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Qwest Communications International Inc. (NYSE:Q)

Q2 2008 Earnings Call

August 6, 2008 9:00 am ET

Executives

Kurt Fawkes - SVP of IR

Ed Mueller - Chairman and CEO

John Richardson - EVP and CFO

Analysts

David Barden - Banc of America

Tom Seitz - Lehman Brothers

Simon Flannery - Morgan Stanley

Michael Rollins - Citi Investments

John Hodulik - UBS

Frank Louthan - Raymond James

Chris Larsen - Credit Suisse

Jason Armstrong - Goldman Sachs

Tim Horan - Oppenheimer

Operator

Good day, ladies and gentlemen, and welcome to the Qwest second quarter 2008 earnings conference call. (Operator Instructions).

I would now like to introduce your host for today's conference, Mr. Kurt Fawkes. Sir, you may begin the conference.

Kurt Fawkes

All right. Thank you, James. Good morning, everyone, and thank you for joining us on the call this morning.

For the agenda of the call, Ed Mueller, our Chairman and CEO, is going to begin our discussion with some observations on our second quarter performance and the current market environment. And then, he is going to be followed by John Richardson, our CFO, and John will get into some of the specifics on our financial performance for the quarter and share with you our outlook for the balance of the year.

This morning's call, on slide three, we have our forward-looking statement. I want to remind everyone that we will be providing some forward-looking statements this morning, which will contain risks and uncertainties that could cause our actual results to differ materially from those expressed or implied during the presentation. These risks and uncertainties are on file with the SEC, and of course, I strongly encourage you to review them.

Additionally, we do not adopt analyst estimates nor do we necessarily commit to updating the forward-looking statements that we are making here.

Also, let me mention that in order to supplement the reporting of our consolidated financial information, we will discuss certain non-GAAP financial measures, including adjusted EBITDA, free cash flow and net debt, and a full reconciliation of these measures are available on our website.

Moving on to slide four, we summarize our net income and EPS results for the quarter along with adjusted EBITDA and free cash flow. We reported net income of $188 million in the quarter. That's $0.11 per share. That compares with $246 million or $0.13 per share a year ago. Net income this quarter reflects full book tax rates, while taxes were minimal in 2007. Additionally, our lower share count in the current quarter affected our earnings per share results.

Adjusted EBITDA for the quarter was $1.14 billion and that's flat with the prior year. During the quarter, two significant items were normalized out of the EBITDA results and they offset each other. There was a $40 million property tax settlement. That was a good guy, of course. And then, we had a $40 million charge to litigation reserves. That was associated with ongoing securities actions. Finally, adjusted free cash flow for the quarter of $460 million excludes $85 million for opt-out payments related to securities litigation settlements we reached last year.

Now, with that, I'm going to turn it over to Ed.

Ed Mueller

Thanks, Kurt. Good morning everyone on the call. I am glad you could join us today and we appreciate your interest in our company.

In my remarks this morning I will review our progress during the quarter, also touch on some of the key market dynamics we are seeing in each of our business segments. I will close my remarks with a review of shareholder returns and a recent management change. Then I will turn it over to John who will discuss the specifics of our financial results for the quarter and review our current outlook.

In the quarter, we continue to produce stable adjusted EBITDA as lower operating expenses offset top line pressures. Within the overall revenue trend, we had mixed performance across our market segments. Clearly, the bright spot for the quarter was our Business Market segment, which achieved annual revenue growth of 5%.

In Mass Markets, revenue declined 3% compared to the year ago period. Mass Market's performance was impacted by a tougher economy in the second quarter in some of our markets. This was particularly true in areas like Arizona where new housing starts have dropped precipitously. Our wholesale revenue declined 8% in the quarter mainly due to pressure on legacy voice products.

In the second quarter, we demonstrated good progress on productivity and profitability with margins improving sequentially and year-over-year. As many of you know, at Qwest we have adopted a series of strategic initiatives to support our overall goal of providing an unparalleled customer experience. These initiatives include establishing strong partnerships, providing simplified integrated customer solutions and delivering leading broadband capabilities.

We have hit a milestone in our fiber-to-the-node build-out, passing 1 million potential customers. We are also underway with our marketing launch of Verizon Wireless services. While we are in the early stages of both of these initiatives, I think they are two great examples of executing on our strategies.

Now we'll turn to slide seven and dig into the individual business unit performance. In the second quarter, our focus on integrated solutions and data and IP capabilities continued to generate strong growth within the Business Market segment. Revenues within our enterprise strategic product suite grew at an annual rate of 36%.

One of the principle drivers for this growth has been customer migrations from the legacy data services to the current generation of IP-based solutions. The Business Markets Group also reported strong equipment revenue in the quarter, partly reflecting improved government sales.

In the second quarter, we were pleased with the ramp in productivity from the business sales team additions we made in 2007. These associates contributed to the strong sales levels we experienced exiting the quarter and we expect them to be at targeted productivity levels by the end of the year.

In the federal government space we are witnessing a substantial pickup of networks bid activity as federal agencies gear up to transition from prior contracts. We believe this activity could result in meaningful revenue gains during 2009. During the second quarter, we received an order from the Social Security Administration to provide the potential for up to $100 million of incremental revenue over the life of the 10-year deal.

Business Markets reported improved segment income this quarter as it leveraged scaling revenue. A key to maintaining this trend is efficient management of facility costs, and we believe there are additional opportunities in this area.

On the slide eight, we outline Mass Markets dynamics. In the second quarter, Mass Markets revenue was impacted by fewer access lines, which were partially offset by a higher ARPU from customers of bundled services.

Our net high-speed Internet sales in the second quarter were 31,000. This was a deceleration from the first quarter due to both seasonality and some share loss following more competitive market pricing and promotional activity.

In the quarter, Mass Market access lines declined 8.8% year-over-year, a step up from 8.3% in the first quarter. The higher line loss is attributable to increased impacts from substitution, the economy and cable competition. In the quarter, new line activations declined. Port outs to competitors and overall deactivations were flat with the first quarter.

Cable telephony services are currently available to about 80% of our residential footprint. Cable has had a presence in nearly all of our major markets for, at least, two years now, with some markets competitive for more than five years. Cable is currently estimated to have approximately 20% share of wireline voice services within our local markets.

While we have seen no significant new market entry in the residential space this year, cable generally has aggressive offers in the marketplace and we're now seeing some focus on small business users in selected markets. We have launched several new initiatives to create separation from our Mass Market competitors and drive service demand.

On slide nine, we highlight some of these actions. I noted earlier our progress on building out fiber-to-the-node. Our goal is to extend these services to a total of 1.8 million potential customers by the end of the year. In the quarter, we added 19,000 subscribers on our fiber-to-the-node footprint. The higher speeds provided by fiber-to-the-node will further strengthen our competitive position as we ramp availability.

We announced the operational launch of our partnership with Verizon Wireless last week. Today, we are selling Verizon Wireless services to new customers and we are preparing for large scale migration of our existing Qwest Wireless subscriber base later in the year. We have also announced enhanced pricing for high-speed Internet services and we are combining this into an attractive package with DirecTV ahead of the upcoming NFL season.

Promotional pricing on our high-speed Internet and video offerings allow customers to get introductory rates on 1.5 meg services for as low as $14.99 per month and we're offering a bundle of 1.5 meg and DirecTV for as low as $49.98 per month.

We have also launched new access line retention product trials, including wireless at home, a landline phone with wireless convergent features. This product, among others, will help to enhance the relevance of access lines among targeted customer groups.

Finally, in the second quarter, we benefited from actions to reduce cost and preserve Mass Market segment income. During the quarter, lower marketing spend and cost savings from organizational streamlining offset the revenue decline.

Now we'll move to Wholesale Markets on slide 10. Wholesale voice services continue to contract due to consolidation, access line pressures and competitive market conditions. Within Wholesale, our focus is to maximize the margin potential of our current voice revenue base and pursue data and IP opportunities.

In the second quarter, the Wholesale segment margin was below our expectations. In addition to the loss of high margin access revenues, we were impacted by some unprofitable long-distance customers that have been addressed. Additionally, one-time items affected comparisons with prior periods. We expect to report improving comparisons in wholesale in the second half.

Now we'll turn to slide 11 and discuss cash flow allocations. Between share repurchases and quarterly dividends, Qwest has returned a total of approximately $600 million to shareholders in 2008. We remain committed to the dividend and completing the original $2 billion share repurchase authorized by our Board. We have a little less than a $300 million remaining under the repurchase plan and we expect to complete this prior to yearend.

At the same time, our cash flow generation has supported our investment in growth opportunities. For example, more than 60% of our capital spending in the second quarter was focused on data and IP services, including our fiber-to-the-node build-out. We expect to update you on our plans for future cash flow allocations by the end of the year.

Before I turn it over to John, I would like to take a moment to review our recent management change. As you know, last week we named Tom Richards as our new Chief Operating Officer. Tom has been with the company since 2005, heading up the sales and operations of our business markets group. He has done a tremendous job in that role, and with our focus on the strategies for growth as well as our new business segment reporting, I believe it is important to have someone with Tom's experience and success to oversee the daily operations of our key customer facing organizations.

This important move enables me to work even closer with Tom as we execute on our strategies with a complementary tactical operations focus. We want to further enhance the customer experience, while maximizing efficiencies and controlling costs. And this new position is designed to deliver on that goal.

Now, I'll turn it over to John.

John Richardson

Thanks, Ed, and good morning, everyone.

On slide 13, we provide the breakout of our product revenue for the quarter. Our total revenue of $3.4 billion was down 2% compared to the prior year and was down a little under 1% sequentially. The mix shift from legacy voice services to data services continued this quarter and data now represents 40% of our total revenue, up from 36% a year ago.

Data, Internet and video revenue grew by 9% in the quarter compared to the prior year. This growth was driven by consumer demand for broadband services, increases in small business data and IP service, and strong growth in the enterprise strategic product suite that Ed noted.

Voice revenue was 54% of overall revenue and declined 9% from the second quarter of 2007. This compares to a 7% year-over-year decline we reported in the first quarter.

Wireless revenue declined by 6% year-over-year. We expect this rate to accelerate through the remainder of the year as we begin to migrate subscribers to the Verizon Wireless platform and move from gross to net accounting for wireless revenue.

On slide 14, we discuss our operating expenses and EBITDA. In the second quarter, normalized operating expenses, excluding depreciation and amortization, were down 1% sequentially due to lower employee-related costs and 3% year-over-year due to the lower spending in the number of areas. Compared to the year ago period, employee count is 7% lower.

Looking forward, we are beginning to see positive results from our Multivariable Testing or MVT trials that should be another driver of improved productivity. As we have mentioned before, MVT is a comprehensive statistical testing methodology that identifies low-cost process improvements that boost productivity.

Some of our more successful trials to-date includes steps to improve national provisioning cycle times and efficiency in penetrating high-speed Internet markets across our fiber-to-the-node footprint.

We are currently developing action plans to propagate our initial MVT findings throughout the business. While each individual MVT initiative is not necessarily going to be a game changer, collectively, they will be an important complement to the day-to-day blocking and tackling that needs to be done to meet our expense expectations.

During the quarter, we booked $5 million in flood-related impacts for events in Iowa. Through the remainder of the year, we expect flood-related expenses of $15 million to $20 million and full year cash impacts to be $25 million to $50 million, depending upon the timing of insurance proceeds. Qwest is self-insured for the first $25 million of these damages.

Adjusted EBITDA for the quarter was $1.14 billion and was consistent with the results in the first quarter and in the year ago period. The solid expense management through the first half of the year has allowed us to improve margins despite the loss of high margin revenue.

Slide 15 reports our profitability at the segment level. Business Market segment margin of 38.8% improved sequentially from a combination of revenue growth and mixed results across expense items, while year-over-year margins are lower on higher employee-related cost. As Ed noted, our sales force productivity continues to improve as rep tenure increases, and this should add to our results for the second half of the year.

Mass Market segment margin of 49.9% improved both sequentially and compared to the prior year as cost actions offset lower revenue. The largest contributors to cost reduction were employee-related expenses and marketing.

Segment margin in the Wholesale Markets declined to 57.4%. Lower access revenue affected the margin in this quarter. In the second half of the year, we are anticipating improving year-over-year revenue comparisons and we expect segment income to be flat to up from the second quarter run rate.

On slide 16, we turn to cash flows and the balance sheet. In the second quarter, we generated $460 million in adjusted free cash flow. In the quarter, free cash flow was impacted by increased working capital requirements and higher capital expenditures. We expect that working capital will reverse in the second half of the year following our typical operational history.

Capital spending was up $118 million sequentially to $534 million due to the timing of investment in our fiber-to-the-node build-out. While the build-out is ahead of schedule, we are still anticipating total capital investment of up to $300 million on this project this year.

The front-end loading of capital in 2008 was as we contemplated and overall capital expenditures should be lower in the second half of the year. Liquidity improved slightly over the first quarter to $900 million in cash and investments, and as a result, net debt declined slightly to $13.3 billion while total debt remained unchanged at $14.2 billion.

Now, I'll turn to slide 17 and I will share our current view on full year 2008 results. In the second half of the year, we expect Business Markets revenue will continue to grow at levels that are consistent with the first half of the year. We expect Wholesale revenue comparisons to improve in the second half and we expect Mass Markets to continue to be pressured due to access line losses.

For the full year, we currently expect overall revenue to decline as much as 2.5%. Excluding wireless revenue, revenue could decline up to 2% compared to the $13.2 billion in 2007. As a result of the migration to Verizon Wireless and the transition from an MVNO model to a reseller model, wireless revenue could be down 20% for the full year.

Adjusted EBITDA, which reflects flood-related charges, a softer economy and some reserve adjustments, is expected to be 1% to 2% below the $4.6 billion reported in 2007. Adjusted free cash flow is expected to be between $1.5 billion and $1.6 billion and capital expenditures are forecasted to be approximately $1.8 billion, and this, again, would incorporate flood-related requirements.

With that, I will now turn it back to the operator for Q&A for Ed and myself.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from David Barden of Banc of America. Your question please.

David Barden - Banc of America

Hi, guys. Good morning. Two questions if I could, please. Just first, obviously, even the adjusted guidance reflecting some of this flood-related spending, et cetera, still very healthy cash flows, obviously we are 85% of the way through the stock buyback. I know that you said you'd kind of update us in the fourth quarter in the commentary. But I think it was about this time last year where you guys kind of began a very lengthy, Ed, review process of kind of all the different things that Qwest wanted to do strategically with the business. It went all the way through to December at which point in time you guys made decisions about dividends, et cetera. We're only eight months down the track here.

My guess is you guys must have, as a function of all the work you did last year, a pretty solid understanding of what you want to do on a go-forward basis with respect to investments and capital expenditure and diversifying the business and returning capital to stockholders. And I think everyone would really appreciate a sneak peek as to what the answers that you developed then are, and if they've have changed, why?

And the second question I have is, again, looking at the guidance in the second half of the year, you mentioned something, John, I think about reserve adjustments in the EBITDA number. Could you be clear, are those negative reserve adjustments or positive reserve adjustments that are going to be moving the needle in the back half? Thanks a lot.

Ed Mueller

Okay. Good morning, David. I'll take the first one. You are right. We did spend a lot of time last year. Our strategies aren't going to change, our balanced return to our shareholders. What we will do in the next couple of months is look at what our outlook would be for '09 and cash and what our business units will do. You shouldn't expect any difference in our strategy. We will come out with that in the next couple months as we take our long range plan to our Board in the next several Board meetings.

I would tell you that our capital expenditures are not going up. Our capital expenditures are where they are. We will evaluate our fiber-to-the-node. We have no plans for increasing that and we will look at how our performance is and how our returns are compared to our business plan.

As I told the group before, we have a business plan that's on track, but very early. As we reported last quarter, that business plan is a little bit behind on what we would have expected on adds, but the ARPU is up and the speeds are up. The ARPU is up because of speed. So I think that's on track. Its way early, but we are not expanding that, I wouldn't think in 2009. So that gives you some idea.

EBITDA, we have been able to keep it flat here. Let me just say while I'm talking about this, one of the big reasons Tom was appointed as the Chief Operating Officer was to continue our drive to EBITDA and cash flow. And there are many more opportunities, we believe, across in integrating the three business segments, particular things like call centers, how we handle experiences, including our network. So we think there is more to have there as well as a day-to-day drive on blocking and tackling, like John said. So that is an important effort for us which should tip-off how we're going to drive the company for 2009.

I'll give the second question to John.

John Richardson

Okay. Thanks, Ed. Good morning, David. David as it relates to our guidance, we indicated that we were going to be 1% to 2% below the $4.6 billion last year and we've got that $25 million of potential flood-related items in there, then also other reserve adjustments. There are a lot of ups and downs that we've identified, but it's effectively a down that affected our re-forecasting of EBITDA as it relates to those reserve adjustments.

David Barden - Banc of America

Some of the adjustment of EBITDA is one-time reserve adjustments?

John Richardson

That's correct, David.

David Barden - Banc of America

Flood-related stuff, I mean some of it is obviously related to the economy, but its not the whole nut.

John Richardson

That's correct. That's absolutely correct.

David Barden - Banc of America

All right, guys. Thanks so much.

Operator

Thank you. Our next question comes from Tom Seitz of Lehman Brothers. Your question, please.

Tom Seitz - Lehman Brothers

Yeah. Thanks for taking the question. Just to follow-up a little bit on David's, when you look at where your stock is yielding, does it make any sense at all to consider leverage in the equation with respect to buying back shares? And then, just on the operational front, I think you mentioned that disconnects to competitors were flat year-over-year. So, are you saying essentially that competition did not heat up at all during the quarter and that cable competitors were not more aggressive or just a little bit more clarification on the competitive environment I think would be great. Thanks.

John Richardson

Okay. Thanks, Tom, and good morning, John here. As it relates to our stock yield, I mean we're clearly aware that our free cash flow yields are north of 20%. It is certainly not lost on us. I would just say that as we take a look at the allocations of our free cash flow and move up toward 2009, again, I think that the whole notion of our capital structure and our returns to our shareholders, as it relates to investment in the business and also returns through dividends or other means, is something that our Board will be looking at and deliberating over.

So, as we come out with our plans for 2009 and beyond, our Board will have certainly contemplated all of the different alternatives there for us. As it relates to the cable competitors and other competitors, we think that we've largely held our own on our competitors for the quarter, maybe with the exception of the high-speed Internet area where we believe that maybe some of the competition got out in front of us with special promotions and offers.

As Ed indicated in his remarks, we put out new promotions on high-speed Internet that we think could be very, very attractive to the customers in our footprint. And we believe that we have the products and offers in place that will allow us to be extremely competitive in the second half of the year.

Ed Mueller

Tom, this is Ed. Let me add to the competitive side of this. We did lose a little share on our high-speed Internet and there was seasonality, obviously, in our second quarter over the first, which is normal. So we did lose some share there. We were not on promotional at that point. We are encouraged that 19,000 out of the 31,000 high-speed Internet adds were in our fiber-to-the-node footprint, which is, as you know, building and ramping. So we will continue that press and pressure, but we are out there with promotional adds right now and we are doing well with them. And so, while we were dark in the second quarter we lost a little ground, but we really feel good about where we're headed.

Our wireless launch, let me talk about that, which the cable guys don't have, our wireless launch in the beginning has been pretty good. Our teams are very, very encouraged, as well as Verizon has been a very good partner. Our full launch comes in some in the back half of the year, somewhere around October, November because that's when all the systems of Verizon as well as ours can make it seamless for the customer.

But we wanted to get going early and we're selling Verizon, as we speak, and I feel good about that. That will be good for us in the third quarter on the competitive front.

Tom Seitz - Lehman Brothers

Okay, great. Now just a quick follow-up, just for clarification, are you saying that, I mean I'm not suggesting doubling leverage, but everything is on the table with respect to the capital structure in minor ways to improve shareholder returns? Is that a fair characterization?

John Richardson

Yeah, Tom. I think the characterization is every year that our Board, when we take a look at what we're going to do with our free cash flow allocation, reviews all alternatives at that point in time. And it's an ongoing process and it's really not anything different than what we've done in the past.

Tom Seitz - Lehman Brothers

Okay. Thanks.

Operator

Thank you. Our next question comes from Simon Flannery of Morgan Stanley. Your question, please.

Ed Mueller

Good morning, Simon.

Simon Flannery - Morgan Stanley

Thank you very much. Good morning. I don't want to beat a dead horse here, but on the free cash flow uses we did see your rate of buybacks drop in the second quarter versus the first quarter, yet the stock price was much lower. What's the thinking about using up the rest of the program? Can you take advantage of the low valuations? Have you been buying it back since the end of the quarter?

And on the networks it sounds like we're starting to get a little bit of visibility into that. Can you help us size the opportunity, Ed? Is this a couple hundred million dollars next year, is this $500 million, what is the visibility you have on that? Thanks.

Ed Mueller

Okay, I'll do that one. Let John clean up on this cash flow.

John Richardson

Yes. Simon, on the free cash flow, a couple of things. I think when you get our Q today, and that coupled with what we've indicated where we have over $600 million returned to shareholders, you'll see that through the reporting date here, August 6, that we bought back quite a few shares than we would have bought back quite a few shares in the month of July. That being said, going forward, we manage our cash here daily. Typically, as you know, our first quarter is very weak cash flow, second quarter is strong, third quarter is weak and fourth quarter is strong. So we try to manage our cash flow and our commitments to that cash flow very closely.

As we go into the third quarter, as an example, and it is also indicated in our 10-Q, we have substantial payments to settle what I would call some legacy costs, which is our '98 through 2001 tax audit. There is over $100 million that needs to be paid out here in the third quarter. So, in managing all of that we believe that we have repurchased a significant amount of shares and we are committed to doing the remainder of that share repurchase program this year.

Ed Mueller

Simon, let me go to the networks. Last couple of quarters I said we were waiting, and I think we're encouraged right now because we have 22 bids we're working on right now. There are two kinds of projects that come out of the government; one is statements of work and that's a bidding process, then there are task orders. Three of the 12 statements of work that came out we've won and we are really encouraged with that. Nine out of the 30 task orders, which is the second category of this, have been awarded to Qwest. Right now, the total awards, we are estimating up to $100 million annual revenue. We've been awarded $15 million to $20 million of that. I think for our size getting to 15% to 20% of what's out there is really encouraging to us.

And as you know, we've told you in February that we're about a 4% total market share in this segment. So to win 15% to 20%, that's really good. Just as a frame of reference, 5 bids were active in the fourth quarter, 10 were in the first quarter, 6 were incremental to the fourth quarter, and again now to reiterate, we are at 22 bids active. So the 22 bids are worth $30 million annually. So I am encouraged and I think we're seeing the results not only in the networks but the federal government et al., which have other bids here that we play a significant role in that we have a good stake in that are outside of even this process. We've had some nice, nice uplift. So we're really encouraged, Simon.

Simon Flannery - Morgan Stanley

Any sense of the dollar amount that's up for bid between now and yearend?

Ed Mueller

Well, the whole is an annual $100 million we think in the task orders, but that would be an annual number. We believe we can get our fair share of that. So it's kind of a moving number as the networks bids come in, but that just kind of gives you a flavor annually. Now, you know that would be spread whatever we do, '09 is really the big hitter, but we're getting some already in the latter half of '08.

Simon Flannery - Morgan Stanley

Great. Thank you.

Operator

Thank you. Our next question comes from Michael Rollins of Citi Investments. Your question, please.

Michael Rollins - Citi Investments

Hi. Good morning.

Ed Mueller

Good morning, Michael.

Michael Rollins - Citi Investments

I was wondering if you could talk a little bit about what you are doing to get your arms around some of the consumer share loss trends with respect to where do you think it could peak and how soon do you think those losses could peak? And if you could talk a little bit about, maybe, how you see the share going at cable versus wireless, it would be very helpful. Thanks.

Ed Mueller

Okay. Thanks, Michael. I'll take that one. It's been pretty steady in the industry as well as ours. We've been losing about 8% and it's a little higher this quarter and this year. The industry has accelerated, so we have. I think the big guys, AT&T and Verizon, are little up with us, a little higher and the rural states or companies continue to move up toward us and we're kind of in between that. Our projections are, crystal ball, nobody's got a call. But I think that it's conceivable and there are people on the Street with by 2012 there could be 25% substitution, which I would say wireless substitution, where we're in the 15% range right now.

In addition, in our households we have 13.2 million households. You can always expect 10% of those are unoccupied. So any math you do, that's just been natural for a long, long time that doesn't change much. And I think cable is around, as we mentioned, 20% penetration of wireline. We believe that they could probably get 30% or something like that or maybe a little north of that. The relevance of an access line is a little different than it is today, so that's why we're rolling out fixed mobile convergence, things like that that are, as John said, not necessarily game changers, but things that make it a little more relevant.

So that's kind of where we see the trend. Our high-speed Internet, we believe that we should spin and be very strong in high-speed Internet, and everything else revolves around that in the home. And we're seeing nice lift in our fiber-to-the-node, particularly with speeds. We are really more encouraged now than ever that our speeds are adequate and we've been able to see some technologies recently that are being done offline in what I'd say the TV business, both over the air like TV from local broadcasters using that spectrum as well as the Internet. There is a lot of money going in there. Our team and myself visited a couple last two weeks ago. I think there is a lot of momentum here and the speeds seem really adequate for us.

So I am encouraged with that, particularly when you add DirecTV, what they are trying to do. Our partnership has been better every day. They will be trying to use the Internet for their up speed. And so, that's where we are in consumer. I hope that gave you some color.

Michael Rollins - Citi Investments

It did. Thank you very much.

Operator

Thank you. Your next question comes from John Hodulik of UBS. Your question, please.

John Hodulik - UBS

Thanks. Good morning, guys.

Ed Mueller

Good morning, John.

John Richardson

Hi, John.

John Hodulik - UBS

One of the bright spots for the quarter is the business market where you saw revenue growth continue to improve, actually it is improving for quite a while now and it seems to be bucking the trends out there. Now you may have covered it earlier in the call that I missed, but what's the outlook for that going forward and is it a function of you guys being more competitive, you guys taking share, or just improvement in the traction you're getting with the new sales force?

John Richardson

Hi, John, John Richardson.

John Hodulik - UBS

Hi, John.

John Richardson

As we indicated in our remarks, as we look forward to the second half of the year, we expect to see growth that's in the neighborhood of being consistent with what we had in the first half. I think if you take a look at the first half results, they are up 3.9% year-over-year; a little over 3% in the first quarter and close to 5% here in the second quarter.

As it relates to why, I think that there is a number of reasons. I mean, number one is that we have put a lot of good sales processes and procedures in place that make our sales force much more disciplined and focused. We have increased the size of the salesforce. We did that last year, and as Ed noted in his remarks, we continue to see improved productivity in the sales force and its driving results.

Thirdly, I mean, we think we have a great product set. Our MPLS-based products that are included on our strategic products are growing significantly. Our strategic product set grew 36% year-over-year. And we believe the combination of all of those gives us the opportunity to improve our share. Our share is in the neighborhood of 4%. We have a goal out there in the future to improve it 1 percentage point and that is almost $1 billion in revenue. And we think that we have the products and the people and the plans in place to continue to drive growth in business markets.

Ed Mueller

John, let me say what's encouraging to me along with what John said is it's broad-based. We're getting it in the government sector nationally. We're getting it in the government sector in our states. As we touch customers, and that is one reason we added the net around 250 salespeople, but as we find even in our local markets as we touch people, including our small business, we buck the trend and we're doing that. We have said before we are more nimble. We're disadvantaged on the network, as you know, because we have to lease more lines than others do. But our nimbleness in being a provider that people like as an alternative, I think we're getting more than our fair share and I don't think it is just a one-off. I think we will continue that.

John Hodulik - UBS

Okay, great. Thanks.

Operator

Our next question comes from Frank Louthan of Raymond James.

Frank Louthan - Raymond James

I've got a couple of questions around the wholesale and on the voice side. Can you give us an idea of what sort of pressure you're seeing in access revenue on the voice side, has that changed any recently? And when you're looking at wholesale, can you give us an idea of what exposure you have to more commoditized long-haul versus local special access wholesale, what's the split there and what's your outlook for those buckets? Thanks.

John Richardson

On Wholesale, we continue to be exposed to it in the legacy voice business across all fronts, particularly in access and UNEs. And of course, I mean, as those businesses continue to shrink, it does have a fairly significant affect on our margin. So our goal is to offset that with high margin data and IP revenues. As it relates to the industry consolidation in long distance, it's really affected our comparisons here in the first half of the year. It's going to affect it less so in the second half. We believe that our revenues and our segment income has flattened out to where we're at in the second quarter of '08.

And if you could repeat the first question, Frank, I'd really appreciate it.

Frank Louthan - Raymond James

My first question, you mentioned access revenue in one of the slides, and looking at the voice pressure, you have been declining by 7%, now down to about 9%. Is any of that coming from network access, minutes of use declines, and what are the trends there that are affecting the voice business?

John Richardson

Yes. I mean, our access revenues are a result of minutes of use decline. And the trend over the last several years has been kind of following the general trend of access lines in general. So, I think that as we move forward, we will continue to see some decline there and our goal is to offset that with other forms of high margin revenue.

Ed Mueller

Frank, this is Ed. I'd like to add to that. The Wholesale is a tale of three stories really. One is the LD revenue that's low margin. We are really after margin improvement, not revenue. We had a little blip this quarter, but that's been corrected. It is just chasing customer by customer. The next one is the switched access, which you're referencing here, and you can throw the UNE-Ps in there with the access lines. That has been continual for I would say eight or nine or ten quarters. It just keeps reducing. It does follow the access lines in our consumer segment and that goes down. And the third is the data IP. The data IP has nice margins that we need to offset those continual losses.

So we have three stories going on here. We need to do a better job on data IP to sell into that segment to offset what has been pretty predictable switched access, both originating and terminating, as well as the UNE-Ps.

John Richardson

Frank, the access minutes of use down 8% in the second quarter compared to the year ago period.

Frank Louthan - Raymond James

Okay. That's helpful. And on the data and IP side, how much of that is coming from sort of the local Qwest ILEC network on special access and related backhaul-type revenue streams versus the long haul national network?

Ed Mueller

I'm going to just take a guess at this, Frank, because I don't have the data right in front of me. But I'd say, we get a lot in region and we do sell out of region. Probably 50/50 would be a good guess on that one. And Kurt could certainly follow-up with you on that to give more color, but I think it's in the 50% range.

Frank Louthan - Raymond James

Okay, great. Thank you.

Operator

Thank you. Our next question comes from Chris Larsen of Credit Suisse. Your question, please.

Chris Larsen - Credit Suisse

Thank you. I'm actually just going to clarify on that last question. Kurt, on what you said access minutes of use down 8%. That basically means that access minutes used per line where relatively flat to slightly up year-on-year. And then, John, a question for you. On the pensions, can you give us an idea of the funded status and the impact that you might have in '09, whether you might have to contribute there and uses of cash flow?

And then lastly, Ed, you talked about the DSL and that you've great coverage with the higher speed products. Can you give us a sense for what percent of your access lines are getting the 7 megabit offering? And is there a thought that maybe you should accelerate the fiber build, so that you've got that 7 megabits comparable with the cable guys have broadly across the network, given that it seems like cable is picking up share in DSL and it seems the reason they'd be picking it up is because they do have the higher speed offerings? Thanks.

John Richardson

Chris, good morning. It's John. Let me address the pension question first. As indicated in our 10-K last year, our pension plan was approximately $1.6 billion over funded. The next time we report out on that will be at the end of this year, and of course, that over funding position will be affected by what happens in the market through 2008 as it relates to our investment returns. This company has not contributed to the pension planned cash for a long time and we don't anticipate having any cash requirements into the plan in the foreseeable future.

Ed Mueller

And Chris, let me take the DSL. We're about 27% with this product. Some of it is in our old footprint because that was just a matter of being close to the central office, which is a matter of just being lucky where you live. But the build out is helping us. We said we're going to get to 1.8 million. It's easier to market obviously into as you roll this out. The base we think could be 30, a little north of there. We like that.

As far as the acceleration of it, and then I'll get to be a competitive part, we see no reason to accelerate at this point because the business case, as you might expect, which we said had a payback of less than five years, has to ramp in that period. So for me to want to accelerate this at this point, and it has something to do with competition too, I really need to see that acceleration occur. While we're encouraged upfront, we're in the second inning of this. We're not anywhere near the ninth inning. And we feel it's a substantial investment. Of the net close to $300 million, we've absorbed probably $160 million or more. In our current capital program, we'll be looking for more of that absorption. And I said before we don't expect to have CapEx increasing next year as we look through that.

On the competitive side, we don't believe its speed. Actually when we are out there with our new offerings we find that we're getting traction that we're are as speedy. So it's not a speed thing. Promotional offers, we were dark in the second quarter and we're out there now. Up to the second quarter, we were head-on-head with the cable guys on adds, we would get 5 out of 10. And so, I do not believe it is a speed issue. I think overtime our customers are now becoming more aware. We have evidence, we have a new advertising group working with us and we're advertising differently. That advertising results while it's of too much into it, awareness has been up significantly and there has been a sea change in where we are.

Again, go back to 19,000 of the 31,000 adds were in our fiber-to-the-node footprint, I think that's good news for us, but doesn't generate acceleration. We're spending plenty of money on there and we need to see how this rolls out for the next several quarters.

Chris Larsen - Credit Suisse

Thanks.

Operator

Our next question comes from Jason Armstrong of Goldman Sachs. Your question, please.

Jason Armstrong - Goldman Sachs

Hi, guys. Good morning. Thanks for taking the questions.

Ed Mueller

Good morning, Jason.

Jason Armstrong - Goldman Sachs

Just to take one more swipe at the balance sheet, this conceptual framework here, I'm sure to some extent your comfort level around leverage is defined based on ratios of leverage to EBITDA and free cash flow. I'm just wondering does a guidance reset, which we got here on both those metrics, really sort of keep the focus on debt reduction in order to keep within specific ratios that you may have in mind.

And then, maybe a second question, just on Business Markets, obviously good progress this quarter. What you lay out sort of makes sense, customers want alternatives to T and Verizon. You guys are a logical choice. But I guess the question on the margins is just the same peers that we're talking about here have greater scale, sort of fully allocated expense structures where their low teens to maybe with low 20s EBITDA margins, as you go up against them with what you said is an access cost disadvantage in a number of areas of the country, are you sort of comfortable with the margin opportunities here and can you step us through what the opportunity actually is? Thanks.

John Richardson

Jason, good morning. I'll deal with the balance sheet. Again, we've made significant progress on our debt reduction, as you know, over the years and we've had a goal of moving toward investment grade on our debt profiles. As a result of the changes that we've made, over half of our debt is rated investment grade by two of the rating agencies.

That being said, again, as we take a look at our overall leverage ratios and we determine and make capital structure decisions on an ongoing basis, we'll reaffirm or change what we're planning on doing as we move up into the fourth quarter of the year and we decide what we're going to do with our free cash flows going forward in 2009 and beyond.

Ed Mueller

Jason, just one add-on on the balance sheet, this is Ed. It's a return-driven strategy. So as we look at what leverage would do, what the rates are, are they choppy and how much leverage we need or could stand and how that returns to the shareholders, we look at all three buckets. So we'll be steadily working on what we believe to be our best return. There is some art in that, obviously, but we are balanced strategy and we'll continue to look at that.

To the margin side of this, we have been really good about trying to increase our margin percent. And Tom, if you'll notice, in the Business segments we've actually increased the margins and we will continue to increase those as a percentage and when you have revenue going up that's a good thing. We don't think we are disadvantaged in the market because of our discipline of who we go to, how we go to and the discipline here in Denver of my three or four major stakeholders, including our network team, who evaluate every one of these bids. So we're not chasing revenue and we're finding that we are making the sales based on other factors.

Why do they pick us? They pick us primarily because we're fast, speedy, do what we say we are going to do and get it done. And we're seeing that lift. It is not just words now. We see that in our marketplace. So I like that. We will continue. Tom's first goal between he and I are to drive profitable revenue growth across all of our customer-facing units. So our margin improvement is trying to get all the way across. You even can see in our Mass Markets a nice job of cost in spite of a bad market out there right now.

Kurt Fawkes

We will take down one more question.

Operator

Our final question comes from Tim Horan of Oppenheimer. Your question please.

Tim Horan - Oppenheimer

Thanks. Two questions, if I might. The other telcos has been losing a lot of broadband market share also and the cable companies are saying it's because of speed and they're saying they didn't really have any promotions. Your trends are kind of in line with your peers out there. Just maybe a little bit more thoughts on that, why you think it's more promotional than it is from a speed perspective, because I think it's important on your fiber-to-the-node strategy?

Secondly, there had been a lot of talk historically about expanding margins overtime significantly. The trends that we're seeing here in revenues and volumes what are your thoughts on margins over the longer term at this point? It would seem like you would have to have this type of headcount reductions on a consistent basis to maintain margins, but just curious on your high level kind of longer term thoughts? Thanks.

Ed Mueller

Okay, great. The trends, actually we were better, if you just take our DSL adds in the second quarter, than Verizon and T significantly compared to our base. That does not make us still better, but we aren't in the same trend as they are. I think there are different markets in the different parts of the country and when you have a [U-Verse] and primarily FiOS going on in Verizon's territory, I think that's a little different than ours.

We are not oblivious to speed because DOCSIS in Minnesota, but we are actually seeing that speed matters, technology matters, but we really believe the promotional activity, because up until the second quarter we were head-on-head with the cable guys on the net adds. So 50% of each one. We were slower to the gate here. Our total market share is probably in the 35% to 40% range, more closer to 35% in the total high-speed Internet. So up until the second quarter, we really were right there with them. So I don't think there is a big sea change. I do think that consumers at all, we see this because we see the inward orders, even the calls we get are trying to reduce their bill. I mean, people are really conscious in what their total bill is.

On expanding margins, you are absolutely correct. One thing that Tom and I will do in the business in all the segments, we will be looking at reducing headcounts. Our network organization has done a great job, our Mass Markets has followed the load. I think there is more to do. Bob has done a great job, Tregemba on our network side. There is more to come. We are margin focused here. And if that means headcount reductions to improve the margins, I think our results will show that. I think they already have. But we're not unwilling to do the hard things here to keep margins going up because that is how we will be able to fund our shareholder returns. We are cash flow margin-focused, EBITDA-focused because we don't pay tax, so then it's just interest and EBITDA. So, if that helps you at all.

Tim Horan - Oppenheimer

It does. Just a quick clarification. What type of promotions were the cable companies doing in your territories this month, what was it more focused on?

Ed Mueller

Well, they were discounting the price. Actually they had moved, they had the triple-play and they did the double-play. They continue to promote heavily in our territory on price initially for high-speed Internet and voice tags along with it. We were dark so we weren't up against them. And so, that made a difference to us and our Mass Markets team has really spun on that. And we're in the conversion of a new advertising agency in the quarter too. That made a difference to us. But we are moving and we already see the results of the last two weeks of our promotions.

Tim Horan - Oppenheimer

Thank you.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program. You may now disconnect.

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Source: Qwest Communications International Inc. Q2 2008 Earnings Call Transcript
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