PAETEC Holding Corp. Q2 2008 Earnings Call Transcript

PAETEC Holding Corp. (PAET)

Q2 2008 Earnings Call Transcript

August 13, 2008 5:00 pm ET

Executives

Tom Morabito - VP of IR

Arunas Chesonis - Chairman & CEO

Keith Wilson - CFO

E.J. Butler - COO

Analysts

Frank Louthan - Raymond James

Simon Flannery - Morgan Stanley

David Dixon - FBR Capital Markets

Ray Archibold - Kaufman Brothers, L.P.

Colby Synesael

Romeo Reyes - Jefferies & Company

Presentation

Operator

Good day, ladies and gentlemen, and welcome to the Second Quarter 2008 PAETEC Holding Corp. Earnings Conference Call. My name is George, and I will be your coordinator for today. At this time, all participants are in listen-only mode. We will be facilitating a question-and-answer session toward the end of this conference. (Operator Instructions). As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the presentation over to your host for today’s call, Mr. Tom Morabito, Vice President of Investor Relations. Please proceed, sir.

Tom Morabito

Thanks, George. Good afternoon, everyone, and welcome to PAETEC’s second quarter 2008 conference call. With me on today’s call are Chairman and Chief Executive Officer, Arunas Chesonis; Chief Financial Officer, Keith Wilson; and Chief Operating Officer E.J. Butler. Following prepared remarks by Arunas and Keith, all three executives will be available for the Q&A session.

Before we get started, I need to remind everyone that in our remarks today, we will be making some forward-looking statements about our expected operating results and financial position, our business strategy, our integration of acquired companies and other matters relating to our business.

Keith’s statements involve known and unknown risks, uncertainties, and other factors that may cause our actual operating results, financial position, or performance to be materially different from those we express or imply in our forward-looking statements. We have highlighted some of the more important risks and uncertainties in our earnings release. For a more detailed discussion, please refer to PAETEC’s 2007 10-K and our other filings with the SEC. We disclaim any obligation to update publicly any of our forward-looking statements.

Finally, please note that on today’s call, we will be referring to certain non-GAAP financial metrics. These metrics are reconciled to the most comparable GAAP measure in our press release, which has been posted on the Investor Relations portion of our website at paetec.com.

With that, I’d like to turn the call over to Arunas.

Arunas Chesonis

Thanks, Tom, and welcome everyone to today’s call. For the second quarter, we are reporting revenues of $405.3 million, net loss of $14.7 million, adjusted EBITDA of $60.2 million, net cash provided by operating activities of $44.1 million, and free cash flow, which we define as adjusted EBITDA minus CapEx, of $25.5 million.

During the quarter, we continued to see significant progress with our dynamic IP, MPLS VPN and network security products among others. Overall, we are seeing solid new sales momentum, and importantly our achievement of synergies from our acquisition of McLeodUSA remains on track.

But despite these positive elements and as outlined in today’s press release and our release two weeks ago, we are experiencing some new challenges in what appears to be a worsening macroeconomic environment. During the quarter, we identified pressure on usage volumes and an up-tick in churn levels, as well as increased demand by our customers for increased price concessions upon renewal of their contracts. Stated another way, many of our customers are hurting and they are trying to cut down on all of their expresses, including telecom.

Today other metrics such as days sales outstanding and accounts receivables appear to be in line with historical levels, although bad debt expense has modestly increased. We have also experienced higher than forecasted sales of our MPLS VPN product, which generally generates fewer billable minutes of use than traditional service. This would suggest that IP substitution is having a greater than forecasted effect on the minute sensitive portion of our business.

But I want to be very clear on this afternoon’s call that as a management team that prides itself on delivering solid performance versus expectations, this was a disappointing quarter. It is incumbent upon the team to not only articulate the challenges that the business is facing, but also our plan of action for addressing these issues.

With that as a backdrop, we remain bullish on PAETEC’s current and future outlook. Management and employees remain very significant shareholders, and we believe our interests are fully aligned with those of all our shareholders. Additionally, the Board has illustrated support by approving a $30 million share buyback over the next 12 months, the maximum permitted under our credit facility during that period.

Let me detail for you the components that drove the lower than expected performance and also discuss why we firmly believe in the core strength of the business. Before getting into the specifics, I would first like to reconcile some significant swings between the first quarter 2008 and second quarter 2008 in an effort to distinguish between certain issues impacting the business versus some changes in the numbers that reflect other factors.

In the first quarter of 2008 on a pro forma basis that assumes we acquired McLeodUSA on January 1, 2008, PAETEC had $5.1 million in fiber sales. In the second quarter of 2008, we had made the strategic decision to suspend many direct fiber sales without supporting network revenue and therefore had only $1.1 million in fiber sales during the second quarter. This accounted for a differential of $4 million between quarters.

Secondly, due to lagging disconnects, many of which were associated with our MetaSolv conversion in the fourth quarter of 2007 we had unusually high customer credits in 2Q over our normalized credit history.

Thirdly, in the first quarter ‘08 pre-merger period, McLeod revised its estimate of discounts applied to monthly recurring charges. This resulted in a one-time benefit of approximately $1.3 million in the first quarter and was an additional negative variance to 2Q performance. So, in an effort to recalibrate, if you normalize the effects of these items, first quarter 2008 pro forma revenue would have been relatively flat to second quarter.

Now, I’d like to address the McLeod performance. At a broad level, the operation is not transitioned to a net growth operation by 2Q as we had anticipated. Despite that fact, the business is showing some stability. We also continue to be pleased with the quality and enthusiasm of the legacy McLeod employees. We do continue to see churn in the legacy McLeod hot space, and for the quarter that was $2.9 million in attrition or 8% for the quarter in net business line. This translates into a 2.7% revenue churn per month, which was in line with our expectations.

Additionally, when adjusting for the items discussed above, the core McLeodUSA revenues grew approximately 1.2% sequentially, despite the disruptions that are typically experienced during an integration. While we anticipated a certain amount of issues associated with the integration, the overall growth of the core McLeodUSA business was not the key driver for the dislocation outside of the business decisions to move from fiber sales not associated with network services or other items noted.

In core PAETEC, we saw pressure in a number of areas, including long distance usage and carrier access revenues. These areas were impacted by lower than anticipated usage volumes, migration of wireless customers, increased disconnects, and pressure on our renewal rates.

These factors were the primary drivers behind our slower than expected growth year over year. A combination of factors including macroeconomic pressures, integration focus, and overall secular changes in both IP and wireless migration were contributing factors. Additionally, due to renewal pressure related to price concessions, the average rate per minute declined approximately 5% year-over-year.

The primary softness in IXC access termination was experienced in PAETEC’s carrier group. This was due to the significant consolidation of the wireless sector as large carriers work to migrate wireless origination traffic and wireless transport onto their own networks, thereby resulting in a flattening of that portion of our carrier services business.

Data growth continue to be a strong component for core PAETEC and was up 2.2% sequentially, led by VPN sales up 6.6% sequentially and over 33% year-over-year. This continues to emphasize a strong offering provided by PAETEC as well as a broader migration away from both ATM frame technologies and usage-based TDM services.

Although the telecom sector continues to shift to more IP centric platform, which can generate lower billable minutes of use, we believe this is of net benefit to PAETEC long term as evidenced by our rapid growth in pro forma data services of over 18%, with particular strength in our VPN services, which grew over 46.1% year-over-year.

Shifting to the cost side of the equation for a moment, our adjusted EBITDA margins were also impacted as we made certain network investments that were based on a higher anticipated revenue stream that did not materialize as expected. As a result, we absorbed network cost without the necessary revenue streams to support the investment and keep our margins where we expected them to be.

I also want to make clear that any sort of softness that we experienced this quarter was not specific to the McLeodUSA business. The integration remains on track, and we fully expect to realize our one year synergy goal of $20 million.

So, now let’s talk about what steps we’re taking in order to address the trends we have been experiencing. First, we plan to grow the direct sales force by 10% to 20% in order to take advantage of our nationwide footprint and to expand our agent and reseller programs as evidenced by our recently announced Toshiba partnership. Our workforce reduction that is outlined in today’s press release primarily involve non-revenue generating back office and support personnel, and will help offset the cost increases associated with the sales force expansion.

Second, we plan to up-sell our existing customer base with the unified product catalog and corresponding product promotions. This will also involve enhancing our account development coverage model and changing our compensation plans to provide greater incentives to up-sell the base.

Third, we plan to continue pursuing various operational efficiencies. This includes regionalizing our service delivery centers to better partner with regional sales organizations and to get centralized or decentralized decision making closer to the customer. Also, the disconnect project as outlined in today’s press release should yield approximately $6 million per year in savings. And lastly, we will be reducing non-essential CapEx to provide capacity to invest in last mile facilities, both fiber based and wireless.

Four, we are undergoing an aggressive integration of our IT systems. We are in the process of finalizing a contract with a billing vendor which will be announced over the next several days, and that will allow a move from seven current billing systems to two over the next 36 months.

We will also be ensuring that our profit assistant system is being leveraged throughout the country as well as enhancing our network operation center monitoring systems. The key takeaway here is that we are not standing still and passively hoping for a turnaround. We are aggressively taking the steps we believe should insure PAETEC’s continued success.

Next, I would like to provide some additional information on the impact on our operations of the flooding that occurred this summer in the Midwest. As you know, the June floods were of historic proportion, and the area where we were most impacted, Cedar Rapids, had some 400 blocks underwater at the height of the crisis. With 600 employees, a network operation center, a switching center, and several POPs in the area, PAETEC did see a negative impact from this disaster.

While we have filed a business interruption claim with our insurance company, resolution of this claim could take several months. Also, we currently estimate the financial impact to be roughly $1 million to $2 million. Aside from the P&L, however, we are pleased to report we have been fully staffed in Cedar Rapids for several weeks now, and I would like to thank all of the PAETEC employees from around the country that contributed in various ways to the relief effort.

And now shifting gears to the regulatory front, recent decisions by the FCC have provided more regulatory guidance to PAETEC and our industry, and therefore we have more regulatory certainty in several of our new key markets that PAETEC now competes in by virtue of the McLeodUSA acquisition.

In late July, a unanimous FCC denied request for forbearance from its unbundling obligations for the largest four MSAs in Qwest’s territory; Denver, Phoenix, Seattle, and Minneapolis/St. Paul. The FCC decision means that PAETEC is entitled to continue purchasing certain network facilities, such as last-mile access loops and transport facilities from Qwest at cost basis prices, set by state utility regulators. Unions in Qwest territory are typically priced substantially than Qwest’s currently offered commercial solutions.

So, just to summarize before passing the call over to Keith, we did indeed see some economy-related weakness this quarter, but other contributing factors specific to PAETEC heightened those challenges. We believe that the necessary steps are being taken to address the current macro-environment and technology factors, while successfully positioning PAETEC for an improved economy and for future growth opportunities that we have come to expect from our company.

Although, our recent quarter was a disappointing one, I would certainly put our 10 year track record up against any of our peers in the competitive telecom sector. This includes strong revenue and EBITDA growth over the same timeframe and the fact that we have been free cash flow positive uninterrupted for 5.5 years now.

This isn’t the first downturn we have been through, and during the last one of 2001 and 2002, things did start off a bit slower similar than expected, similar to this time, but we came out stronger than ever. While we obviously cannot guarantee the same results, we are very confident we can continue to successfully grow the business long term.

Also, our stock buyback program represents our belief that there is sufficient cash flow to pursue this opportunity given that our current stock price is not indicative of what we believe to be the company’s value or our growth prospects.

Now let’s turn the call over to Keith, who will take you through our second quarter results and provide our revised outlook for the year. Keith?

Keith Wilson

Thanks, Arunas, and good afternoon, everyone. As Arunas indicated, while we are pleased with several components of our second quarter results, overall the quarter came in weaker than expected. As we’ve been doing for the past several quarters, I will first discuss the actual results of PAETEC Holding for the second quarter as it compares to legacy PAETEC second quarter of 2007. I will then discuss pro forma results for the second quarter of 2008 and second quarter 2007, giving effective PAETEC’s acquisition of McLeod as if it had occurred on January 1st, 2007.

As a reminder, the McLeod acquisition closed on February 8th, 2008. The pro forma information is not necessarily indicative of what the combined companies’ results of operation actually would have been if the mergers had been completed on the dates indicated.

So first the actual performance. Revenues for second quarter of 2008 were $405.3 million, which is a 47.7% increase over the second quarter of 2007. Network services grew by 39.3% year-over-year to $317.6 million, largely as a result of the McLeodUSA acquisition, which was the core driver of the revenue growth. This business accounted for 78.3% of the second quarter revenues, and continued to see solid increases in MPLS VPN network sales as well as increases in our Dynamic IP and network security products, resulting in an annual growth of over 46%.

Overall, we continue to see steady sales of our core integrated voice and data T1 products, which make up the bulk of revenues in the network services business. Second quarter 2008 revenue experienced some softness, as Arunas mentioned, by usage pressure and increasing churn, and a desire by some of our customers to negotiate lower rates upon contract renewal.

The softer areas for the quarter were long distance, with growth of only 33.8% and carrier access revenues which grew at just about 31.8% year-over-year. As discussed earlier, lower than expected usage resulting from a number of factors was the primary driver for the softness, together with the rate compression driven by more aggressive rate concessions during the contract renewal process.

Carrier services, which accounted for 17.7% of second quarter revenues, grew by 91% to $71.6 million, largely due to the inclusion of the McLeod revenues, which as a reminder, has a higher percentage of its revenue base coming from carrier customers. Despite the growth rate within carrier services, the pressure on carrier access led to headwinds within the sector and are continuing. Additionally, wireless carrier migration also provided a drag on overall performance of the carrier services business.

Integrated solutions, which sees a fair amount of volatility from period to period made up the remaining 4% of revenues and grew by 79.7% year-over-year to $16.1 million. The addition of Allworx, which was acquired during the fourth quarter of 2007, contributed $3.5 million to the top-line results for this segment.

Core integrated solutions continues to be well received by the broader customer base with annual growth in the [VAR] segment of 48.6% year-over-year. Additionally, Allworx continues to perform well, with a 27.7% growth sequentially as the operation has integrated smoothly and has become a complementary product set for our field sales force.

Adjusted EBITDA for the quarter was $60.2 million, which was a 14.7% increase from the prior year. The improvement in adjusted EBITDA was largely driven by inclusion of the revenues from McLeod. As a percentage of revenue, adjusted EBITDA declined to 14.9%, down from 19.1% in the prior year period, which was largely impacted as anticipated by the addition of lower margin McLeod and Allworx revenue contributions.

In addition, and as mentioned previously, we also increased network investments as revenues came in softer than expected, resulting in an increase in cost of sales. Almost half of the increase in network that outpaced revenue growth came from a broad support for our data growth. The remainder came – coming in broader underlying network support for our integrated local, long distance, and IP backbone.

Our margins were also affected by higher SG&A expenses. Overall SG&A expectations were more or less in line with expectations in key areas such as payroll, sales and marketing, and outside services. The one noticeable increase was in facilities expense necessary to support the significantly broader infrastructure that is in place due to the McLeod acquisition. Due the lack of maturity of a number of acquired markets, there is an operating leverage opportunity in this area, and we hope to benefit from that opportunity during 2009.

Net loss for the second quarter 2008 was $14.7 million versus net income of $6.0 million in the second quarter of 2007. Second quarter 2008 included a significant increase in depreciation and amortization to $51.6 million versus $20.9 million in the second quarter of 2007. The increase in D&A resulted from growth in our depreciable asset base as well as the recognition of increased intangibles due to the McLeod acquisition.

CapEx for the second quarter 2008 was $34.7 million or 8.6% of revenues versus $21 million or 7.6% of revenues in second quarter 2007. The change was largely due to the timing of certain investments, and overall, we continue to expect CapEx to be in the range 8% to 10% of annual revenues. Free cash flow, which we define as adjusted EBITDA less CapEx, was $25.5 million, which marks our 22nd consecutive quarter of free cash flow generation.

Now, I will discuss the year-over-year results for the second quarter 2008 and second quarter 2007, giving effect to PAETEC’s acquisition of McLeodUSA as if it had occurred on January 1st, 2007. Once again, please keep in mind that the pro forma information is not necessarily indicative of what the combined companies’ results of operations actually would have been if the mergers had been completed on the dates indicated.

Pro forma revenues for the second quarter 2008 were $405.3 million, a 0.6% increase over the second quarter 2007 pro forma revenues of $403.1 million. If we do not include McLeod fiber sales from both comparable quarters, the growth rate would have been 1.9%.

Pro forma adjusted EBITDA for the second quarter 2008 was $60.2 million versus a pro forma adjusted EBITDA of $65 million in the second quarter 2007. This is a 7.4% decline period over period. The decline on a pro forma basis was driven primarily by the timing of network investments that anticipated stronger revenue growth. The net impact of the lower revenue growth resulted in lower gross adjusted EBITDA.

Pro forma adjusted EBITDA as a percentage of revenues for the second quarter 2008 was 14.9% versus 16.1% on a pro forma basis for the 2007 quarter. Continuing operating leverage of the company’s network and employee base was offset by the lower margin at McLeod and Allworx revenue base, as well as by the increase in network and SG&A expenses mentioned previously.

Pro forma net loss for the second quarter 2008 was $14.7 million compared to a pro forma net loss of $6.6 million for the second quarter of 2007. The increase in pro forma net loss was primarily due to the increase in network investments and higher SG&A costs previously mentioned, as well as a $2.1 million increase in D&A.

Now for PAETEC's expectations for the remainder of the year. Before updating our previous guidance, by way of background it may be useful to review how the second quarter played out in terms of monthly variances. While a bit softer than what we had anticipated, were fairly stable throughout the quarter, with overall positive trends experienced in June actually being stronger than those in April. Due to the second quarter results combined with our expectation that the macro driven softness could last for at least the remainder of the year, this afternoon we are updating our 2008 guidance on both an actual and a pro forma basis. The pro forma guidance represents the anticipated results of combined PAETEC and McLeod businesses for 2008 as if the acquisition had occurred on January 1, 2008 instead of on February 8, 2008. PAETEC's actual 2008 results will not include the results of McLeod from January 1st, 2008, through February 8th, 2008.

On an actual basis, PAETEC now anticipates generating revenues between $1.545 billion to $1.585 billion, adjusted EBITDA in the range of $224 million to $249 million, and capital expenditures between $122 million and $147 million. On a pro forma basis, we now expect revenues between $1.6 billion to $1.64 billion, adjusted EBITDA in the range of $230 million to $255 million, and capital expenditures of between $125 million and $150 million. While management is not pleased to have to modify guidance, we have always maintained a candid approach with investors, and we believe responding to issues we can identify. This updated view best reflects our expectations for the remainder of 2008 and will position PAETEC for a solid 2009.

That concludes our prepared remarks, and I would now like to ask the operator to open up the call to questions.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from the line of Frank Louthan from Raymond James, please proceed.

Frank Louthan - Raymond James

Hey, great. Thank you. You said that one of the issues in the quarter -- you had built some network ahead some customers and needing to back off of that a little. Can you give us more color on that? What exactly were you building out and what kind of services was that for? And of the $6 million you think that you are going to be able to take out, where are you on that currently? How long will it take you to that ramp, and should we think about that as OpEx savings or CapEx? Or what is the split there? And looking at your guidance, quite a bit of range on the pro forma guidance for the EBITDA. What would have to happen for you to be at the lower end of that range? What are you assuming in that scenario versus where you are, which appears to be moving towards the higher end -- a wide range there? Thanks.

Arunas Chesonis

Okay. Why don't I take the second one and you and E.J. can handle the first and third question.

Keith Wilson

Okay.

Arunas Chesonis

Just on the disconnects, Frank, we will probably have about half of those completed by the end of the third quarter, with the remaining at the end of the fourth quarter. So when you look at the run rate for next year, we should see all of those savings.

Frank Louthan - Raymond James

And that's operating expense savings?

E.J. Butler

Frank, hi, it is E.J. Butler. Just to talk to you about the network build-out, we had embarked on a project late last year to put in redundant IP facilities in the legacy US LEC territories. That is a project that has continued for the first six months of the year as well as putting in some additional facilities to accommodate data growth as well as anticipated future growth in the legacy McLeod territories.

Frank Louthan - Raymond James

Okay. So the growth as you are expanding the T1 based products in the McLeod territory?

E.J. Butler

Largely the MPLS products, the data IP product set.

Frank Louthan - Raymond James

Okay. Great.

Keith Wilson

And then Frank, really the answer to the last question -- what would have to happen for us to get to the lower end of the GAAP guidance, I guess the question was. I think that we have seen impact on a number of different moving pieces of the business. And on the usage based stuff, while we talked about a fairly stable trend through the quarter, again when you look at some of the unemployment statistics and some of the impact in some of our larger markets, which we all can -- off that Bureau of Labor statistics, but they're up double-digit in many places. If the economy gets significantly worse toward the back half of the year, we think this guidance provides us the bandwidth to comfortably operate inside of that. So I do think that if we see increased pressure there, that may drive us down towards the lower end of the guidance, but I don't think that's our expectation, although we don't see the economy improving, I don't think we see it going to the place that would lead us down toward the lower end.

Frank Louthan - Raymond James

Okay. Great. Just one other thing, investors have been looking at, looking at the variable minutes and the voice minutes and how much that changed, can you give us an idea of how -- going forward, how is your model going to continue to be exposed to the variability? What percentage of an average customer contract has a variable component, and do you have any customers that are say 100% variable minute based business? And is that shifting 12 or 18 months from now, is that going to be materially different?

Arunas Chesonis

E.J., take the first and I will add on.

E.J. Butler

Okay. I mean, you know, pretty wild swings depending on whether a customer is ordering predominantly a data product set or a traditional TDM product set from PAETEC. I can tell you for a customer that is a traditional local, long distance, and internet customer, Frank, probably about 25% of their usage is variable -- meaning permanent usage, whether it is on the local or long distance side. On the data customers, it is probably closer to 10% that we would get that would be variable usage that would just be their long distance. The softness that I think we are experiencing in the core base is from -- lower than historical usage minutes. And then you also got less carrier access minutes associated with that. So, I think as we move to selling more, and as we're selling more data products, that mitigates some of the risk. But it is certainly something we've seen in the business over the course of the last quarter, which is a slight drop off in the amount of usage sensitive revenues.

Arunas Chesonis

If I could just add onto E.J.'s comment, I think when you look historically how we grew the company, it was a combination of both local, long distance, internet revenues, and the traditional bundled offering to medium enterprise customers and we were very focused on the usage component as part of the cash flow that would drive free cash for the company. What ended up happening the last couple of years as a sales organization, we saw that usage were going to be challenged in the future, so we started focusing much more on multi-recurring charges and fixed service contracts, and I think we've lost a little bit of our edge on the usage component, which is still fairly strong revenue stream out there in the industry. There's also an opportunity for us to provide some new promotions on the sales side the next 18 months for us to get back some of those usage revenues that we haven't been focused on in the past with our customer base.

Frank Louthan - Raymond James

Okay. Great. Thank you.

Operator

Your next question comes from the line of Simon Flannery from Morgan Stanley. Please proceed.

Simon Flannery - Morgan Stanley

Okay. Thanks very much, good afternoon. Could you talk about the sequential trends month-by-month? Has this been a sudden drop in terms of activity and the drop in usage, the increased pricing pressure -- has it been building fairly steadily? And as you exit Q2 and you see July and early August, our activity levels fairly stable with what you've seen coming out of Q2 or is it deteriorating further? And if you could just give any color on how you're seeing the weakness in particular geographic regions, particular customer sets either by industry or size of customer large, medium, small? Thanks a lot.

Arunas Chesonis

Keith, do you want you to start with that?

Keith Wilson

Absolutely. Simon, great question. We appreciate it. The biggest challenge, if you go back to the beginning of the call discussion, what Arunas tried to do is recalibrate the starting point not to make excuses but to differentiate for folks, the core revenue drivers of the business versus things that we had from legacy McLeod and would have reset the table as it were. So, if you think about the $405 million as your rough starting point and understand that we are trying to illustrate some moving pieces just to be able to answer this question, because I think it is an important one, is that the trend line that we saw on the usage based components of the business, were relatively stable throughout the quarter.

And so it is not that we saw a big drop in the usage components. On the specific [CABS] pieces we have talked about the wireless migration that was partly made up through some other customers that we brought in, but on the long distance piece of it, which I know has given people the biggest question mark, those have been very, very stable. They just haven't grown where we expected them to grow. So, while that doesn't make up the whole differential for folks in terms of where we anticipate it to be, I think it's important for people to understand that it wasn't necessarily declining. It just wasn't growing at the rate that we had expected. As we anticipated the budget getting stronger and stronger through the year, that variance became larger and larger as you went through the quarter just based on that.

If you look at some of the places where we've seen the biggest softness in those usage based components, they're going to be all of the places that you would expect to see. Hospitality area, real estate agents and managers, motor vehicle dealerships, things like mortgage bankers those are all within the top 15 folks or six segments that we saw softness.

To the question on geographic concentration, while we did see a relatively broad base, and there were areas that clearly had strength over others, we did see specific weaknesses in places like Fort Lauderdale, Miami, Orange County, places in the Rust Belt. The interesting part of that is that while Orange County was extremely soft for us this quarter, Los Angeles was quite strong. While we saw places like Miami and Fort Lauderdale being weaker, places like Jacksonville continued to perform well. It’s really more pocketed in terms of the extreme softness, but you do have some broad based across geographies.

Simon Flannery - Morgan Stanley

In terms of size of customer?

Keith Wilson

I don't know that we have seen a clear break out on that. I think that there is probably more exacerbation on the lower end, but I do think that it wouldn’t be fair to say that we're seeing a little bit across the board.

Arunas Chesonis

Simon it's Arunas. Just to add to Keith's comments, we are seeing from the reasons why customers are canceling the service with us right now that there seems to be a higher percentage on the price -- the pricing side is the main reason they would be leaving us at the smaller end. If you look at the customers we have and put them in two buckets -- the medium enterprise where we do 80% or 90% of their business, all their voice and data, and then the larger enterprises we may have 10% or 20% or 30% of their wallet share and the smaller accounts, because of the way we sign contracts, you typically can't separate the long distance usage or the usage sensitive portions very easily into two carriers. So, when you look at the large customers, that's where they're negotiating with us for contracts for local or LD or internet or data or separate types of bundles. That's where you tend to see the usage sensitive piece potentially leaving us faster on the larger enterprise customers.

I will tell you -- one thing we have done the last month or so is begun taking a look at just the type of category of customer by our [SIC] codes we use for marketing purposes. And that may be something we want to share with our shareholder group at the next quarterly call once we have more six or nine months of results. It is interesting for us to look at the different between hospitality, different types of financial services firms, everything down to car dealerships, accounting firms, health care providers of different types. That's something that we are finding very interesting right now. E.J is there anything you want to add to that?

E.J. Butler

No, I would just echo Keith's remarks that where we see the most pressure for pricing is where our services are more of a commodity in that sub $1,000 a month customer. Our churn is historically two times higher in that group than it is for our more managed base, and I think that's where we will continue via macroeconomic issues and others to have customers really try to beat us up over price when it comes to renewing their agreements.

Simon Flannery - Morgan Stanley

Okay. Great. Thanks a lot.

Operator

Your next question comes from the line of David Dixon from FBR Capital Markets. Please proceed.

David Dixon - FBR Capital Markets

Thanks. Two questions. Arunas and Keith a couple of questions. The first one on guidance and the second one on the buyback. Just looking at guidance, here specifically, the year-to-date results that we have seen, $65 million in the first quarter, $60 million in the second gets us $125 million. We are seeing better trends if I am reading correctly in June or April and I am assuming the rate into July gives you some confidence as well. We are certainly seeing potential for [COGS law] provisioning in the second half, and SG&A was down sequentially, which was a great result. It seems like the integration is going very well. So if we are seeing these trends certainly on a month over month basis improving, and annualizing the EBITDA gets us really to the midpoint of guidance, to what extent are we really being overly conservative here would be the first question, and I want to come back on the buyback if I could?

Arunas Chesonis

Sure.

Keith Wilson

Yes David this is Keith. I think that we were very disappointed with having to revise guidance at all. I don't want to have to do that again. I think we feel comfortable with the range that we have put out there, and again I think you have hit the math right on the nose and I think we feel very confident about the remainder of the year. There are some things out there that we hadn't anticipated that hit us during the first half of the year, and we want to make sure that we have the ability to absorb any unforeseen incidents that hit us in the second half of the year.

David Dixon - FBR Capital Markets

Okay.

Arunas Chesonis

David, this is Arunas, thanks for the question on the guidance. I can just add to Keith's comment that making the midpoint of the guidance is not the internal plan for the senior management team at PAETEC. Any incentives that the executive team has is for performing much better than that this year.

David Dixon - FBR Capital Markets

Okay. And circling back just on the buyback, wanted to just get a sense of -- outside of this $30 million buyback here, the timing really for the next board meeting in anticipation of some discussion around additional buybacks wanted to get a sense of the process for engineering a larger share buyback here, and the fact that you would be considering in shaping a larger size buyback going forward into the second half year?

Arunas Chesonis

Keith do you want to start and I will add to that?

Keith Wilson

Yeah, I would say that, David, we have -- a lot of investors have asked us about the potential of various size buybacks. A couple of factors that we will be looking at, that we want to be very cautious about are one, the appetite for support in the credit markets, if we wanted to do something significantly larger. The credit markets today, some weeks they're good and some weeks they're not so good. We would have to go to our lenders and our bondholders and have them rethink the structure of our baskets to allow us to do that. While the debt markets have been very supportive of PAETEC in the past, there is risk that would cause for some [ASCS] from those folks, so those are things we would need to look at.

The other thing, which is a very important component for us, is that depending on the magnitude of the buyback, we could be at risk of tripping any 382 limitations, which might actually negate the amount of NOLs that we hold today to a significantly lower number. Those are the two biggest drivers that we will consider as part of a larger buyback as we go into the fall.

David Dixon - FBR Capital Markets

Okay. Terrific. Can I circle back on the fluid state of the integration realistically, how long do you think it takes before you get to the point where you have lock down the integrated assets in terms of the resources and systems, just to mitigate the risk of this type of left field event occurring in the future?

Arunas Chesonis

David, I think there's different pieces to that. I think more than anything, our management team and our employees just need to focus on the existing integrations and not be looking too far in the future. So, I think in another 18 months we should have a lot of the heavy lifting accomplished with both major mergers, US LEC and McLeod. US LEC will primarily be behind us, and McLeod will need another 18 months, beyond that on some of the IT systems. But, I do think just having the management team focused on their current stack of mail, the next year and half is going to allow us to make sure that we perform well in the future.

David Dixon – FBR Capital Markets

Okay. Thanks. Well congrats on the SG&A trend sequentially, which was obviously done during a difficult quarter.

Arunas Chesonis

Thanks, David.

Operator

Our next question comes from the line of Rai Archibold from Kaufman Brothers. Please proceed.

Ray Archibold - Kaufman Brothers, L.P.

Good afternoon, thank you. First, I was curious if you could just share with us the magnitude of price concessions you have been granting in terms, and directionally is the expectation that those will become more generous or, kind of, where we are today?

Arunas Chesonis

Hey, E.J. do you want to handle that one?

E.J. Butler

Sure. I think what we are seeing, on average, right now is ASCS that are probably upwards of 10% to 12%. We have been generally able to hold the line at sub 10%, depending upon the customer's willingness to extend the term and perhaps take on future services, but a lot of these contracts are three-year agreements that people would have $0.03 or $0.04 long distance rates. And so, markets for those types of services have just come down quite a bit during that time. So, while we would like to preserve as much revenue as possible, in some cases, we have taken the side that we will accept a 7% or 8% of write-down on the LD side if we can get the customer to re-term for us for a two- to three-year period. So, it fluctuates a little bit, but overall, it is probably in the 5% to 6% range as a rule.

Ray Archibold - Kaufman Brothers, L.P.

And then also, you referenced in the press release, and I think you talked on the call here the idea that the some of the sales pipelines continue to be strong, if not full, and you also talked about the full array, full menu of service being deployed across the McLeod footprint. So, can you give us a little color where are you in terms of training the McLeod sales force to sell that, and where are you starting to see a sales cycle lengthen? And if that's part of a factor here, why would we see some disappointment on the revenues?

Arunas Chesonis

E.J. you want to try the first one?

E.J. Butler

Sure. I can tell first of all, all excellent questions. First of all on the sales side, we are at 102% versus our quotas year-to-date across all distribution channels. We had a strong second quarter. We were at 99% of our goal for July, and usually in the summer time that's where you tend to see a little softness against quota. So the sales -- both the closed sales pipeline and prospective sales pipelines are strong. Our full product portfolio will be available to the McLeod market, late fall. Several of our product offerings are available now, including MPLS and our equipment for services programs.

And in terms of the McLeod sales force -- and this was something that we anticipated, this was a sales force that was generally selling probably about 35% to 40% below what the average sales person at PAETEC was selling in terms of monthly volume. Theirs was more like $1,800 a month and ours was more like $3,000 a month. And the, I think we have, you -- as part of the integration we knew that there was going to be a learning, a training curve, including going out and bringing in some new sales talent. But I think we have been able to attract, in a lot of cases, because of the fact that we do have a nationwide footprint and a growing national reputation. But it is still one of our foremost challenges and something that we will continue to work on, not only through the balance of the year, but also in 2009 as well, to make sure we are adequately staffed and represented in all of our 82 markets.

Ray Archibold - Kaufman Brothers, L.P.

Okay. And then -- I am sorry!

Arunas Chesonis

No, Ray, I just want to add -- that was a great question. I think E.J. and I always have this debate with our teams that even though the sales organization for the number of people we have is doing well, we still are underbudget of our goal of the number of sales professional in the organization. I think that is where some of the miss came from is that we really wanted another 50 or 75 people to be part of the company this time this year. And that is why we are emphasizing not just getting back to original budget headcount, but even expanding the sales organization.

Ray Archibold - Kaufman Brothers, L.P.

Thank you. And one last question, you talked to making investments -- last mile investments in fiber and wireless. Can you give us sense of order of magnitude of those investments and perhaps what geography is they are occuring in?

Arunas Chesonis

Sure. E.J. do you mind, I will take that first and then you go next.

E.J. Butler

Sure.

Arunas Chesonis

We probably would like to carve out something in the neighborhood of $5 million to $15 million in our CapEx program every year to begin chipping away at the last-mile solution that we know we need ultimately to have in the company for a portion of our connections with our customers. So, I think on the fiber side, you will see some of that focus more on the legacy McLeod territories because it is going to be much less expensive to build out the spurs on the existing network that we already inherited from McLeod. On the wireless side, I think, you will see that throughout the entire PAETEC footprint, primarily focused on large and metro areas, where we have got the kind of density of existing customer base that we can leverage there. They are loops that we already paid for into various buildings and then we are able to provide that wireless last mile to other potential customers in those buildings themselves. So I think it will be a mix between the two. E.J., what’s your thought on that?

E.J. Butler

Just kind of following up on that, as many of you know, we acquired MPX Wireless towards the end of 2007. They were a Rochester based company that we had done several private projects with for alternative last mile wireless access. And, one of the things that we have initiated here is a network grooming project, where we are looking at multi- tenant facilities where we have multiple PAETEC customers that have multiple T1s, where we could go in on a cost effective basis. We can provide a wireless last mile alternative to provide our customers with business continuity, disaster recovery and lower cost access into PAETEC. And that's something that we have identified several buildings we will be looking to complete in 2007 as kind of our first beta trial. And if we are able to upsell into those buildings, I think you will see us use that as a more aggressive strategy in 2009.

Ray Archibold - Kaufman Brothers, L.P.

Very good. Thank you.

Arunas Chesonis

Thanks, Ray.

Operator

(Operator Instructions) Our next question comes from the line of Colby Synesael; please proceed.

Colby Synesael

Great. I just had a few questions. One, just want to get a sense of your comfortability as it relates to the -- because of your customer base. Have you guys gone through that now, and in terms, I think you mentioned bad debt expense has gone up a little bit, do you think that’s now behind you, and are you comfortable with where that is today? I am also just curious if you think that you will need to draw down on your revolver in the second half of the year, potentially for the stock buyback or are you pretty comfortable with your cash position? And then finally, as it relates to the wireless weakness you mentioned on the carrier side, I was just curious if that was anticipated and two, if you expect more to come in, and if so, how much? Thanks.

Keith Wilson

I will take the first couple here and then I will have E.J. talk a little bit about the wireless carrier migration. On drawing down the revolver, we have got $80 million plus in cash. We are generating net free cash and we are talking about a $30 million buyback over the next 12 months. I don't anticipate having to draw down the revolver to complete the buyback. So, I think, we feel comfortable about the free cash flow generation of the company. And I think as evidenced in this quarter, despite some softness, our ability to continue to generate free cash flow is something that’s incredibly important for us as managers.

On the bad debt expense, I think it comes back to relativity. We ticked up from about 0.7% bad debt to 85 basis points, 87 basis points. So it's a little bit of a pickup. We will keep our eye on it. I suspect that there is probably risk that, that goes a little bit higher over the next 12 months, but I still think that's probably as low as you are going to find in the space. So, it is really more of a, kind of, a relative analysis. But I think it is important for us to at least share with you guys what we are seeing and when we are seeing it.

E.J. Butler

Colby, I will speak to the wireless kind of dislocation. Some of the mega mergers that have gone on in the wireless space in the last couple of years, we have been a provider of network transport and toll free origination services for several of the wireless service providers. You could kind of see that window starting to close on that business for us once these mergers were announced, and obviously people looking to save money by moving more of that traffic on net. We have been in discussions with these customers for the last couple of years. It never happens when they anticipate that it is going to happen, and they have never really been able to give us firm migration dates for that traffic. But over the course of the first four to six months of this year, we saw a lot of that migration occur. Right now, we are not seeing over the last 90 days much traffic moving at all. My guess is it has kind of stabilized, and we won't see the types of migrations that we have seen for the first quarter plus this year.

Colby Synesael

Great. Thank you very much.

Arunas Chesonis

Thanks, Colby.

Operator

Our final question comes from the line of Romeo Reyes from Jefferies and Company. Please proceed.

Romeo Reyes - Jefferies & Company

Good afternoon, and I have a couple of quick ones for you guys. As you look at your LD traffic and LD revenue, if you were to look at those revenue streams and to -- I don't know if mark-to-market is the right word here, or right way of looking at it, but if you were to re-price that revenue stream, how much of an impact do you think that would have on your revenue streams and your EBITDA? That's the first question. And then the second question with respect to guidance, I am just trying to figure out how much of the $20 million end-year McLeod synergies are anticipated in that second half EBITDA that you have there? I guess the implication just using your midpoint is that you will do a $112 million in EBITDA just using the midpoint of your guidance down from $125 million in the first half. So, I am just wondering if that $112 million includes $20 million of EBITDA in the second half. So, apples-to-apples we would we be looking at maybe even at a worse decline there? And then the third one is with respect to the ability to layer debt, based on your permittive means, it seems like you have the ability to layer about $230 million of debt in front of debt -- in front of the bonds they give out there. So, can you just confirm that? Thanks.

Arunas Chesonis

Keith, you want to handle a couple of those?

Keith Wilson

Sure. Romeo, I think that I don't want to kind of go out and say what the number is in terms of debt capacity, but I think suffice to say there is a fair amount of bandwidth, for us to be able to layer on some capital. It is not quite two turns of leverage, but there's a fair amount there. So, I think again it is really more a function of the appetite of the markets as opposed to -- I am really -- our desire to take on that leverage for whatever purpose we might use it for. So --

Romeo Reyes - Jefferies & Company

If you, Keith, just on your -- on that thought -- I guess your secure debt is 2.5 times, and your permittive means are about 3.5 times. So you have about one turn rather of secured indebtedness room?

Keith Wilson

I think we have capacity up at the bond level for up to five times. So, I think, there is plenty of capacity there.

Romeo Reyes - Jefferies & Company

But I am talking about senior debt?

Keith Wilson

Okay. I thought you just asked about debt.

Romeo Reyes - Jefferies & Company

No, just senior bonds.

Keith Wilson

Yes, it is less than that, Romeo. It is going to be about $125 million that's available on our uncommitted facility today.

Romeo Reyes - Jefferies & Company

Okay. Great.

Keith Wilson

So, Keith to your first question on LD traffic – mark-to-market, write that down, what the impact would be both on the revenue EBITDA -- to be perfectly honest we haven't done that analysis, because that's contracted revenue. I think there always has been from the time the company started to -- and there will continue to be, so long as the market continues to compress on that price per unit, that there will be write-downs as part of the business. So, I think we continue to expect that. We did anticipate some write-down pressure on our base just happened to be little bit greater than we had anticipated. I think our best guess across the entire spectrum there would 3% or 4%.

Romeo Reyes - Jefferies & Company

Of revenues?

E.J. Butler

Yes. This is E.J., I mean we historically see somewhere between 3% or 4% of compression on LD revenues over the last several years.

Romeo Reyes - Jefferies & Company

Of the 35% of revenues, is that mostly LD -- that you just paid?

Keith Wilson

It is about 20%.

Romeo Reyes - Jefferies & Company

20% is LD. Okay. Thank you.

Keith Wilson

And that -- I guess did you have one other question, Romeo or is that it?

Arunas Chesonis

It was the $20 million synergies.

Keith Wilson

Yeah, on the $20 million in synergies, I would say that it is more back-end loaded than front-end loaded, but I think what we would want to do on the third quarter call is walk you through because of all the moving pieces in this quarter. Obviously, it is a little bit harder to come out and say that we have clearly identified $10 million or $15 million in synergies in the first half of year with the softness that we've had. When we identified specific work items that we have been through, we are at -- we are running as projected about 96% of where our targeted synergies are, and that's going to be in about the 25% to 30% range of the anticipated total synergies.

Romeo Reyes - Jefferies & Company

So I guess since you closed in February you haven't realized those one of those synergies at least in Q2?

Keith Wilson

There is still more than half of them to come in the second half of the year.

Romeo Reyes - Jefferies & Company

Okay. Great. Thank you.

Operator

Ladies and gentlemen, this will conclude the Q&A session. I would like to turn the call over to Mr. Arunas Chesonis for closing remarks.

Arunas Chesonis

Well, thanks everyone, again for joining us on the call. I would just like to conclude our remarks by assuring everyone that first, we acknowledge that the quarter was indeed below our expectations and we are not pleased with the results. Second, we are aware of the issues involved and we have a plan to address those issues. And finally, we have got the experience and hardworking people in place to execute on our plan. With the nationwide presence we have, broad product portfolio and strong free cash flow generation, we remain very confident in our growth prospects and our leadership position in the competitive telecom sector. Thanks again, and we very much look forward to updating you on our progress next quarter. Thank you again.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Good day.

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