BellSouth Corporation Q1 2006 Earnings Conference Call Transcript (BLS)

BellSouth Corporation (BLS)
Q1 2006 Earnings Conference Call
April 20, 2006, 10:00 a.m. EST

Executives

Pat Shannon - Chief Financial Officer
Nancy Davis - Vice-President, Investor Relations

Analysts

John Hodulik - UBS Warburg
Michael Rollins - Citigroup
Frank Louthan - Raymond James & Associates
Tim Horan - CIBC World Markets
Simon Flannery - Morgan Stanley Dean Witter
David Janazzo - Merrill Lynch
David Barden - Banc of America Securities
Chris Larsen - Credit Brief
Jonathon Chaplin - JP Morgan Chase & Co
Mike McCormack - Bear Stearns & Co.

Operator

Good morning. My name is Judy and I will be your conference facilitator to day. At this time, I would like to welcome everyone to the BellSouth First Quarter 2006 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks, there will be a question and answer period. If you would like to ask a question during this time, simply press star, then the number one on your telephone keypad.

As a reminder, ladies and gentlemen, this call is being recorded today, Thursday, April 20, 2006. Should anyone need assistance at any time during the conference, please press star, and then zero, and an operator will assist you. Thank you.

At this time, I would like to turn the call over to Nancy Davis. You may begin your conference.

Presentation

Nancy Davis

Thank you, Judy. Good morning. Thank you for joining our 2006 first quarter earnings conference call. During this call, we will refer to a slide presentation. The presentation, earnings press release, investor news and our financial statements are posted on our investor website at BellSouth.com.

Before we get started, let me point out that some of our remarks today may contain forward-looking statements. Actual results could differ materially from those projected statements. For discussion of factors that could cause actual results to differ, I refer you to our various reports on file with the Securities and Exchange Commission.

I will begin our discussion by covering BellSouth’s consolidated financial results. Pat Shannon, Chief Financial Officer for BellSouth, will cover the quarter’s highlights in our business unit results.

The supplements of reporting of BellSouth consolidated financial information under GAAP, the company presents certain non-GAAP financial measures, including normalized operating results, and operating free cash flow. Normalized results from continuing operations include BellSouth’s 40% proportionate share of Cingular’s revenues and expenses, which are recognized as equity earnings for purposes of GAAP reporting. Normalized results also exclude the impact of significant non-operational or non-recurring items.

I’ll review the normalizing items for the first quarter. A complete list of normalizing items, as well as a full reconciliation of normalized results to GAAP reporting, is included in the quarterly financial statements, which are also available on our investor website.

Slide 5 shows consolidated GAAP results from continuing operations for the first quarter of 2006. Revenue was $5.2 billion, up 1.6% compared to the same quarter of the previous year. Operating margin was 24.1% for the quarter. Year over year reported operating margin comparisons reflect the financial impacts associated with ongoing repair and restoration costs for hurricanes that hit our region in 2005.

Reported earnings per share was $0.43, up 16.2% compared to the same quarter a year ago, reflecting Cingular’s improving performance.

Normalized results for the first quarter are on slide 6. Normalized earnings per share for the quarter was $0.54, a 20% increase compared to the same quarter of the previous year, reflecting stable [ComGroup] results and improved performance of Cingular.

First quarter 2006 revenue was $8.7 billion, up 4.5% compared to the same quarter of 2005, as all three BellSouth segment’s grew revenue.

Operating margin for the first quarter was 21.9%, a significant year over year improvement for Cingular, offset slight decline in wireline margin.

Wireline margin’s were impacted by $85 million in storm repair expenses from Hurricane Wilma. Consistent with fourth quarter treatment, these expenses are not normalized from our operating results.

On slide 7, you can see the detail of normalizing items. Adjustments to reported earnings per share from continuing operations include costs associated with Hurricane Katrina, wireless merger integration costs, and intangible amortization.

For the first quarter of 2006, pre-tax costs associated with Hurricane Katrina were $94 million, primarily for wireline network restoration expense, which is net of $20 million in insurance recoveries during the quarter.

BellSouth also incurred approximately $135 million of incremental capital expenditures for Katrina restoration.

Since the third quarter of 2005, BellSouth has incurred approximately $730 million for Katrina related network restoration expense and capital. We expect a portion of the costs associated with Hurricane Katrina recovery effort to be covered by insurance. While the exact amount has not been determined, our current estimate of the total amount of covered losses that will be covered by insurance net of our deductible, is approximately $250 million. The actual recovery will vary depending on the outcome of insurance loss adjustment efforts.

At this point, I will turn the call over to Pat Shannon. Pat will begin his comments on page 8.

Pat Shannon

Thank you, Nancy, and good morning. Clearly our most noteworthy highlight for the quarter is that on March 5th, BellSouth and AT&T announced an agreement to merge the two companies, a combination that will create a more effective and efficient provider of wireless and broadband products and services.

We think this merger will benefit our shareholders, customers, and employees.

BellSouth first quarter’s earning results were strong, with revenue, margins and income reflecting solid growth for the first quarter of 2006. The communications group, Cingular, and advertising and publishing all continued to grow revenue, as demand remained strong in all three segments.

The communications group added a record 263,000 DSL customers, and continued to drive up total revenue per unit, with further penetration of product packages.

Data revenue grew 9%, and strong growth in the small business market continued with revenue up 9.4% year over year.

Cingular added 1.7 million customers, and now serves over 55 million customers nationwide. Their operating revenues continued strong growth, and their retail revenue per unit is up year over year, and sequentially, driven by strong data revenue growth.

Cingular service operating margins before depreciation and amortization improved year over year, and [are sure to] improve again. They are on track with their plan to reach industry leading metrics in 2007.

Advertising and publishing grew revenues 3.1%, and continued to make a strong contribution to BellSouth’s bottom line.

Slide 9 shows the breakdown of our revenue growth by segment. Cingular’s and AT&T’s results were strong, at more than 9% and 3% growth respectively.

Following similar trends as in the fourth quarter, the communications group again grew revenue in all retail segments year over year and sequentially.

Consumer’s drove more than 2% revenue growth in the first quarter of ’06, driven by higher DSL and long distance revenues.

Small business had a record quarter, with revenue growth at 9.4% year over year. Our small business team continues to reacquire and retain customers with competitively priced term agreements while also increasing customer revenue per unit with DSL and long distance bundles.

Large business revenue was up slightly as revenue from long distance and emerging data products offset declines in core, voice and data products.

Wholesale revenue declined 2.7% year over year. This segment continues to experience the expected revenue erosion due to a lower [UNIP] access line base. The [UNI] market decline was offset by growth in wireless and a stability in the general transport area.

Turning to slide 10, the communications group revenue was up 1.3% year over year, and flat sequentially. Operating margin was 23.6% in the first quarter of 2006, down 60 basis points from the first quarter of ’05, and up 170 basis points sequentially.

In addition, first quarter operating margins were negatively impacted as the company incurred approximately $85 million in incremental expenses to complete the network repairs associated with the damage caused by Hurricane Wilma, which struck the southern Florida coast in late October ’05.

As Nancy pointed out, to be consistent with the way we treated repair efforts, other than those of Katrina, these expenses were not normalized from out operating results, and had the impact of reducing first quarter margins by 180 basis points.

Repair efforts for this storm are essentially complete, and will not impact margins going forward.

On a positive note, the most significant driver of wireline margin improvement, was margin improvement on DSL, both year over year and sequentially. Given the importance of this product for our future, the margin improvement that comes with increased scale and falling churn is a welcome trend.

Year over year, network data revenue growth continued to improved, reaching 9% in the first quarter, driven primarily by a 30% growth in DSL revenue. Retail network data without DSL also grew 4% driven by emerging data products, such as Metro Ethernet and Network VPN, and growth in complex long distance services.

Total wholesale data revenue was stable. Demand for wholesale services from wireless carriers remains strong, with transport volumes up 14%. General transport revenue was flat, reversing recent downward trends due to strong volumes. These positive trends in wholesale data revenue were offset by a $17 million decline in revenue from the wholesale aggregation of dial-up Internet traffic.

Slide 12 shows more specifics on our DSL growth. BellSouth set a new record on DSL net adds in the first quarter of 2006. We added 263,000 net new customers, driven by successful pricing and promotion strategies, and lower term.

In January, 2006, we reduced the monthly price of the 3MB product by $5.00 to $37.95, driving both new adds as well as migrations from lower speed products.

As a result of strong upward migrations, 80% of the first quarter net adds were to our 3MB or 6MB product. And as a matter of fact, in the past six months, 72% of our net adds were 3MB and higher, and in the past year, 57% were 3MB and higher.

At the end of the first quarter, DSL customers totaled more then 3.1 million, up almost 34% from the end of the first quarter of ’05. DSL penetration increased to 16.4% of retail [switch] access lines, and revenue increased 30% year over year and 8% sequentially.

DSL ARPU held steady at $42.00, reflecting increased customer migration to higher speeds and higher ARPU DSL plans, and our discipline and targeted approach to the marketplace.

Benefits from customer growth and migration to higher speed service, stable revenue per unit and reduced promotional costs, all drove significant improvement in DSL margins during the quarter.

Access lines declined 238,000 in the first quarter of 2006.

The sequential improvement pictured on slide 13 follows typical seasonal patterns.

Wireless substitution continued to be the main driver of loss in residential lines across both retail and wholesale services. Losses to CABLE and VoIP providers have been at an absolute level of about 50,000 to 75,000 lines per quarter for the past year, and that trend continued in the first quarter of ’06.

In the business segment, small business gained an impressive 48,000 lines, the sixth consecutive quarter of line growth. Large business lines declined 28,000 in the quarter after experiencing some stabilization in the second half of 2005, in line with negative seasonal trends that we usually see in the first half of the year.

We’re keeping out top line growing to further penetration of DSL and long distance services. Customers continue to combine long distance, DSL, DirecTV, and Cingular services in the BellSouth Answers Bundle.

BellSouth added another 179,000 long distance customers, a 59% penetration of our mass market customer base.

Revenue per unit remained stable at $17.00, and churn continued to improve.

Mass market and complex long distance revenue totaled $464 million in the first quarter, an increase of 14% year over year.

In the first quarter another 105,000 added DirecTV to their BellSouth bundle, and at quarter end, 628,000 have included DirecTV services in their BellSouth communications packages.

In total, more then 5 million residential customers, almost half of our base, has a BellSouth answers bundle.

Our package penetration strategy in the mass market continues to increase the value of each customer through deeper penetration of packages.

Through targeted pricing and promotions, and upselling existing bundled customers with additional products, consumer revenue per unit reached a high of $62, more than a 6% increase over the same quarter last year.

A small business revenue per unit reached $80, which is up 4% compared to a year ago.

Slide 15 shows that Cingular again improved across all metrics. Service revenue grew nearly 8%, and total revenue increased 9%. Operating margin before depreciation and amortization benefited from merger synergies, revenue growth and lower churn as margins improved 640 basis points compared to the same period last year.

Cingular added 1.7 million customers in the first quarter of ’06.

Both overall churn and postpaid churn declined to the lowest levels thus far. Total churn of 1.9% and postpaid churn of 1.6%, both improved 30 basis points compared to the first quarter last year.

Cingular’s continued strong performance in customer additions and churn improvement can be attributed to improved service quality as the company integrates its networks and focuses on a steady stream of innovative products and services.

Clearly better churn results flow through every part of the business -- customer growth, revenue, expense, and most importantly, the overall reputation of the business.

Slide 16 illustrates Cingular’s year over year significant earnings growth, and how a more profitable Cingular provides incremental value to BellSouth.

Cingular still has more opportunity to drive value as integration efforts continue, and as overall business gains market momentum.

These opportunities include the completion of the network integration, completion of the [T-Mobile online], further billing and IT consolidations, further customer service integrations, and a full-year benefit from last year’s distribution rationalization.

In the first quarter of ’06, $0.13 of BellSouth’s normalized earnings per share came from Cingular. This compares to $0.04 and normalized earnings per share in the same quarter last year, and over the past four quarters, Cingular has contributed $0.47 to our earnings per share.

Slide 17 shows advertising and publishing’s results. First quarter revenue was up 3.1 percent compared to the first quarter last year. This segment continues to show strong growth. A&P has delivered six consecutive quarters of year over year revenue growth, a unique attribute in this industry.

Operating margins were 44.7%, down 230 basis points, or the equivalent of about $12 million compared to the same period last year. This decline was partially driven by revenue reductions association with lower billings in the areas affected by Hurricane Katrina. In addition, costs of improving the speed and salability of the yellowpage.com platform, along with higher advertising and online distribution expenses also impacted margins relative to the same period last year. We expect margins to improve somewhat later in the year.

Additional key financial metrics are on slide 18. BellSouth’s dividend was $0.29 for the quarter. We generated $551 million in operating free cash flow during the first quarter of 2006. Capital expenditures for the quarter amounted to just under $1.1 billion. Net of the storm impacts, increased levels of capital expenditures were driven by a decision to accelerate 2006 broadband investments, especially infrastructure and system investments towards the first half of the year.

Given the level of capital spending in the first quarter, I wanted to provide some further context. Slide 19 reflects capital trends for the last five quarters. Without the storm related capital and the first quarter planned acceleration of broadband investments, ongoing capital [expend] is in line with 2005 quarterly capital expenditures.

We expect broadband investment levels to drop over the remainder of the year after we shift our focus from fiber deployment to D-SLAM installation.

In addition, our plan calls for declining system investments over the remainder of the year.

We remain committed to our original capital guidance for 2006 that we gave in December.

I’ll conclude on slide 20. For the first quarter, BellSouth has delivered strong financial results, with a focus on shareholder value, and we now have an opportunity to further drive shareholder value, improve innovation for our customers and enhance opportunities for our employees by merging with AT&T.

BellSouth operates in the thriving economy of the southeast. It has strong relationships across residential and business segments. We’re replacing local voice revenues with profitable growth in long distance and broadband services across the mass market.

We’re gaining market share in small business, and we have stable results in both large business and wholesale services.

Our results this quarter demonstrate the strength of our business and our ability to deliver strong financial results in an ever-changing competitive market.

The merger with AT&T is an excellent opportunity to build on all that we have achieved and to move our vision forward to the benefit of our shareholders, our customers, and our employees. Now, I’ll be happy to answer any of your questions.

Operator

(Operator instructions)

Your first question comes from the line of John Hodulik from UBS.

John Hodulik - UBS Warburg

Thanks, good morning, guys. First quarter, you saw a nice little turn in the large business market, and small business continues to accelerate. Could you talk about some of the trends you’re seeing there, and do you think we should continue to expect improving top-line performance in the business market?

And secondly, on DSL, could you update us on the plan to rollout the faster 12MB service, and you know, the ARPU continues to remain strong. Just your thoughts on the growth of that business over the next few quarters, that would be great.

Pat Shannon

Sure. As far as the business market, you know, small business has been, I think really with the demise of the UNE P model I think was really the big turnaround there, and even before that, with long distance and DSL coming into the product mix, they had done a great job of reaching out to our customers and putting them in packages and in term contracts, but really with the demise of that UNE P model, I think the retail side has turned around significantly. And they’re taking good share in that market, and that’s then building momentum really over the last six quarters, so I would look to see that continue.

On the large business side, really the main thing that’s happened is in the terms of pricing pressure on core voice, and if you look back over the last three quarters, we’ve seen virtually no pricing pressure on the core voice side, so even with modest declines in the volumes around core voice and access lines, that has caused a stabilization of that revenue stream.

And we’ve also seen some good sales of some of the emerging data products, like I said, around Metro E and Network VPN, so you know, we’ve got two good solid data ports now for the last two quarters around that business. I feel pretty good, a little cautious still, but pretty good about that business.

On DSL, DSL’s been a great story, you know, for us. We had good reaction every time we made a pricing move. Some of our pricing moves have not been nearly as aggressive, I guess, as some in the market. We’ve had solid response. We went to an everyday low pricing model late last year and saw some great volumes, and profitable volumes.

And then this latest move to just make really a tweak to our 3MB proxy and dropping it down to $37.95, has stimulated some migrations from the lower end of the spectrum, so we really stopped doing what we were doing. I believe it was kind of over-promoting some of the slower speeds at the lower prices. Now we’re pushing people up into the portfolio, so it’s very welcome to see record net ads at higher speeds, higher ARPU’s. And as you can imagine, since the cost for these products are the same across the speed, that really provided a nice margin lift, enough to really float the whole boat. I mean, the entire wireline margins are up because of that important product, and I think that’s a great sign.

Churn is coming down. We’ve seen a set improvement in churn over the last four quarters. It’s still higher than our base product, and we’d like to see that come down to sort of the base churn levels. We’ve seen the LD product act that way at scale, coming back down to the base churn levels. We expect over time that we’ll see the same thing on the DSL side.

So solid trends across retail. I think that’s what is really driving our margins up, is that our cost structure is so leverageable, on the up and the down. And after experiencing the down side for the last several years, with just some stabilization and minor growth on the retail side, we’ve seen a good pop in the margins, and that’s well-received.

John Hodulik - UBS Warburg

Are you able to -- you guys have said in the past that DSL margins were approaching the voice margins. Do you still look at it that way? And is that relationship true? Do you ever see the inverse being the case, where you actually see better margins in DSL as the voice market [itself is under] more pressure?

Pat Shannon

Yeah, what we’ve said is the marginal, so you’ve have to sort of…

John Hodulik - UBS Warburg

Right, direct from the growth.

Pat Shannon

This is all, right now it’s all in. The overall margin from DSL, including some [trial] acquisition costs and the bit, not only on a marginal customer basis, is positive and it caused a very significant lift in the overall wireline margin.

As long as you have a significant subscriber acquisition cost, especially with a product, I think it will be tough, even at common churn levels, I think it will be tough to get all the way up to the margin of the local business. But I would certainly see it approaching it over time.

John Hodulik - UBS Warburg

Great, thanks.

Operator

Your next question comes form the line of Michael Rollins with Citigroup.

Michael Rollins - Citigroup

Hi, good morning. Just a couple quick questions. Just first, a little bit more on just some of the business trends that you’re seeing. You talked about some of the share gains and pricing, but what about the health of the overall market economy and how that’s playing into the revenue side?

And then the second question I had was just a little bit more on what you’re seeing from wireless substitution in your markets. You mentioned the cable voice data point. I’m curious what you’re seeing overall term, and how that relates to what you’re seeing on the Cingular side in your specific region. Thanks.

Pat Shannon

Sure, I think the overall health of the economy is strong. It’s driving some good volumes, especially on the data side of the business, which we saw some good growth, even outside of DSL, in some of the emerging data products on the retail side. The 4% percent growth, that’s a good solid trend compared to what we’ve seen over the last several years.

As far as the wireless substitution goes, the absolute amount of wireless substitution was a little bit lower in this quarter than we’ve seen over the last several three quarters, but I think you fall into some seasonality trends.

Clearly it is still the main driver of [off-net] line loss that we’ve seen, so again, the absolute number of lines dropped a little bit, but I’m not ready to call it a trend by any stretch of the imagination.

And I don’t know the details of Cingular’s southeastern results just off the top of my head. I will tell you that in the past, we’ve looked at. Their southeastern properties tended to grow a bit faster than the overall portfolio, so we’re still by far the net beneficiary of that trend, given our ownership interest in Cingular, and it’s probably more than just the average of Cingular, because I think they do a little bit better in the southeast.

Michael Rollins - Citigroup

Just on that point, my understanding was that you guys were going to be trialing some joint distribution efforts with Cingular, wherein some of those stores you might sell wireline product, DSL or the satellite TV product. Are you far along in that process where there’s some results that you could talk about on how that works from a customer and a productivity standpoint?

Pat Shannon

We’re far enough along in it that we’ve launched it in several of the stores. I do not know the results. We could follow-up with you, but it’s a program that internally we call “Doors and Stores