly about that. We haven’t seen anything of significant size since spin-off to invest in. And then if we don’t need to use it within the business, then our viewpoint is it ought to be returned to the shareholders, whether that is returned as a dividend or a share repurchase is a decision we made at that point in time. And this topic is continually reviewed by management and by the Board.

Did that answer your questions?

Michael McCormack - J.P. Morgan

Yes, that’s fine. Just on the DSL stuff, it seems like you guys are relatively under-penetrated on primary lines and I’m wondering if there isn’t some initiatives that could be undertaken there without pressuring margins too much.

Gene Betts

One of the things that was mentioned is that we have added what we call extended DSL, where we are pushing out our looped links. So we are going to address 150,000 customers, or another 5%, with the expansion of our footprint. So that’s a good example and we’re going to charge more for that because there are some special costs so we’ll charge a one-time set up cost and a higher per-monthly rate. But that’s a good example of where we could expand the footprint for more DSL.


Your next question comes from Michael Nelson with Stanford Group.

Michael Nelson - Stanford Group

I was wondering if you could provide us with an update on the regulatory environment. Are there any changes that we can expect in the next several months? There seems to be some interest from the FCC and some politicians on USF. We’ve heard about audits and questions regarding the use of USF subsidies. Can you comment on the recent activity and if you expect any changes in the near term?

Tom Gerke

Sure. You know, the regulatory environment is one that on USF and inter-carrier compensation has probably gotten attention and will continue to get attention, frankly, for years to come. I think there are some in the industry that see the potential for change in the beltway and look for an opportunity to try to press things, at this time.

There is also, in at least one particular case, a court deadline for the commission to act at least on some of the matters. So, we’re hopeful that parity, which is paramount to us, can make some progress here in a couple of areas. One would be pole attachments. We think parity between us, the electrical industry, and importantly, our competitors within cable, is a place that is ripe for some potential beneficial activity. Fam traffic is another place that we think is a decent opportunity. You know this is simply rules to require people to pay what, to identify what they’re taking through the check out lane, if you will, and pay the appropriate price for it. I think with inter-carrier comp it’s a complicated area and so there’s always the potential for progress to be made.

There have been several industry initiatives over the years that have not gained traction and really gotten there. We continue to have discussions and/or proceedings in particular states that we vigorously represent our interests. We represent rural America, along with some of our other peer carriers. There are some of the other carriers who spun-off or basically walked away from or don’t have the same presence in rural America that we do and therefore don’t have the same interests. I think that’s a very viable political contingency that’s well represented.

And then USF, you know, we just went through proceeding in Texas on a state USF fund over the last 12 months. We are very satisfied with the outcome there. We will continue to focus on, there’s at least some Congressional interest in collecting data. We think that program’s pretty transparent, already, but more than happy to provide that data and again, strenuously represent advocacy for rural America and broadband and that part of our carrier-of-last-resort obligation that we think goes hand in hand with that support.

So, it’s always hard to predict, can’t provide any guarantees, but we think it’s a process where we, on our own, our peers speaking up on their behalf and various industry associations that we play a meaningful leadership role in, we believe we will be well represented. So, a bit of a long-winded answer but I wanted to kind of cover that waterfront for you.


Your next question comes from David Coleman with RBC Capital Markets.

David Coleman - RBC Capital Markets

Just a question as far as access line losses. Wondering if you can talk about trends that you’re seeing in the Nevada and Florida markets? I guess also as well as trends in household disconnects overall.

Trevor Erxleben

The specific state results we consistently have not provided for competitive reasons. The trends on gross additions and disconnects, as Tom indicated in his prepared remarks, have been fairly consistent over the last few quarters. Disconnects in the consumer business have gotten better, gross additions have gotten worse. In business it’s a little bit different in that gross additions are down and disconnects are up a little bit as well. But by and large, it’s a gross addition issue more than a disconnect issue.

David Coleman - RBC Capital Markets

You mentioned the CAPEX for NSAs $100.0 million lower versus 2007 levels. How much of the $740.0 million that you’ve been spending on CAPEX this year would be for new service addresses?

Gene Betts

It would be probably 40%, zip code.

Trevor Erxleben

Somewhere in the 35%-40% range, I think is probably a good estimate.


Your next question comes from Frank Louthan with Raymond James.

Frank Louthan - Raymond James

Just wanted to go back on the enterprise side. Are there any material changes you’re seeing there? You know, we did see some more negative numbers out of some of the gaming companies you have some exposure to. Can you comment on what you think the outlook is there and then circle back to Mike’s question on use of cash. Is reloading on the buyback a serious consideration this year?

Tom McEvoy

On the enterprise side we continue to see high demand and request for our large data pipes and, of course, ways to help them improve their productivity and help their bottom line. But I can tell you in that segment overall, we have seen growth year-over-year and year-to-date, so we continue to get decisions coming our way and we continue to be putting proposals out on the market place.

Tom Gerke

And basically I would reiterate the algorithm that Gene talked about and endorse it. And second, think that we’ve established a track record through multiple dividend increases, then the announcement of the buyback and then, you know, which was discussed as a much longer period than six months, discussed more in a 12-18 month time frame, but we aggressively got after it in the last two quarters. And so have a track record of being willing to commit to returning cash and then of looking for the optimal way to do it.

As we kind of finish out the current buyback, there’s a little bit more left in it. We’re going to be doing what we’ve always done with our Board, is just keep watching it, regularly reviewing it with them and seeing what determinations they make and sharing them with you on a prompt basis when they do.

Frank Louthan - Raymond James

And just to clarify, are you saying on the enterprise side seeing some growth year-over-year. Is that sort of on all levels, from T1 and above or kind of all over the enterprise or really at the large end. Can you clarify that a little bit?

Tom McEvoy

It’s more on the high capacity services, T1 and above. And specifically around our Ethernet Net IP product set.


Your next question comes from Jason Armstrong with Goldman Sachs.

Jason Armstrong - Goldman Sachs

Just one follow-up question on broadband and the extended reach service, you talked about using smart coils. Tom, I think you said it extends the foot prints, I heard 130,000 lines, I heard 5%. Can you give us more details on the technology behind this, maybe what the deployment actually looks like. I guess what I’m really trying to get at is, is this applicable for the rest of the footprint? Should we be talking about 100% DSL coverage or is this sort of limited to the 5% that you talked about?

Tom Gerke

We don’t have our network person on so there will be some limitations to the precise discussion here, but basically it is just is additional network component that allows the service to work for a longer loop and we can put it in on a limited basis. We feel very good about the 130,000 because it is likely areas where people are hungry for the higher speed data product offering and quite likely that they don’t have the ability to get it from cable.

Technology continues to advance. I think this product, as it currently exists, we don’t think would go a lot further than this. Maybe a little bit further, but it’s also an area where there is constant change. To give you a feel for it, the reach extends from about 19k to 24k in terms of loop length. So I think stay tuned, this is an area where we’re working hand-in-hand with the vendors. We’re a ready buyer if they can continue to provide product enhancement.

Harry Campbell

Let me add something real quick. On the 130,000 it is a total between business and consumer. And this is a mixture of more rural markets plus it can be some fringe markets around cities. So it isn’t just a pure rural play. What it is is it’s getting 19,000-24,000 better capability for people that far from the CO. We think with the product we have we’re going to get a chance to get more penetration.


Your next question comes from Michael Rollins with Citigroup.

Michael Rollins - Citigroup

I was just wondering if you could talk a little bit about the wholesale segment. Were there any transitory items in the quarter that we should be thinking about, or any areas where, I know you talked about special access, but any points that led to a little bit wider of a sequential decline.

And if I could just follow up quickly on the cash repatriation comment. Is there any thought, just in terms of balance sheet strategy, where you want to shake out with respect to optimal financial leverage? And given what some of your peers have done and maintained, do you have any thoughts in terms of where you want to be relative to your peers on that basis?

Tom Gerke

On wholesale, I don’t really think there’s anything occurring in that market that is worthy of note. We are still aggressively pursuing it, making sure, as we talked about with our fiber initiative, and those cell sites that can justify it, building the fiber. We’ve got sales comp programs in Tom McEvoy’s area to make darn sure that the business folks sell Ethernet and other products off of that fiber once it’s been installed so we get the absolute maximum bang for the buck there.

But in terms of specific trends or other characteristics you were asking about, I don’t think anything worthy of noting.

Gene Betts

On the optimal leverage, conceptually we have said for a long time that we are targeting investment grade, don’t want to be on the edge of the cliff, so to speak, but lower investment grade, but have no aspirations to be an A credit or BBB credit. So that’s really our target. I think what those metrics are that will deliver that do vary somewhat over time. I think they also vary somewhat even between peers and certainly, at least at this in time, the larger LECs or ILECs have experienced somewhat more competition and so I think the rating agencies have a somewhat different view on what is an investment grade cash structure there versus perhaps a very small ILEC that has very protected territory. So, there can be some difference in the metrics.

It’s something we continually review when we talk to the rating agencies and I think does vary somewhat over time.

Michael Rollins - Citigroup

As you talked about accelerating your buyback program in the first seven months of the year versus what you expected to take longer, how do you weigh coming to the completion of that program versus your debt leverage? And do you have interest in potentially taking financial or higher leverage, depending on where you see the valuation of your stock? Is that one of the inputs into your consideration process?

Gene Betts

Obviously we take everything into account. Maybe to state it somewhat differently, in sort of the algorithm format, I think the way we think about it is, while we want to maintain a lower investment grade rating and feel comfortable with that, we basically said in excess of that, if we don’t need the money in the business, we ought to distribute all of it. So if you look at this year, for example, between the repurchase program and our dividend, we are basically returning all of the cash flow that we anticipate generating.

So, it’s sort of the chicken and the egg, of what comes first, but I think what we’re saying is that we will maintain that lower investment grade rating, we’ll distribute the cash above that. What it takes, metric-wise, to maintain that is a little bit subjective and moves over time.


Your next question comes from Simon Flannery with Morgan Stanley.

Simon Flannery - Morgan Stanley

If I could talk about the sale. You talked about weaker gross adds and I think it’s a theme we’ve seen across the industry. You also talked about perhaps an improved momentum n Q3. Can you give us a sense of what your research is suggesting? What’s causing the slow down? How much of it is cable taking share versus what might be seen as saturation versus some macro economic factors, from the work that you’ve done? And talk a little more perhaps about what you expect for the second half on broadband.

Tom Gerke

I look at broadband, I try to look at it from a macro view and say how many households have high-speed date, how many households have a computer, and what’s the gap. And you’ve got as much access to data that will answer those questions, but we think there’s a significant gap still between, as much as 30 points in there. And so we think over time, anybody, or nearly everyone that has a computer will want a high-speed data connection.

I suppose the state of the economy will determine, to some extent, how many of those can afford it. I think that in hindsight we will be able to look back and have a better feel for how we’re holding on share of decisions, but we feel pretty good about that, but that’s something you can only be 100% confident of in hindsight.

And then there’s a number of things that we’re going after, in terms of the new product, this new offer with dish TV is part of a bundle and it’s meant to drive a nice bundle that clearly has the DSL piece in it. Our efforts and continued expansion of the 10mg tier, as well as having five full tiers is another way that we’ll continue. We’re looking at constantly refreshing our marketing, advertising, and sales approach within both consumer as well as the business. I think you’re going to continue to see some of these various new offerings that we talked about, often one sort of data pipe or another necessary to take advantage of those within the business segment.

And so, that’s how I kind of think about and how I get comfort that we still have a pretty nice growth engine there. But this last quarter, and not only our results, and as you noted, in other companies, tells us that there’s some softness and we need to get after it with the best approach possible.

Gene Betts

I would add, just mathematically, of course, I think what I call the law of large numbers is playing into this. And if one thinks about it compared to wireless, when it was going from a new product to now 80%-90% penetration, when you get up to the 50% range, even if you have steady churn, and our churn is actually very good and improved some, but every year you have a bigger number and you start sort of in the hole so to speak because you’ve got this churn number and then you need to offset it. And plus I think just the rate of adoption tends to slow.

So I would expect, even though there’s a big gap left, we think, between people who will buy it and people who have purchased it, which is probably the difference between like 50% and 80% or 90%, so there’s a lot of runway. I think it’s logical that the rate is slowing down.

If you notice, like AT&T I think had 40,000 net additions. We had 22,000. So we were over 50% of their net adds. Now, I’m sure one of their factors is they have a big base and they have a lot churning off. But I think, relatively, we’re doing well. But I think probably expectations for the whole sector, and including the cable companies, is just that the law of large numbers and where we’re at in the penetration is logically going to lead to a somewhat lower add rate than what we’ve seen over the last several years.


Your next question comes from David Barden with Banc of America.

David Barden - Banc Of America Securities

If I could, just on the broader somatic side, the biggest theme beyond the economy that’s been hovering over the space has been M&A. And I think historically Embarq has expressed a desire to maybe be an acquiror but at the same time it has always faced a challenge with respect to its currency, in terms of valuation relative to peers. And relative to another question that was asked, the leverage has always been a question mark. Your commitment to the regulators was always a softer commitment to investment grade metrics. So I have kind of two related questions, one, Tom, how do you see Embarq positioned in a consolidating industry, acquiror or acquiree?

And then, Gene, does investment grade have to be the litmus test or can you go back to these regulators and say, “Look, you like us, we like you. Let us increase our leverage, get our currency up the way Century Tel did and let us start making acquisitions in this industry?”

Tom Gerke

First, in terms of metrics and the currency that you talked about, that is something we have talked about and it’s just kind of Finance 101. And the good news is you will see in our results and what we talked about, progress on margins, progress in maintaining a core top position on ROI, and a continued confidence in our ability to improve. That is sticking to our netting and we need to continue to do that to have a solid currency, M&A or not.

In terms of regulatory commitments, I think we’re two plus years out now. There’s nothing in any written or other type of commitment that limits us from doing what, in my belief, what the Board wants to do. We’ve told the regulators, almost three years ago when we were going through the approval process, that this was a solid company, we had bright prospects, we’ve proven that to be true. And have not had the need to have any discussion with them concerning our cap structure, etc. So we feel good about that. We were far more sensitive to that during the earlier days.

With respect to the ongoing speculation comments, etc. that’s something obviously I can’t comment on. What I have said numerous times is how important it is for us not to lose focus on achieving operational excellence in our business and so that’s that.

We have always considered alternatives for improving the business, including participation in industry consolidation. And going to your point, whether that’s as an acquiror or as an acquiree, it’s just a matter of does it maximize in an optimal fashion the value for our shareholders versus our plan that’s in place.

And I guess the only other point I would make is that we have talked about how M&A can be a distraction and so the really small deals have not been something that we have been as focused on just because they come with distraction that may outweigh any possible benefit. So when I talk about things that we might be interested or things that we would spend our time looking at, it’s more the move-the-needle type of transactions.

David Barden - Banc Of America Securities

And if I could just clarify, are you engaged with the regulators now to try to move this leverage deal or is that not something you’re engaged in right now?

Tom Gerke

We are not engaged because we don’t believe there’s any prior approval requirement or covenant or condition that requires anything. Now, naturally if we were to go acquire someone or if someone acquired us, and most of our footprint or most of the footprint of whoever we would acquire, there would be a regulatory approval process at the PUCs and their standard is to make sure that you have got a viable company capable of taking care of and serving the consumers in that area.

But that’s absolutely no different than any other LEC-to-LEC combination approval process. So I don’t see us as being differentiated against or hampered, regardless of acquiree or acquiror in the approval process vis-à-vis anybody else in the industry.

Gene Betts

You mentioned Century and there have been some earlier questions about leverage levels. You know, Century, as I understand it, is still an investment grade company. Now their rating came down I believe, to BBB- but with respect to commissions our commitment was to maintain an investment grade rating. And I think it is an open question with discrete metrics of how do those compare to ours. That’s obviously something we’ll be discussing with the rating agencies and value their input on. But Century, per se, doesn’t really raise a question because they’re still an investment grade credit. In terms of the leverage level, because that was our commitment.

Trevor Erxleben

That will have to be the last question today. I would like to thank everyone again for joining us and wish you all a good evening.

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