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tw telecom inc. (NASDAQ:TWTC)

Q2 2008 Earnings Call Transcript

August 12, 2008 11:00 am ET

Executives

Carole Curtin – VP, IR

Larissa Herda – Chairman, President, and CEO

Mark Peters – EVP and CFO

Analyst

Colby Synesael – Merriman Investments

Nick Netchvolodoff – Lehman Brothers

David Dixon – FBR Capital Markets

Ray Archibold – Kaufman Brothers

Simon Flannery – Morgan Stanley

Tim Horan – Oppenheimer & Co.

Frank Louthan – Raymond James

Tom Watts – Cowen & Co.

Michael Rollins – Citi Investment Research

Donna Jaegers – Janco Partners

Operator

Good morning and welcome to tw telecom inc. second quarter 2008 conference call. (Operator instructions) With us from the company is Chairman, Chief Executive Officer and President, Miss Larissa Herda; and Executive Vice President, Chief Financial Officer, Mr. Mark Peters.

At this time, I will turn the call over to Carole Curtin, Vice President of Investor Relations. Please go ahead.

Carole Curtin

Welcome to tw telecom’s conference call. Let me start by directing you to our website at twtelecom.com where you can find our press release and supplemental quarterly information.

Before we begin, I will read our Safe Harbor statement. Issues discussed on today’s conference call include certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are based on management’s current expectations and are naturally subject to uncertainty and changes in circumstances.

Actual results may vary materially from the expectations contained herein due to the risks disclosed on our annual and quarterly filings with the SEC, especially the section entitled Risk Factors in our annual report on Form 10-K for the fiscal year ended December 31, 2007, and our supplemental materials posted to our website.

tw telecom inc. is under no obligation and expressly disclaims any obligation to update or alter its forward-looking statements whether as a result of new information, future events, or otherwise.

In conjunction with SEC Regulation G, I’d like to point out that we report several financial measures that are non-GAAP, including modified EBITDA. Our non-GAAP measures are not intended to replace our GAAP disclosure, rather they merely are presented to provide additional insight into our performance. Please see our press release and other information posted on our website for more details on these and other matters.

Now, I’m pleased to introduce tw telecom’s Chairman, CEO and President, Larissa Herda.

Larissa Herda

Thanks Carol. Hi everyone and thank you for joining us today. This was another great quarter for the company. Our performance included strong revenue growth, continued margin expansion, significant cash flow creation and positive net income. Our performance was particularly impressive when considering the prevailing economic headwind. And once again, our enterprise growth engine produced solid results and our acquired operations continued on track with new product investment now reaching 16 of those markets.

Also this quarter, we launched our new name, tw telecom, reaching out to customers, vendors and employees as we turn the page to a new era with more branding related activities to follow throughout this year.

I’ll have Mark take you through the results and then I’ll share more about overall trends in the business, progress in our acquired markets, and ongoing demand for our products. Mark?

Mark Peters

Thanks, Larissa. Let me direct you to press release for all the detailed results, as I turn to an overview of trends and accomplishments. We executed well this quarter, passing several important milestones and posting strong results. Let me review a few key financial accomplishments.

First, we posted strong total revenue growth, growing 3% sequentially. Driving our revenue was continued growth in enterprise space, as enterprise revenue expanded for the 24th consecutive quarter representing 4% sequential growth. Additionally, we achieved modest sequential growth in carrier revenue this quarter.

Second, by executing on both revenue opportunities and integration cost savings, we drove both EBITDA growth and margin expansion. We grew modified EBITDA an impressive 19% year-over-year. Gross margin grew to 58.5%, expanding 110 basis points year-over-year and 90 basis points sequentially. We experienced strong modified EBITDA margin expansion, which grew 300 basis points year-over-year and 100 basis points sequentially.

Our ongoing integration savings and scaling of the business yielded up a 34% modified EBITDA margin for the quarter, which was within our targeted guidance range for our post integration margin. We are pleased with our performance and see further opportunities to expand our margin while balancing such expansion with our goals of revenue and cash flow growth. Lending further strength to our performance was the fact that included branding cost to launch our new name. Excluding these costs, modified EBITDA margin grew to 34.8% this quarter compared to 33.2% for the prior quarter and 31.8% for the second quarter last year, again representing excellent margin progress.

Next, we produced positive levered free cash flow of nearly $29 million year-to-date or 5% of revenue. Let me revisit our message from last year. We said that once integration neared completion, integration related costs are winding down and we began to experience the benefits of our cost synergies that we expected our cash flow to accelerate and that in fact has happened. We expanded levered free cash flow by $40 million for the first six months of this year compared to the same period last year.

Finally, we achieved a new milestone by delivering positive net income. This is an important accomplishment as we propel the business forward and it speaks to the strength of our model, the success of our acquisition and the positive momentum in our business.

Now, let me turn to a few more details on revenue starting with our enterprise segment, which has grown for 24 consecutive quarters. The strong long-term consistent growth has been driven by the strength of our products, differentiated costumer care, and network capabilities.

From a product perspective, enterprise revenue represented approximately 95% of our data and Internet services. It also represented about 95% of our voice services and more than 35% of our network services with carrier revenue representing the balance of those product lines.

A key driver for enterprise growth is our ability to deliver complex services serving multiple customer locations. Ethernet and IP based services are a critical component of delivering these types of solutions providing a solid foundation for complex customer needs and a strong driver to enterprise growth.

This quarter, about two thirds of our enterprise revenue was derived from customers that we serve in multiple locations with some of our customer solutions reaching up to 200 to 300 locations, which clearly differentiates us from other providers.

Another item contributing to the enterprise growth was our voice product performance. We find that when we sell data and Internet services, we usually win the voice services as well as part of a comprehensive set of solutions. A component of our 2% voice growth this quarter was a sequential increase in usage, representing strong seasonal growth. As a reminder, our first and third quarters historically have been lighter usage quarters. This seasonality is due to holidays and vacation breaks impacting usage per customer such as those in our educational vertical market among others.

Both our usage based voice services represent a small percentage of our revenue and was only about 4% of total revenue this quarter primarily comprised of long distance service which is bundled with other products as well as local and regional calling.

Now, let me turn to a few headwinds we encountered for enterprise revenue. Similar to last quarter, we lost about $1 million of gross revenue due to the mortgage industry. And to put that into prospective, on a net basis, we essentially sold through the impact of this churn, reflecting our ability to continue to sell into the broad group of diverse customers within this category.

Another trend impacting this quarter was our efforts to continue to migrate the smallest of our acquired customer base toward our sweet spot. We are mining these customers for high potential opportunities and allowing the balance to churn.

Sequentially this quarter, we lost about $1 million of net revenue as a result of this effort similar to the prior quarter. We suspect some portion of this churn may also be related to the softening economy. As we continue to evolve this customer base, we expect churn of our very small acquired customers to continue.

Overall, enterprise performance was strong for the quarter and continues to represent our growth engine. Before we leave the enterprise revenue, I would like to provide some more color by giving you a glimpse of some of the key characteristics of our targeted service area or sweet spot.

Our medium to large sized customers representing high growth accounts and are right in the middle of our sweet spot sandwiched between two highly competitive markets, which includes the small business market on one end and the Fortune 1000 type of customers on the other.

Our smaller customer base represents two distinct profiles for our business. The first includes the more sophisticated businesses with multiple T1 type services or bundled products and represent profitable high growth potential customers. The second profile consists of very small customers billing below $500 a month, who represent lower margin, higher churn customers with more basic product needs and as such are below our service profile. This latter group of very small customers accounts for 3% of our total revenue, and as I mentioned earlier, we are mining this very small size customer base to identify and up-sell the high potential customers while allowing the others to churn.

On the other end of our enterprise base are strategic accounts, which include Fortune 1000 type of customers. These customers generally take longer to cultivate a relationship with and probably the longer in the current economic environment. But once we do, they yield very large and profitable relationship. Selling to this customer base is also more competitive and at the large global incumbents [ph] apply many resources to compete for that business.

Although we find more competition at the low and high ends of our targeted customer base, the middle of our sweet spot has continuing strong demand with fewer qualified competitors to serve them. These high growth core customers are not only searching for the right value, they are looking for a service provider that can help build the foundation for their future business needs.

Our efforts to cultivate customers in the middle of our sweet spot is paying large dividend. These core customers represent a majority our enterprise revenue and they grew at a 20% annualized growth rate for the first half of this year. Within this segment, the majority of the revenue represents customer billing of $10,000 or greater per month and also include customers with monthly billings into the six figures.

We find that not only is the revenue growth from these customers is impressive, but the customer churn is very low reflecting the stickiness of these long term relationship in the middle of our sweet spot. This is just a snapshot of a few of our enterprise customer characteristics that demonstrates why we remain focused on serving more and more medium to large enterprises. We hope this provides you a little more color on how our targeted customer base differs significantly from others in the competitive space.

Turning to carrier segment, we experienced 1% revenue growth sequentially. Just to recap, our carrier revenue represents local connectivity to their customers as well as services for the local infrastructure. However, it does not include inter-carrier compensation which we break out separately. We like the direction of our carrier revenue growth this quarter, which was helped by a decrease in this period [ph] but burdened by ongoing disconnects from one wireless customer.

Looking at other metrics in the business, they remained strong, including very low bad debt expense, industry leading day sales outstanding and strong liquidity. We closed the quarter with $325 million in cash and equivalents. In addition, we have only $6 million of annual debt maturities until 2013 and we have strong leverage ratio.

For example, our annualized modified EBITDA covers our net interest expense by more than five times and our annualized net debt to modified EBITDA is less than three to one. The strong liquidity position allows us to continue to aggressively pursue profitable growth opportunities and to consider strategic investment.

Before I close, I want to remind you of something we talked about every quarter and that is the fact that we have items that routinely impact our business and cause fluctuations from quarter to quarter. These items include the timing of sales, installation, seasonality and disconnect to name a few. These are just part of our normal business fluctuations and that is why we can continue to manage the business based on long term opportunities and performance.

Let me sum up the quarter by saying we delivered strong performance balancing all the important aspects of generating cash, investing in the business and streamlining our operation, of passing several key milestones including a 34% modified EBITDA margin and positive net income. We are pleased with the quarter and will remain focused on continuing to profitably grow tw telecom for the long term.

With that, I’ll turn it over to Larissa.

Larissa Herda

Thanks, Mark. Let me start by first addressing the 800-pound gorilla on everyone’s mind which of course is the economy. I believe many if not most businesses are reevaluating their purchasing decisions to ensure they are making the optimum choice for their investments during this current business cycle; I know we are. The good news for us is that we believe the economy is causing customers to shop for the best value, including product innovation and lower cost of ownership, coupled with the right type of customer experience, and those requirements are creating an opportunity for our business.

Let me characterize the overall trends we have seen through the second quarter. Our enterprise growth and sales funnel were strong for the quarter and we feel good about the business. That said, we continue to see increased customer churn from very small customers which Mark talked about as well as pockets of pressure in our local markets, which was largely outpaced by our overall market results.

The beauty of our business is that we have 75 local markets networked across the country supported by a comprehensive product portfolio and serving a broad range of business customers in an environment with fewer and fewer competitors who can do what we do. This diversity of our footprint products and customer-base served us well again this quarter.

For instance, although we did see some local market pressure in certain markets, we also saw strong growth across most of our markets. Given the economy, we saw strength in areas that would be counterintuitive, such as cities across California, medium to large customer sales in Florida markets and ongoing growth in cities like Las Vegas, and yes, even those markets where we expected pressure such as Phoenix and Hawaii did well this quarter.

We find that when our sales teams are challenged, whether by a change in the economy or competition, they adapt by pursing new verticals and other growth opportunities and we are benefiting from our agility and local decision making. And let's face it, we have really low market share which allows us to take share and grow even in a market that may be growing more slowly.

This environment may also have slightly impacted our sales cycle time, but it’s hard to tell, as we continue to win large multi-city deals and focus on moving our business upstream to larger sized business opportunities, which naturally can elongate the sales cycle. For instance, culminating from a two-year long sales effort, just last week, we won a $5 million deal for a food chain in California for VPN services to network together almost 200 stores. This is a terrific win and will probably take five to six months to fully install the services and generate revenue, but a good example of the nature of some of our really large type customer wins.

There seems to be a lot of discussion and debate by industry analysts and others about the expected buying patterns for 2008 for enterprise customers. In June, as part of a broad-based service related survey we conducted of some of our own customers for which we received over 2,000 responses, we asked about demand and planned telecom spending adherent what those customers told us.

First, let start with demand. When we asked our customers about what was driving demand for new or different telecom and network applications in their business, half of them said they expect business growth or expansion. Half are updating their existing telecom services to new technologies and about three quarters cited growing bandwidth demand from enterprise applications or disaster recovery planning needs.

Next, we enquired into their planned spending. When asked about how they expect their telecom and network service expenditures to change for the balance of this year, one third said they expect an increase of more than 10%. About 20% said their expenditures would increase but less than 10%. Another third said they expect their expenditures to remain the same and only 10% expected their expenditures to decrease.

So let me recap that. About 90% of these customers said they expected to spend the same amount or grow. Now remember, for many of these customers, we represent only a portion of their current spend. Therefore, these are positive metrics given our focus on cost effective solutions and ability to win share.

This customer survey also aligns with what I just heard recently from our sales team. Last week, I had a call with our sales leadership which I do every quarter to gather further qualitative feedback on customer trends, nuances and changes in the competitive environment.

Here are three messages that surfaced and seemed to be true across most of our markets that correlate with the comments in our customer survey. First, the technology conversion continues. We continue to see an ongoing demand to convert from frame relay and ATM to Ethernet and IP-based services.

Second, bandwidth growth is a key demand factor. Bandwidth needs are driving customers to optimize their private line solutions and move to Ethernet to gain more efficiency.

And third, total cost of ownership is more important than ever. We see customers continue to spend money on solutions that require capital expenditures, even those who were reluctant to spend their capital budgets, when these expenditures are cost justified based on the total cost of ownership.

We recognize that buying patterns can change with the shifting economic climate, but this feedback is very real time and it tell us that enterprises continue to have growing needs that we can serve. So, summing up the quarter, I have to say that we had impressive growth. While we can’t predict the future, we do believe we are well-positioned for the long term including when the economy returns to a more robust environment.

So, now let me provide you with an update on our progress in our acquired markets. As you will recall, we acquired 43 markets, 12 of which were overlap markets which have been fully integrated and 31 represented new growth opportunities for our enterprise model.

We have now invested in 16 of those markets, 10 last summer, 4 earlier this year and 2 more that I will talk about in a minute. Since we are at the one year anniversary of the first 10 markets, we thought it would be a good time to tell you a little bit about how they’re doing.

Last summer, we initially invested in these 10 markets, first enabling their infrastructure for our advanced product capabilities and then adding local market resources to sell, install, and manage new customer demand. After one year, these markets are starting to see accelerating sales growth and have a vibrant and growing asset base, driving not only local sales growth but also growth to other legacy locations for multi-site customers.

We’ve seen about a 50% increase in sales in these markets for this quarter compared to the same period last year and our buildings on net have increased nearly 30% in these markets over the last year, demonstrating nice traction with medium to large customers. While these markets are in their early stages and we have further work ahead of us, we feel good about the direction of these investment markets. In fact, so much so we invested in two more markets this quarter including Tulsa and Fort Worth, providing additional expansion of our sales opportunities.

Now, let me turn to another area which highlights our sweet spot and core competencies with advanced products. I would like to walk you through the evolution of our Ethernet products and how that continues to drive new demand today.

When we first launched our Ethernet business, we focused on serving the needs of the enterprise within the metro, leveraging the fiber infrastructure we had and the buildings on net. We then leveraged our IP backbone to support the capabilities of delivering Ethernet across our backbone market to market and doorstep to doorstep.

To say that we’ve been widely successful with our Ethernet strategies even forcing our competitors to get into the business is a bit of an understatement. So, let me tell you what’s new and where we continue to see future strength and opportunities.

We’re beginning to see an emerging and growing trend where enterprise customers are taking their mission critical quality of service dependent applications across the wide area, city to city, and are demanding even greater more scalable bandwidth regionally. We’re seeing an increasing demand for circuits upwards of 10-gig and we expect that the bandwidth will climb in the future toward 40-gig and 100-gig. This regional demand for networking is right up our alley and we have responded by upgrading our capabilities on some of our regional fiber networks to address this opportunity for large demand.

We can now delivery Ethernet at speeds up to 10-gig today and up to 100-gig down the road with even better network performance to meet our enterprise customer needs for mission critical applications like data center to data center connectivity, storage and convergence.

Let me share an example of this type of demand for a customer we just won several weeks ago. A healthcare customer in San Antonio has purchased multiple Ethernet circuits to Dallas and Houston for data center connectivity with some locations as high as 10-gig. This represents a multi-year contact value at nearly $1.5 million which is served 100% on our fiber network between the markets and all the way to the customer’s premise within each market. And we have a strong funnel of opportunities for this type of service, because when you consider local fiber based connectivity into enterprise buildings is the table stakes for this type of service, the only real competition in this area is from the big incumbents. This highlights the fact that we are different from other competitive carriers and we can do this because of our fiber infrastructure and the thousands of fiber connected buildings.

In closing, I know many of you continue to have questions about the economy, so let me point you to our track record. The bottom line is we continue to execute well with our proven strategy. We delivered 24 consecutive quarters of enterprise growth because we continued to invest through strong and weak economic cycles developing a truly differentiated asset and a defensible market position.

Most importantly, we have grown. We’ve grown our network reach, our products, our revenue, margins and cash flow and we will continue to focus on growing in the future. We believe there is no other carrier in competitive telecom that has the combination of our strategy, assets, operational capabilities and execution, and we believe these differentiating factors will allow us to continue to win new business and grow.

We’ll now take your questions.

Mark Peters

Operator, we’ll take questions now.

Question-and-Answer Session

Operator

Thank you very much. (Operator instructions) Your first question comes from Colby Synesael with Merriman Investments.

Colby Synesael – Merriman Investments

Great, thank you for taking my questions, I have two of them. One on the growth adds, I know in the past you’ve said you don’t provide growth adds, but you do provide customer churns. Can you kind of back into that? It looks like your growth adds for the first half of ’08 as well as your enterprise growth had both decelerated for where we saw at least in 2007. One, is it fair to make some type of correlation between those two things and then two what are your expectations for growth adds as well as enterprise growth going forward, so we continue to see that slow down and is there a reason specifically behind that?

And then my second quest have to do with customer churn, it seems like customer churn improved in the second half of ’07 after you guys had integrated Xspedius a little bit and then it’s reaccelerated in the first half of ’08. I need to take a reason why that happened and where should churn finally start stabilizing and start to improve. Thanks.

Larissa Herda

So when you say growth adds, you mean the number of customers?

Colby Synesael – Merriman Investment

That’s correct.

Larissa Herda

Yes, because there’s really no average customer that we serve, we don’t use growth adds, we provide them but we don’t use them as a metric of success. We could add one $100,000 customer and we can add ten $1000 customers or 100 $100 customers and so your growth adds with the smaller customers will be greater, but which customer do you prefer to have? Well we’d like to have them both, but the one $100,000 customer is high margin and probably a lot less maintenance issues and easier to install.

Colby Synesael – Merriman Investment

Sure, and I understand that but I mean obviously we have to go by some metric and these other ones that your providing and it does seem that we are seeing the correlation between decelerating enterprise growth and that growth adds number kind of coming together. Is there anything that we could read between that or –?

Mark Peters

(inaudible) having to read between them. I mean we are, as we’ve been speaking about, really focused on medium to large sized customer and that’s really where our growth has been coming from as I mentioned right in the middle of sweet spot which is where those medium to large customers are. Now that where we’re growing at a 20% annualized growth rate. So the correlation is there. I think there is more likely a correlation there than anything else going on from a growth rate.

Larissa Herda

Yes, and you would see that some of our revenue growth is also obvious on our enterprise side as being impacted by the small business customers that are churning off. So, for instance, our revenue churn was 1.2% but if you take those small businesses customer out, it was 1%. Our customer churn without those small costumers is 0.6%. So I think there’s a lot of noise being created in our enterprise growth rate and obviously in the churn as result of the churning off of this small business customer base.

Colby Synesael – Merriman Investment

So when you would expect the enterprise growth in term of deceleration to start to stabilize and start to go in the other direction?

Larissa Herda

Well again, if you look at the core sweet spot enterprise customers, if you take out the small business customers that are causing some noise and you take out the just the slower growth of the super large business customers which were more of a boutique provider too when you go to the sweet spot, it’s growing at 20%. I say that’s pretty impressive, but I don’t know of any carrier out there who is growing enterprise revenue at that rate.

Mark Peters

And then I think if you look at the sequentially growth rate and we had, if you look at the breakdown of the decimal about 3.6% sequential growth in enterprise which is higher than the prior quarter sequentially and then higher in the quarter before that. So, I think we really have some overall strength in the enterprise sequential growth rate. As our comments – we made the comments, we have some pockets of weakness, but overall we see strength at a local level and we are largely selling through the weakness we’re seeing. So, we felt a little bit of pressure, but again when you look at the last three quarters, we saw an uptick in the most recent quarter.

Larissa Herda

So, I think that once we get through the churn on the small business side, I think that will alleviate some the pressure as well.

Colby Synesael – Merriman Investment

And that follows up to my second question, so you mentioned 3% I think of your revenues come from these sub 500 per month ARPU.

Larissa Herda

Right.

Colby Synesael – Merriman Investment

Do you expect all of them to churn out and maybe over what time period?

Larissa Herda

No, we definitely don't. In fact, we’re up-selling a lot of them as we speak, we put programs in place last year that are starting to take effect and in some cases, in a lot of cases, we’re seeing a lot of the customers that we’re talking to are either upgrading or in some case where you are seeing the churn, we just don’t have a product to really offer them for the long term. We’re not competitive with that small business customer from a price standpoint and we don’t really have the service capability to be able to serve them and quite frankly the margins are so low and sometimes nonexistent, we really don’t want them.

Colby Synesael – Merriman Investment

Great, thank you very much.

Larissa Herda

All right.

Operator

Your next question comes from Nick Netchvolodoff with Lehman Brothers.

Nick Netchvolodoff – Lehman Brothers

Hi, guys. I just want to follow up on your comment about strategic investments and get some idea on what sort of things you would be looking at.

Larissa Herda

We make strategic investments all the time. We’ve been doing market expansions in a lot of our markets where we see a lot of business opportunity and we have core, what I’ll call, anchor customer revenue to get those expansions going. We’ve been expanding our co-location facilities to address the demand in those markets. Some of our co-los, the moment we say we’re going to build it, it’s already filled up. So we’re finding a tremendous amount on demand on the co-location side.

We continue to invest in our product portfolio. But most of the strategic stuff is basically market based expansion and co-los, and we’ve also made investments in upgrading our regional fiber networks. I talked a little bit about Texas wins and we’ve upgraded that network. We’ve just completed the West Coast network and we’re taking a look at some of the others. We’re taking it slow, although our markets would like us to go faster, but we’re being cautious. But we are seeing great opportunities to bring Ethernet between the markets at much higher bandwidth speeds than ever before.

Nick Netchvolodoff – Lehman Brothers

Okay, great. Thanks guys. Good quarter.

Larissa Herda

Thank you.

Operator

Your next question comes from David Dixon with FBR.

David Dixon – FBR Capital Markets

Thanks. Good morning. Wanted just to touch on the positive commentary regards on the sales funnel and the demand trends that you see in the business, with the language in the quarter on enterprise revenues which seem to introduce more uncertainty on the outlook for future growth rates in the enterprise space. I was just wondering if you could give us some color on how that language has shifted sequentially in the Q. And then secondly, just looking at the gross margin outlook, we saw obviously higher direct costs going in the second quarter. We did see a sequential decline in that regards in the first and second quarter ’07. Just trying to get a sense of how we’ll see gross margin going forward. You are adding less customers, so I would have thought that you would see perhaps a more moderate growth right in the network ops line. Thanks very much.

Mark Peters

Let me try to understand a little bit (inaudible) your question on the sales funnel. We did make the comments. We did see a strong funnel in the quarter and –

Larissa Herda

What specifically is your question about in the Q, is it the Q's pretty big, so –?

David Dixon – FBR Capital Markets

Yes, sorry, just looking at the discussion in terms of the enterprise segment, it just seemed that sequentially there was another line item introduced in terms of how to predict the impact of the economy and it just appeared to indicate that there was perhaps a little bit more uncertainty in terms of the enterprise growth outlook relative to what you saw in the first quarter. Now, obviously in the call there, it seemed to be a lot more condition [ph] around certainly the demand trends that you’re seeing in the sweet spot, so I just want to make sure I understand very clearly that you’re seeing perhaps sequentially better visibility relative to last quarter?

Mark Peters

I’m not sure that we’re saying any better visibility. Our sales funnel, we volume tracked our sales funnel. We mentioned that we had a strong sales funnel in the quarter, but we also see fluctuations from quarter to quarter from the effect of the timing of the signing of those sales, closing sales, signing of sales, installing them that can cause a fluctuation from quarter to quarter. The discussion, any discussions around the economy are really in the context, I really think of that is that the economy impact the timing of sales. We mentioned that at the larger end of our customer base, we’ve perhaps have seen a lengthening of that sales cycle, but again it’s hard to tack that into any one particular item. I’m think that’s really what the message in the Q was that a variety of things can impact quarter to quarter growth rate.

David Dixon – FBR Capital Markets

Okay. Okay, terrific and then just on the gross margin?

Mark Peters

Yes, the growth margin, again from a – clearly we had strength there continued expansion. Much of it had to with our continued ability to get additional cost synergies and getting the run rate benefit of the integration cost energies over the last quarter or so. And then really there’s a contribution from the revenue growth. Now, it can’t – it’s not a perpetual expansion because even though, like you mentioned, you – it appears that there’s fewer customers, more selling products to do – it also encompass an ultimate [ph] component, our BPM products for instance.

So, with our BPM products, we will connect up the customer’s main location, their data centers, their corporate headquarters but then also connect up their satellite offices that as part of the BPM product offering will encompass a type two component. So while I still see an opportunity for long-term expansion in the gross margin, we are with the product mix and with our continued expansion of our reach, I’m not going to be – you are not going to see 100 basis points expansion every quarter.

David Dixon – FBR Capital Markets

And just following up on SG&A and LIBOR [ph] cost trends there, we did talk a little bit about expanding the sales force, Larissa. Any update there in terms of how much progress you’ve seen there on the headcount increases?

Larissa Herda

Well, as you know, some of the hiring that you do on the sales force is just keeping up with churn in the sales force as well and we continue to do that, but we are looking at sales teams in some of the markets that we may add but we’re doing it. We’re being careful and we’re very focused on sales force productivity and we have a lot of sales people and you always have – I don’t know if the status is exactly accurate, but you’ve got your 80/20 rule where you have the vast majority of your productivity coming from a small percentage of your sales force. And so, our goal is to try to get the rest of the sales force to be more productive before we start adding incremental heads.

With that said, we have a number of markets that are really starting to come on strong. Atlanta, for instance, we just did – are about to start adding another sales team there and some other markets where because we have the right combination of leadership, market opportunity and network capability, and the competition is lacking in a number of these places, we feel like we have an opportunity to add sales people. So we’ll do so as we see the opportunity on an opportunistic basis.

David Dixon – FBR Capital Markets

Okay, thanks very much.

Mark Peters

I just want to go back and make one additional comment on our gross margin, and while I mentioned network cost in that category, it’s important to note that our gross margin is different than some others in that we are fully burdened not only with network costs but also with our network operations centers and with all the staff in those centers are field technical operations and other costs. That’s really what it takes to run the business, but it’s a fully burdened gross margin. So, to the extent we are taking care of these large complex customers, there’s other components of it other than just network costs. So, it’s important to keep that in mind.

David Dixon – FBR Capital Markets

The key takeaway there is that you’re moving up the curve to larger customers. That's a bit more of an off-net mix.

Larissa Herda

Yes, absolutely, especially as we sell more VPN. Last year, we talked about the target when we installed services to 200 of their locations. We built fiber into their core locations, core corporate locations and data center locations but to each of the stores that we served, we were not going to be building fiber to those locations. So, those are all type-two circuits that you’ve – the reason why we win these deals is because we provide the fiber, the core fiber infrastructure into those key locations for the customer and then the other locations can be served via type two. So, yes, you can – as we sell more of those customers, it’s possible. I would expect that we would see that scenario.

We try to focus on customers where the majority of the revenue is on our fiber network. We have the largest percentage of our revenue is 100% on our own fiber network. We like that model. It makes us more competitive. We are in a much better competitive position where we can use the fiber as much as possible for those types of customer applications but branch offices are probably never going to be on – very few of them anyhow will ever be on that.

David Dixon – FBR Capital Markets

Okay, thank you.

Larissa Herda

Thank you.

Operator

Your next question comes from Ray Archibold with Kaufman.

Ray Archibold – Kaufman Brothers

Good morning and thanks for taking my call. I just wanted to get a little bit color in terms of contract renewals and what you’re seeing in pricing? Are you seeing more pressure on pricing and/or are you seeing the customers expanding their relationship with you at the expense of perhaps some of your competitors?

Larissa Herda

Contract renewals go on literally almost everyday in this business both on the enterprise customer side as well as the carrier side. We’re not seeing any additional pressure than we’ve seen all year. It’s just customers are always looking for something. Our strategy typically on the enterprise side is to go into those customers before the contracts expire and upsell the services so that we can, to the degree that we can, be as neutral on a revenue basis as we possibly can, we’ll renew the contract and that’s very effective. We have a very effective plan doing that.

So, we’re not seeing anything different in the renewal side of the business and as far as expanding, sure, we’re expanding our business at the expense of our competitors everyday. That’s a lot of what we do, is take away share away from our competitors. It’s a wonderful thing when you have a small piece of the pie and you can go in and not only take advantage of the growth for a customer but just take the existing services away. So yes, we certainly are seeing that.

Ray Archibold – Kaufman Brothers

All right. Just on that, you went through several markets, where as you pointed out, counter intuitively saw some pockets that perhaps performed better than would have been expected. Can you walk us through sort of the converse on where you did see weakness?

Larissa Herda

Sure, yes. The two markets that I talked about, Phoenix and Hawaii, we were expecting and we even talked about it in the last call, the last investor call. We were expecting that we might see some softness in those markets due to the mortgage industry. In the case of Hawaii, the travel and some of the bankruptcies they’ve had on some of the airlines going there and prices have gotten higher for air travel, etc., etc., but in fact those markets did quite well during the quarter. But a lot of it has to do with the fact that the cities do – they are very adaptable out there and they find that the opportunity in the niche and they go after it and so, I applaud them for that. An area that we are seeing softness is really one of the few areas in the country we’re seeing softness is in the Midwest and we think a lot of it has to do perhaps with the auto industry.

Ray Archibold – Kaufman Brothers

All right. Thank you.

Larissa Herda

Sure.

Operator

Your next question comes from Simon Flannery with Morgan Stanley

Simon Flannery – Morgan Stanley

Thanks very much. Good morning. We haven’t really talked about the cable companies today. I was wondering if you could talk about – are you seeing much impact from them in the marketplace or are they really attacking more of the low-end versus your sweet spot and to what extent are you seeing the Bells changed their pricing behavior? There has been a lot of talk that they’re trying to sign customers to longer term contracts to prepare for the entry of the cable companies. So, is that a dynamic you’re seeing changing or is that really not affecting your sweet spot? And then secondly, on the enterprise 14% growth, would you ever parse that out in terms of how much of it is existing customers growing their spend year-over-year or you getting more business with them versus new business being one? Thanks.

Larissa Herda

Okay. So, on the cable companies, really not many things different than we’ve been seeing all along. They’re primarily selling to the small business customers. We run on them on a spotty basis. A few of them have a more evolved business services group and they will go after universities and things like that, but it’s primarily just point-to-point circuits which we’re really focusing on networks.

A lot of what we’re doing – so much of what we’re doing today is multiple city. That’s not the way they do it, so they’re more focused on the low end. And the Bells’ behavior, with regard to their customers, hasn’t changed either. They have been aggressive for a long time. They always try to sign long-term contracts. We have not seen any indication that anything that they’re doing in that regard, at least in the customer base that we’re going after, is any different than what we’ve always seen.

We don’t have a public stat for the number of customers that are buying new services, existing customers that are buying new services versus new customers but we have a nice combination of both. Keep in mind, the more we sell to larger customers, the more we’re going to see that because very often, with the larger customers, we get our foot in the door, you get just a tiny piece of the business and then you’re constantly minding that customer for new and new, more new business.

It’s interesting that the tale that I just talked about on this call to the grocery food chain on the West Coast that’s close to 200 sites, that deal started off with just a couple of circuits. We actually connected up this customer between an old location they had that they were moving from to a new location that they were moving to and we provided them with– I want to say it was like a gig’s worth of capacity between the locations, so that they could move their data between the locations and interestingly enough, their long-term vendor, incumbent vendor couldn’t provide that capacity because they didn’t have the product. So we got our foot in the door and then we moved up, then we wanted to get all their other locations, so we did a pilot with them and we connected up a few of their grocery stores and that was kind of an interesting test also because they found that the speeds were so fast that the people in their grocery stores thought the service wasn’t working because they were – they kept on clicking the button because it’s so immediate and that they found that their old service was so slow that the things had to go.

They were used to the slow system. When they saw how fast it was and how much time they saved, we ended up getting this very large contract. It took two years for that to happen, but we started off with a little bit of business, we proved ourselves. We did a pilot here. We do that and then finally, we get the whole thing and it’s not over. There’s more business to get from this customer, so that’s a very typical process that we go through.

Simon Flannery – Morgan Stanley

All right. Thanks a lot, Larissa.

Operator

Your next question comes from Tim Horan with Oppenheimer.

Tim Horan – Oppenheimer & Co.

Thanks, guys. Good morning. A couple of questions, if you don’t mind. I was wondering – I apologize if missed this at the beginning, but maybe you can talk about your usage based revenues. I guess it’s primarily on the voice side. And related to that volumes, have you seen any slowdown at all in volumes on a sequential basis and maybe you can talk about what percentage of your revenues you think are more usage based?

Mark Peters

Let me just recap that. About 4% of our total revenue is usage and we actually saw sequential increase this quarter in our usage and it is primarily in our voice category and it’s primarily long distance type services. There’s some other local and regional calling in there as well. So, it goes up and down. We historically, we’ve seen the first and third quarter have been lighter due to holidays. We have educational institutions that they dip in the summer but nothing unusual.

Tim Horan – Oppenheimer & Co.

Any change in maybe data volume growth at all either sequentially or year-over-year versus trend?

Larissa Herda

No.

Mark Peters

Not really, we haven’t.

Tim Horan – Oppenheimer & Co.

I mean, on the (inaudible), this is first time you had some sequential growth in quite a while. You think this is kind of a start of a trend and maybe what’s driving that a little bit?

Larissa Herda

Well, one quarter doesn’t make a trend, right? But we have had very good success with the carriers. It’s taken a while. We are getting involved in a number of the wireless proposals that have been out there and we’ve won a few of them, so we’re seeing a good momentum there.

We’ve got the incumbents buying out of region. We’ve got regional – smaller and regional carriers doing quite well and using us. Overall it’s – I’m not going to predict growth in that segment. I think it’s too soon to claim victory there but we do have – I think we’ve got a great team. We’ve got the best team we’ve ever had working on it and our relationships continue to get stronger with the carriers. With that said, you always have fluctuations in carrier revenue. You’ve got big stuff coming in, big stuff coming out.

We had a lot of the wireless revenue came out again and I think that’s going to continue for a few more quarters. And then carriers are notorious for disputes and the way we deal with our disputes is we reserve a 100% of those disputes, so those are themselves – and sometimes they’re not resolved within the quarter, so those themselves can cause big fluctuations in that revenue stream, but we feel good about that revenue stream and the future. I think the future looks good but I’m not going to predict growth there on a consistent basis just yet.

Tim Horan – Oppenheimer & Co.

Maybe last, Larissa. If you just see any kind of slowdown in your customer base or pick up in churn or bad debt expense, because historically most management teams have been very surprised when this happens, time and time again, are you taking any steps that could prepare you for that in case it does happen or do you just not expect it to happen, so you’re not worried about it and maybe something different what you’re doing this time in terms of credit requirements or what you are doing on your fixed costs or expense fund [ph] that give you maybe a little more flexibility, if you do start to see a slowdown?

Larissa Herda

Well, Tim, I assure you we worry about everything and we are never satisfied with what’s going on out there. And so we’re constantly looking and searching within organization. We’re looking at our internal trends. We’re always watching and we’re also are very conservative on the cost side of the business. We’ve been making sure that we are keeping our costs in line with our revenue. We are always planning for possibilities, planning as though, people who plan ahead are always the best prepared for what may or may not happen and we feel really good about just in general what is going on with the business.

We are making strategic bets because we’re one of the few companies out there that can. We’re well-positioned to do it. We’re very careful about the credit worthiness of the customer base that we are bringing in. Keep in mind, the churn in our core customer base is extraordinarily low on the revenue churn side. And even on the customer insurance side, it’s a very, very modest churn for this industry. The stuff that's churning is the stuff we – primarily, it’s the stuff that we acquired and that’s what’s taking it a bit higher and I would say that the acquired company did not have discipline around their credit worthiness of their customers.

So, I would say we always plan. We feel good about our plans. We are prepared for any number of scenarios in this business and I think if you, those of you who have followed us for many years, have seen us manage through much more difficult economic times than this. We are pretty happy with the position that we’re in today, which is a large percentage of our revenue coming from such a diverse customer base that we can adapt to the move and change and refocus very, very quickly. And we also have a lot of new products that will be coming out over the next six months to a year that again give us more and more opportunities with our existing customer base to go in and sell to them and that again helps build the revenue stream and build more stickiness with these customers.

Tim Horan – Oppenheimer & Co.

Thanks so much.

Mark Peters

I was going to take you back a little bit just to really emphasize that point that really unlike some other that in our industry, we are so strong from a balance sheet and a capitalization standpoint, and a cash flow standpoint, so there is no debt maturities except for about $6 million per year until 2013. Strong cash position, no maintenance covenants in our debt, so that’s what allows us to do what Larissa was talking about and investing with our customers, going where the demand is.

Larissa Herda

Yes, and we’re generating cash. We generated $40 million of cash already this year that we want to invest in – have opportunities to invest in the business and we’re going do that.

Mark Peters

Yes.

Operator

Your next question comes from the Frank Louthan with Raymond James.

Frank Louthan – Raymond James

Great. Thank you. Not to belay [ph] with this point too much, but just a quick clarification on the 4% of variable revenue. Is that inclusive of your inter-period comp revenue and if not, within that, are there any customers, is that all related to other contracts or any customers that are say a 100% in that bucket? And then where do you stand as far as your 35% EBITDA margin run rate or where do you see that going, say at the end of July where you were closer to that run rate, is that still a good target by the end of the summer? And where there any larger deals that maybe were signed in the first half that are just going to be hitting their stride that can give us some confidence on the back half of the year or anything that was signed through the end of the second quarter that didn’t really show up that should start to impact the second half as we’re looking at the growth going forward? Thanks.

Larissa Herda

Well, Frank, those are a lot of questions so let’s see if we can get them. In the 4% variable usage, that does not include our carrier comp.

Mark Peters

Yes, we break that out as a separate line item and I’m sure the company can pull that off to financial statements.

Larissa Herda

That second question you had on customer buckets, what exactly was that?

Frank Louthan – Raymond James

Well, within that 4%, are there any customers that are say a 100% voice that are in that category, some customer concentration in that category?

Larissa Herda

No, not many.

Mark Peters

No, we don’t sell them along long distance. It's bundled with other products, so it's probably with voice or data, whatever the other products the customers are buying from us. So highly diversified revenue stream. Let’s see so – EBITDA. So, as we mentioned we think that we are talking about getting to the mid-30s during the summer. Well, with the 34% all in EBITDA margin in the quarter, we’re well within that range and then obviously if we pull out the branding, it puts us at 34.8. So, we think we’re there. We believe we have further opportunities for further expansion as we continue to get additional synergies and grow the business.

Longer term, we’re going to keep investing in the business. Obviously, I can’t have every year a 300 basis point expansion in the EBITDA margin. We’re investing in the business, adding sales people. All those different factors plus quarterly fluctuations, the revenue growth, the EBITDA is expanding like it’s done over the past year but a different times, we’ll make investments in the business from upgrading the IP backbone, investing in products and services, adding more sales people, all of those things obviously impact the margin.

So, again, we feel we’re in a good position this quarter, further opportunities for expansion but overall, at least in the short term, don’t look for those dramatic margin expansions.

Larissa Herda

And on the last question about larger deals, we always have large deals – literally every month we have large deals that take a long time to install. The $5 million contract that I talked about probably, you won’t see any of that revenue this year, if any, maybe towards the very end of the year. So, there’s nothing, nothing like we had last year, where we felt compelled to point out the one large sale that we knew was going to really move the needle. Just a lot of solid customers coming in throughout the quarter, the past few quarters. It takes usually a quarter to two quarters to install things, so that’s the nature of our business because we are selling large complex solutions and more and more of those, so there’s a bit of a time lap between the time we sell it and the time we install it.

Frank Louthan – Raymond James

Just that $5 million contract, how many years was that spread over?

Larissa Herda

We didn’t say.

Frank Louthan – Raymond James

Okay, thank you very much.

Operator

The next question comes from Tom Watts with Cowen & Co..

Tom Watts – Cowen & Co.

Hi. Good morning and congratulations on the solid results.

Larissa Herda

Thank you.

Tom Watts – Cowen & Co.

In terms of the rebranding, you had a number expenses on that. Did you comment to what extent we are going to see additional rebranding expenses going through remainder of the year?

Mark Peters

Yes, we didn't talk about it here. In the press release, we did provide the guidance of the full year, we expect to spend between $5 million and $6 million, again, for the full year in branding including up to about $2 million of capital costs for signage and that sort of things. So that will be switching between [ph] OpEx and CapEx.

Tom Watts – Cowen & Co.

And then without the rebranding, you were at 34.8% EBITDA margin and I know you comment a little bit on EBITDA margin expansion, but will we be able to assume most of that rebranding expense goes away in ’09?

Larissa Herda

We’ll always have some sort of costs that are related to branding in ‘09, but the majority of the rebranding activity will be done this year.

Tom Watts – Cowen & Co.

Okay. And have you received any particular response to the new name and will there be name recognition studies and things of that sort going forward?

Larissa Herda

I guess the best analysis of that is when I asked my sales organization last week on the call that I talked about earlier, if the name has had any positive or negative impact and they basically said it's had absolutely no impact on their business which is a good thing when you come off of the name like Time Warner to a less well-known name there, to have the sales team be – they were actually very excited about it. They felt that the branding was done really well, very smooth, customers accepted the name very easily. In fact many of them had already been calling us that. And since it was – our web site is the same, our e-mail addresses are the same, not a lot changes in their lives. It’s really been a very good smooth transition.

Tom Watts – Cowen & Co.

Okay. And then secondly, could you comment – how much business do you do with the wireless carriers and does Alltel’s acquisition affect that and what are trends you’re seeing from wireless in terms of are there increased bandwidth needs.

Larissa Herda

Alltel does not affect us. They were not – they may have a very small customer but it was insignificant to even talk about. so it does not impact our revenue stream at all, if there’s kind of consolidation. With regard to the other wireless carriers that we do business with and we business with quite a few of them, we are seeing very strong growth there. It’s been a very good market for us. There’s a lot of activity and we have good relationships with the wireless carriers. So we’re seeing good growths there. We’ve not – I don’t think we’ve – did we say it the call? I think we said in the Q what our percent of wireless revenue is. I don’t think we’ve done that. So, I’m sorry we haven’t put that up publicly.

Tom Watts – Cowen & Co.

Okay. Thanks very much.

Operator

Your next question comes from Michael Rollins with Citi Investment Research

Michael Rollins – Citi Investment Research

Hi, thanks. Good morning. Just a few quick questions, first just a follow-up question. You mentioned that the first half of the year core enterprise grew 20%. Could you tell us what that was specifically in a second quarter of this year over the second quarter last year? Secondly, I was curious also just to follow up on your comments around the strong sales funnel. Can you just help put that in prospective, maybe giving us a sense of how the funnel exiting June or in July would compare to maybe other quarters in which you’ve seen I guess “strong funnels as well?” And then just finally a question about Xspedius. Can you give us a sense of where you are in those markets in terms of climbing up the sales capacity curve. How well are those markets doing relative to where full capacity for sales will be at some future point and maybe to some extent how long, if there is further room for improvement, how long do you think that will take to get there? Thanks.

Larissa Herda

Okay, first question on the 20% quarter-over-quarter from second quarter last year to this year. I’m sorry we don’t have that number. We had the number that we had, we were looking really just on a sequential basis from the first quarter to second quarter to try to provide a little bit more color to investors as to what’s really going on with the sweet spots and I suspect it’s not too dissimilar because we’ve had consistent growth in that sweet spot customer base for a very, very long time.

So, it’s not really – the needle hasn’t moved all that much in terms of – obviously we have a bigger base than we had two years ago but we’ve had pretty consistent growth in that sweet spot but I’m sorry we don’t have that number to give you.

The sales funnel, the reason why we communicated that is we wanted to – for us, sales funnel is a forward-looking indicator. Obviously, the sales funnel has to turn into sales so funnel is– it includes all the proposals that we have out there and the things that we think are going to sell and that the sales force believe is going to sell and obviously some percentage of that sells or some percentage of it does not.

When the sales funnel is strong, it’s a good indicator for future quarters, not necessarily the next quarter because that would have been the sales funnel probably from the first quarter, so you have – and there is delay obviously from the time you look at your sales funnel, you look at your sale and then with our timeframe, your installs. So, a sales funnel in this quarter tells us a lot more about what will happen probably in the fourth quarter of the year. If you make the sales this coming quarter, this quarter that we’re in, the things probably won’t install for at least in a quarter or two.

But what it is an indicator of is that we’re not seeing a decline. We’re seeing consistent strength there. And that’s really the message, is that we’re not seeing a falloff in the sales funnel. If we did, then that would be an indicator of future growth issues potentially and so we thought it was an important thing to communicate. There’s consistency there and the sales organization is feeling very good about the demand.

Now, that’s not to say that we don’t have fluctuations in sales. We do. And we have talked about those fluctuations year after year after year and that’s one of the reasons why when we communicate to the Street, I know it’s hard for them to realize this is not a quarter-to-quarter business and that if you look at something that happens in any one quarter, you can’t hyper-focus on it because you could have the same number of installs in a quarter but if a few big ones just happened to come at the end of the quarter, then your quarter will look “softer” than say previous quarter.

So, the key thing in our business is to really look at the long-term trend and that sales funnel for us is a long-term trend piece of information that we think is an important forward-looking indicator of what’s going to happen in the coming quarters. So that’s the best I can tell you on that. Hopefully that provides you a little bit more insight.

With regard to Xspedius, the markets are doing well. They are far from full capacity. They are really just starting to get their mojo [ph] and it’s exciting to see, to go and see them, and we’ve gotten some leadership there and honestly, our success in our market is all about leadership. It’s about the team that we put in place. If we have a good team in place, they will take a market that seemed like a sleepy market and turn it into a wild cat.

So, we’re excited about the people that we put there. They’re seeing some great traction. We’re also seeing some really good traction in the markets that we turned up, not the older legacy markets, some of the newer markets like the Atlanta and the Minneapolis is just a killer market for us and Seattle and Portland and San Francisco for goodness sake and L.A. I mean these are markets that had been hard markets for us but we put some great leaders in these markets and we’re really starting to see some momentum and we’re going from a very small market position in some of those markets to really turning it on and there’s just a lot of opportunity to go after.

So, it does take time. It can take a year or two to really get a market going. Sometimes it’s faster, sometimes it’s slower, but it takes time and we like where they are in that continuum of growth.

Michael Rollins – Citi Investment Research

Great. Thank you very much.

Larissa Herda

We have time for one more question.

Operator

Your next question comes from Donna Jaegers, unaffiliated.

Donna Jaegers – Janco Partners

Hey, thanks for taking my question. I’ll keep it short. The $10.4 million that you still have I think in auction rate securities, can you give us any sort of visibility on what you expect to recover there or what sort of tactics you can take?

Mark Peters

Well, because we have taken impairment on the balance of the – I think that these are not auction rate securities. These are commercial paper, so we didn’t have any auction rate securities. But what we’ve done is we’ve made estimates based on discussions with advisers to those particular instruments and have taken another impairment this quarter down to – the current balance is now on the long term. It’s not in our cash balances. It’s in the long term. And our best estimate is that we expect to recover that balance but time will tell. Obviously, there’s no perfect clarity on that.

Donna Jaegers – Janco Partners

Okay. Congratulations on a great quarter.

Mark Peters

Great. Thank, Donna.

Larissa Herda

Thanks, Donna. Thank you all for taking the time to talk to us today. Have a good day.

Operator

That concludes our program. Thank you for joining us.

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