SureWest Communications Q2 2008 Earnings Call Transcript

SureWest Communications (SURW)

Q2 2008 Earnings Call

August 7, 2008 11:00 am ET

Executives

Misty Wells - Investor Relations Manager

Steve Oldham - President and Chief Executive Officer

Fred Arcuri - Chief Operating Officer

Dan Bessey - Chief Financial Officer

Analysts

Christopher C. King – Stifel, Nicolaus & Company, Inc.

Jonathan Levine – Jefferies & Company, Inc.

Thomas Watts – Cowen & Company LLC

Presentation

Operator

Welcome to the second quarter 2008 SureWest Communications earnings conference call. (Operator Instructions) I would now like to turn the call over to your host for today, Misty Wells.

Misty Wells

Welcome to SureWest second quarter of 2008 earnings conference call and webcast. SureWest recorded financial results for the quarter this morning. The earnings press release is available on our investor relations section of our website at www.surw.com and the second quarter 10-Q will be filed soon. With us on today’s call are Steve Oldham, President and Chief Executive Officer, Fred Arcuri, Chief Operating Officer, and Dan Bessey, Chief Financial Officer.

Before we begin, I would like to remind you that some of the statements, comments, and discussions which occur during this call are forward-looking a nature and relate to future event and/or performance. These statements should not be relied on as historical or absolute fact as future performance and future events are subject to numerous risks and uncertainties that frequently cause actual results and actual events to change. There are many such risks and uncertainties which could affect the economy or industry and our company in particular. Some or all of which could affect the future results.

Before making any investments decisions about our company, we encourage you to review the company’s most recent filings with the securities and exchange commissions, which contain a description of many of these risks and uncertainties under the heading Risk Factors. These reports are available on the Investor Relation section of our website at surw.com.

I would like to now turn the call over to Steve Oldham, President and Chief Executive Officer.

Steve Oldham

I am going to spend a few minutes discussing the progress we have made in the execution of our long-term strategy. I will then ask Fred Arcuri, our Chief Operating Officer, to discuss our second quarter operations and initiatives and after that Dan Bessey, our Chief Financial Officer, will present our financial results. We will, of course, have time for your questions at the end of the discussion.

As we have discussed many times, SureWest made a decision several years ago to position itself as a premier broadband service provider in the communities we serve. At that time the management team anticipated significant increases and competitions and fundamental changes in historic regulatory policies. We also recognized that the looming growth in the demand for ultra high performance broadband services, including IPTV and extremely fast internet was just around the corner. It was clear to our team that network improvements were necessary to take full advantage to the demand for high quality IPTV and the rising demand for video access across the internet. Our employees embrace these changes as an opportunity for growth and have since made significant progress in transforming SureWest into the bandwidth leading Company focused on advanced network services for residential and business customers anywhere we serve.

Over the last two years we exited businesses that were not directly related to network services. Consistent with this strategy we purchased the assets in Kansas City earlier this year, which expanded our commitment regionally and provided another growth market for our broadband services. We are very pleased that our second quarter performance demonstrated our ability to grow the broadband business segments both in Sacramento and the Kansas City markets. Consolidated operating EBITDA from continuing operations surpassed the $20 million mark and residential and business subscriber growth continues to be strong in both markets.

The second quarter marked our first full quarter operating in Kansas City. Our early experience in the region provided encouragement that our estimates of the growth opportunities were accurate. As Fred will discuss, we are particularly pleased with the solid growth in the business segment in this market. Our marketing campaigns to sign up new business customers in Kansas City have resulted in a 26% year-over-year and a 7% sequential growth in Kansas City business revenue. In addition, as we expand our Kansas City network, we continue to expect residential growth in subscribers and revenues.

The company rolled out of Voice over IP products in the Sacramento market late in the first quarter of 2008. During the second quarter results showed that the Voice over IP product provides us with a potent offer to combat line loss competition in our ILEC in addition to being a very competitive product to compete for voice RGU’s outside of the ILEC. New Voice over IP customers effectively reduce line losses, access line losses from consolidated voice RGU’s to just 1% sequentially. Of the 3,900 sequential telecom access line losses, 14,000 chose to switch their traditional voice service to the newly offered Voice over IP broadband product. In addition, more than 25% of those converted customers were previously single-play phone customers who added a SureWest data subscription to their servers and 69% upgraded their calling plans.

These early results encourage us to continue with our marketing and deployment in this varied feature rich Voice over IP offering. We continued to invest our ILEC upgrade, ILEC network fiber upgrade. So far this year, we have converted approximately 4,200 homes in the ILEC from copper to fiber. At the current levels of capital expenditures we will complete the ILEC upgrade in the next two to three years. Our current plan is to upgrade about 60% of the total ILEC copper homes of which we have already upgraded about 28%.

We plan to use other cost efficient techniques to greatly improve bandwidth and services to the ILEC homes that we do not intend to convert to fiber. In spite of the economic slowdown and loss of jobs in California, our strategy to proceed as an over builder provides us with the ability to continue our growth by competing aggressively for existing residential and business customers. SureWest continues to experience the industry trend of declining traditional access lines and telecom revenues. We are also seeing effects of previously announced reductions in subsidies, such as the California high cost on payments. We expect to see that trend continue for some time period but as I just discussed we believe our broadband growth strategy including aggressive Voice-over- IP marketing. The ILEC fiber upgrade and the advantages of bundling multiple services is the key to thriving in the markets we serve today.

In addition to the success of the Voice-over-IP in Sacramento, we made a number of enhancements to our recently launched IPHD digital video recorded and, as a result we have increased our DVR penetration rates to 28% of video subscribers in Sacramento with nearly 50% of all new video subscribers in the second quarter, subscribing to the DVR service. In both regions, we have seen a growing number of consumers purchase HD television and these consumers are looking to gain the best programming options available. We are confident that our customers are choosing SureWest because of the value of our marketing bundles and the addition of HD channels to our advanced network that our advanced network provides.

We are pleased with our success thus far in both markets year-over-year. We increased consolidated broadband residential RGU’s by 7% and broadband business customers by 13% and we believe that by executing on our business plan that we will continue on this growth trajectory and remain a very strong competitor with our robust triple-play bundles. But it is important to note, as we grow our broadband business, it is clear that the growth has some seasonal aspects to it and generally is not evenly spread throughout the year. As we look to the second half of the year, our plans include marketing programs connected with the rollout of new products and services as well as to the regular ongoing activities to increase penetration on our existing networks.

It is important to note that the senior management team is very focused on our growth opportunities. Our entire employee base is on a performance-based compensation program that includes heavy emphasis on revenue growth and on EBITDA expansion.

Finally, as the industry appears to be serious about USF reform, we are in an excellent position to manage this risk as we have worked hard to build a business that is not dependent on garnering subsidies which could go away in the future.

I will now turn the call over to Fred Arcuri, Chief Operating Officer, who will discuss our operations in greater detail.

Fred Arcuri

As Steve have mentioned, this is our first full quarter of ownership of the Kansas City network and I am happy to say we are very pleased with these operations to date.

The employees and the management team led by Ken Johnson, our top notch and they have demonstrated considerable energy and creativity allowing us to grow the Kansas City business from the outset. As we announced in July, the Kansas City market is now successfully transitioning from the Everest name to SureWest and the transition will be complete by year end. When we purchased the Kansas City network we saw a real opportunity for growth in the region particularly with new business customers. We have seen a strong demand for higher margin business services. To capture more of that market, we increased our business sales force to 16 reps and enhanced our sales and marketing spend. As result of these efforts, we expect continued growth in the Kansas City business customer base.

We began expanding the Kansas City network in July and we will pass approximately 10,000 additional residential homes in 2008 including an expansion into adjacent communities where we believe that there is a great demand for competitive provider of quality services. Of the new homes passed 8,000 will be served by SureWest advanced fiber to home network that provides a truly superior video experience and the fastest symmetrical internet feeds of any provider at up to 50 megabits per second both uploading and downloading.

Kansas City market has built on its already impressive triple play stature in the quarter. Our Kansas City customers average 2.7 RGU’s and 75% of them subscribe to our triple- play. Our talented team has accomplished a lot this far and we anticipate more in the future. As we build new network and aggressively implement marketing campaigns we expect to see sizable residential growth which is in line with the history of the Kansas City operation. There are also developing programs to increase the already impressive penetration rates in the Kansas City.

Now, let us take a look at an overall look at the business at the broadband segment. During the quarter, we experienced strong growth in both the residential and business broadband market. Sacramento in particular experienced considerable growth in large part due to the rollout of our new Voice-over-IP product, which positively affected the total residential RGU’s. The success of this product in the Sacramento market created an appetite for additional higher ARPU services which are peripheral to the voice product itself. We bundled Voice-over-IP into a triple-play, which offers us the opportunity to achieve higher overall subscriber margins.

We believe more consumers will begin to see Voice-over-IP as a cost effective and reliable option because of the multiple package offerings, price flexibility and the inclusion of on line interactive features, such as Find Me/Follow Me, sequential ringing, and selective call screening. We truly believe that Voice-over-IP as a significant part of the future of telecoms; we are excited to be able to offer it to our customers. SureWest now offers service in the broadband footprint and we are ramping up our marketing efforts and introducing the product to selected areas in our Sacramento ILEC territory that were previously untapped.

Regarding our video business, we continue to enhance our HD TV offering and today provide 52 high definition channels in the Sacramento region and 42 in Kansas City. We will be deploying a significant amount of HD channels in both regions during the fourth quarter to ensure SureWest continues to lead the premium television markets in HD offering. We have also significantly increased our DVR penetration in Sacramento by making exciting enhancements through our IPHD DVR. But first began marketing the DVR in the Sacramento market earlier this year and have already achieved the 28% penetration rate of video customers with nearly 50% of all new video customers taking this service.

DVR service was introduced to Kansas City market in 2004 and as of this quarter, 48% of all video customers subscribe to the DVR service with room for double-digit take rate growth. Due to the significant growth in DVR take rates across the industry, we believe our DVR penetration will continue to grow in both regions. In addition to the ongoing plans to grow our digital and HD channel lineups, we are making efforts to grow video RGUs and ARPU through unique programs that take advantage of our IP based network such as caller ID on your TV, DVR networking in a customers’ home, increasing DVR storage, adding additional DVRs in the home, and adding additional screens to those DVRs.

We also have plans to double our on-demand content in the next six to eight months. In our telecom segment we continue to see a shift in the Company’s revenue structure as planned for our revenues continue decline as we saw declining access line trends with many of our residential customers in the Sacramento region switching from traditional telecom phone service to a Voice-over-IP service. Steve talked about this but I want to reiterate that because we are able to offer customer SureWest Voice-over-IP we retained a significant number of existing residential voice customers while capturing new ones.

In addition, data growth in the Sacramento market during the quarter was particularly tied to the success of SureWest Voice-over-IP which requires voice customers to subscribe to a data package. Because Voice-over-IP is an online interactive service over 82% of the current data subscribers who signed up for Voice-over-IP increased their data speeds to enhance the overall experience. This also reflects our customers’ demand for internet bandwidth which continues to increase and is now growing within our Company by 60% per year. This has resulted in an increase in consumer demand for faster internet speeds and we now have over 40% of our Sacramento data customers subscribing to speed of 10, 20, 50 megabits.

I would now like to turn our focus to business services. We serve four categories of businesses: small office customers, small to medium sized businesses, and enterprise or large business customers and carriers. The broadband and telecom business revenues this quarter represented 30% of total revenue and we continue to believe that business revenue growth will be an important way for us to diversify our revenue growth as business customers provide higher margins than traditional residential customers.

In both Sacramento and Kansas City, we believe that SureWest has a competitive advantage that sets us apart from traditional telecom companies including Ethernet and customized business solutions. While many of our competitors have a one-size-fits-all approach to working with business customers, we take the time to get to know their specific requirements in order to develop customized services and solutions to fit their business needs.

We see that there is a tremendous opportunity for SureWest and we believe we will be the business provider of choice and the reasons in which we operate. Additionally, due to the customer demand we expanded our data center space this quarter spending an extra $2 million in capital to upgrade an existing facility to provide unique requirements needed for our data center. We have already signed customer contracts and with construction still to be completed, they are currently occupying over 60% of the space.

This is an example of our ability to create a high margin facility from our existing space at a low cost with virtually no risk because of customer demands. In addition, these customers subscribe to other services in order to connect their data centers. We look forward to realizing the results of this effort in the third and fourth quarter.

Finally in the quarter, we closed the sale of our wireless business to Verizon Wireless for an aggregate purchase price of $69 million. Verizon is expected to fully take over operations of the wireless business in August.

In conclusion, we are proud of our accomplishments and the progress we have made in executing against our strategy in becoming a leading broadband and advanced network services provider. We are confident in the initiatives we have put in place combined with our enhanced marketing and sales efforts will yield greater benefits in the future.

With that, I will turn the call over to Dan Bessy, our Chief Financial Officer, who will discuss our financial results in greater detail.

Dan Bessy

SureWest continued to perform well in the second quarter of 2008. As Steve and Fred have mentioned, the second quarter financial results include a full quarter capture of the Kansas City operations and also reflect the continuing growth in our Sacramento operation.

As we discussed last quarter, we introduced a new reporting format in the first quarter of this year in an effort to provide greater clarity into the nature and sources of our revenue streams. In that regard we continue to break out residential and business service revenue and the related operating metrics for the broadband and telecom segments. Additionally, we have provided results of operations on both a GAAP basis and a pro forma basis. Also, the results of the wireless operations are reported as discontinued operations for all periods presented. The operations of the Company on communication towers that were retained with the sale are included in the broadband segment.

Now, let us cover the second quarter results on a consolidated GAAP basis. Consolidated revenues for the second quarter of 2008 totaled $60.3 million, an increase of 36% year-over-year and 17% sequentially. Consolidated EBITDA totaled $20.1 million, an increase of 29% year-over-year and 35% sequentially. This growth was due to continued broadband residential and business growth offsetting telecom revenue declines in Sacramento and the positive impact of our new market in Kansas City.

Consolidated income from continuing operations was $1.7 million of second quarter of 2008 compared to income of $2.7 million at second quarter of 2007 and a loss of 11,000 in the first quarter of 2008. The year-over-year decline is primarily due to interest expense and depreciation expense related to the Kansas City acquisition and a majority of the sequential quarter improvement is due to a full quarter capture of the Kansas City earnings compared to only six weeks in the first quarter of 2008.

Earnings per share from continuing operations for the second quarter was $0.12 compared to $0.18 for the same period last year and [$0] per share sequentially. Net income increased $20.9 million from $1.5 million year-over-year and $283,000 sequentially of which $90 million was due to the gain on sale of SureWest wireless in the second quarter.

Operating expenses exclusive of depreciation and amortization increased 39% to $40.2 million in the second quarter of 2008 from $28.9 million in the second quarter of 2007 and increased 9% sequentially from $36.8 million. Cost of services increased 69% to over $22.9 million in the second quarter of 2008 from $13.6 million in the second quarter of 2007 and increased $4 million or 21% sequentially. Primarily, as a result of the Kansas City acquisitions and increases in programming, transport, and access costs related to the growth in broadband subscribers.

Customer operations increased 34% to over $8.8 million in the second quarter of 2008 from $6.6 million in the second quarter of 2007, an increased $1.2 million or 16% sequentially, primarily as a result of the Kansas City acquisition and increases in sales and advertising costs to promote subscriber growth and new product offerings within the broadband segments.

General and administrative expenses declined 4% to $8.4 million in the second quarter of 2008 from $8.8 million in the second quarter of 2007 and declined 18% sequentially from $10.3 million due primarily to labor savings associated with our ongoing cost reduction initiatives and a decrease in legal fees related to certain regulatory matters. I would like to now discuss the broadband results on a pro forma basis to include the Kansas City acquisition in prior periods before the transaction for comparability purposes.

For the second quarter of 2008, total broadband revenues were %35.6 million, an increase of $3.4 million over the prior year and a $1 million increase on a sequential basis. Year-over-year residential subscriber growth increased roughly 6% to approximately 99,000 subscribers. Total subscriber penetration of marketable homes increased 2% to 33.9% year-over-year. As of June 30, the 207,700 total RGUs were split relatively even between the Sacramento and Kansas City regions. This reflects a 12% year-over-year increase in RGUs in Sacramento and a 3% increase in the Kansas City region.

Data RGUs year-over-year increased 7% with a 9% year-over-year increase in the Sacramento market and a 5% increase in the Kansas City market. Results in the Sacramento market reflects the success of the voice offering as customers who signed up for our voice services also are required to take data service.

Data ARPU increased from $36 in a second quarter of 2007 to $37 and remained stable sequentially. As Fred and Steve have previously mentioned, we believe that our advanced fiber based networks provide us with a competitive advantage over other providers in the areas we serve. Video services in our Sacramento market are offered over our advanced fiber to the home network and in the Kansas City region utilizes an advanced HFC network with significantly less homes per node than typical HFC network utilized by our competitors.

As a result, year-over-year video RGUs on our fiber to the home and HFC network increased 9% to $54,500. This increase was slightly offset by a decline in the video copper RGUs in the Sacramento ILEC territory of 300 year-over-year and 100 sequentially. Video ARPU increased $60 in the second quarter of 2007 to $62 and will remain relatively stable sequentially. For the quarter, we have 56,600 broadband voice RGUs and increased of 7% year-over-year and 5% sequentially.

During the quarter, 14,000 voice RGUs migrated from the telecom segment to broadband to subscribe to our new launch VoIP service. With a higher margin potential when compared to SureWest traditional land line service due to its bundling requirements for SureWest data and long distance, VoIP is a cost effective and reliable option for consumers because the multiple packages and pricing flexibility. At $32 VoIP’s ARPU remained stable year-over-year and sequentially. In the Sacramento and Kansas City triple-play footprints, RGUs per subscriber remained strong both year-over-year and sequentially at roughly 2.6 RGUs per sub and average revenue per user increased $2 from $107 to $209 year-over-year.

Turning to broadband business revenues, business revenues are a significant aspect of the success of our broadband segment representing almost 23% of broadband total operating revenues. Business revenues by the Company with both product and customer mix diversification but also represent significant growth opportunity in both the Sacramento and Kansas City regions.

Broadband business revenues increased 15% year-over-year and 6% sequentially to $8.3 million. Business customers grew 13% from the prior year and 3% sequentially to 6,200 customers. Total business ARPU grew 1% from the prior year and 3% sequentially to $458. Overall broadband business growth was substantial consisting of new additions of enterprise business customers and the addition of new services by existing large customers utilizing SureWest Ethernet and data center services.

Kansas City’s business operations experienced solid customer growth rates of 26% year-over-year and 7% sequentially as the Company has allocated more resources in this area to take advantage of significant growth opportunities. EBITDA for the broadband segment declined less than 1% compared to prior year and increased almost 17% sequentially, again demonstrating our strong second quarter results.

Broadband revenues for the second quarter of 2008 represent 59% of our consolidated quarterly and year-to-date pro forma revenues and broadband EBITDA represents over 20% of our consolidated pro forma EBITDA. As we continue to focus on the growth of both our residential and business services in our broadband segments we expect that we will become the primary source of both revenue and EBITDA for the Company.

Now, let us discuss our telecom segment results. Operating only in the Sacramento market, telecom segment revenues were $24.7 million in the second quarter of 2008 declining 10% year-over-year in remaining stable sequentially due to an increase in telecom business revenue offsetting revenue loss in telecom residential and access revenues. Telecom residential was impacted by anticipated losses in telecom voice RGUs of 60% year-over-year and 6% sequentially. However, the Company is successfully mitigating this RGU loss by continuing to migrate voice RGUs from the telecom segment to the broadband segment to its new VoIP products which allows the broadband segment to offer VoIP in the ILEC territory.

As a result of migrating 1,400 telecoms voice RGUs to the broadband VoIP product. The loss and consolidated voice RGUs was 6% year-over-year and 1% sequentially. Telecom residential will continue to see an increase in the movement of voice RGUs to the broadband segment as existing and new voice customers demand SureWest VoIP and its feature rich capabilities. The telecom segment rise up to 40% of each revenue streams from its business service offering and continues to aggressively pursue telecom business customers by utilizing its advanced fiber network to offer customized voice and data services. Telecom business revenues increased 2% in the second quarter compared to the prior year quarter and 8% sequentially. While telecom business subscriber counts decreased 3% from the prior year, they were stable sequentially while ARPU grew 6% from the prior year and 10% sequentially to $341.

During the quarter Verizon Wireless purchased approximately 450,000 in backhaul support services previously recorded as inter segment revenue and expect to continue these services through the latter part of 2008. Upon completion of these transition services, the Company expects the impact to EBITDA to be minimal.

Telecom access revenues which consist of the Company’s switched access revenues and subsidy revenues from the California high cost fund increased 14% year-over-year and 5% sequentially due to scheduled reduction in the California high cost fund subsidies of 510,000 in the second quarter as well as the decline in switched access revenues due to loss of access lines.

Moving to the balance sheet, for the second quarter cash and short term investments were $12.5 million compared to $52.3 million at December 31, 2007. The decrease in cash is the result of the acquisition of the Kansas City operations, share repurchases, payment of cash dividends, and the ongoing investment in the Sacramento and Kansas City networks. Our business is fundamentally strong and our balance sheet is sound. As of June 30, 2008 total debt was $216 million of which $30 million is short term.

As previously discussed, we used $46 million of the proceeds from the wireless sale to repay debt including paying down $30 million of our $60 million term loan and another $60 million to pay down our line of credit. All in all we continue to operate from a position of strength particularly relative to our peers and have the resources and capital in place to continue to build a business and increase our penetration in all of our markets. This will allow us to aggressively continue our growth strategy while affording us the financial flexibility to adjust capital spending as necessary.

Consolidated capital expenditures totaled $23 million for the second quarter. The Company continues to focus its capital expenditures on targeted network builds and success based capital associated with increased penetration and ARPU on the existing network. Capital expenditures for 2008 are expected to be approximately $80 million, up from our previous projection of $78 million. The addition was due to a $2 million improvement made to existing facility to take advantage of additional demand for using data center space. Year-to-date June 30, 2008 we added 11,500 fiber homes in the Sacramento market of which 4,200 were ILEC upgrades.

The full year capital plan for 2008 projects an increase of 10,000 marketable homes in the Kansas City market and approximately 14,000 fiber homes in the Sacramento market of which approximately 55,000 will be ILEC upgrades.

In summary, we are pleased with the financial results and operating metrics for the second quarter. And we have made great progress in the growth of the business as we continue working to increase broadband penetration, add business customers, and enhance our triple-play offerings.

Now, I will hand to call back Steve Oldham, President and Chief Executive Officer.

Steve Oldham

These are exciting times at SureWest. We are pleased with our second quarter results and our strong EBITDA growth. As always, we remain committed to improving long-term shareholder returns by growing the business, increasing sales and revenues, and cash generation. While we are in the early stages of realizing the benefits of our transformation to an advanced broadband provider with triple-play and business services, we are aware that there is more work to do in order to achieve continued success.

We will move the Company forward by focusing on our time and resources on our strong assets and operations. We will continue to aggressively roll out our products including Voice over Internet Protocols, which has already proven to be a tremendously valuable product in adding significantly to our triple-play bundle and helping to offset access line losses. Our talent team is working hard on both of our regions to penetrate our footprint, expand our network, in region of business and residential customers. Of course, we are always mindful of both the competitive nature of this industry and the seasonality and that said we will believe that all of the ingredients for success are necessary and we have those in place. I guess that is it.

We will open for questions now.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from Chris King - Stifel Nicolaus.

Christopher C. King – Stifel, Nicolaus & Company, Inc.

I was just curious as to your view of the economic outlook both in the Sacramento area and the Kansas City area does not seem to have impacted you guys very much at all during the second quarter. But I am just wondering with your outlook there is and any kind of macro driven trends you expect in the second half of the year. And second question, I just wanted to double check on your ILEC EBITDA margin which was up roughly 700 basis points or so, on a sequential basis. I just was wondering if there was any kind of cost allocations going back and forth there between the broadband unit and the telecom unit or the whether 63% to 64% EBITDA margin type of range for the telecom unit is a good run rate to use going forward.

Steve Oldham

The Sacramento, there is no question that northern California, in fact California in general have seen a pretty significant down turn has suffered some job losses. That is true in the Sacramento region and all of California. I do not see any reason why that would not change in the short run. We are expecting to see that continuing in the short run. But if you know, our plans for building and overbuilding on existing customers allow us to go ahead and capture new RGUs, revenue, customers whatever by expanding to those customers that currently exist. It is a vital part of the plan that allows us to thrive even if we are not seeing new construction going on and taking place.

The business climate, business customers are fiercely competitive with one another and when we can go in and provide them cost effective ways to communicate with their own customers, there is a very robust opportunity for growth. We have seen expansion in medical and higher education markets; however, in this area and both of those target markets provide us with a good opportunity as those medical and education markets really desire the kind of high bandwidth we are offering so to the extent that we see growth in certain markets like that tech markets that is good for us.

We are not seeing any expansion of actual residents and businesses. We are always be able to go after existing residents and businesses. In Kansas City while they have not had the kind of economic downturn we have seen in northern California. We are essentially going after existing customers there too by leveraging off that fiber ring we have around Kansas City to capture new business customers and by expanding the network to over 10,000 homes in Kansas City we are going after existing residential customers.

We are fairly confident that we can continue with the growth model as an over builder in spite of the fact we have had the economic downturn in northern California. I am going to ask Dan to address the EBITDA question.

Dan Bessy

The question was about ILEC EBITDA margin from Q1 to Q2. And when you look at that on a pro forma basis you will see that the majority of the cost reductions on Q1 to Q2 where in the general administrative area. There are a couple of reasons for that. Number one, we had some fairly significant labor and benefit savings in Q2 as a result of ongoing headcount reductions as well as some changes in our executive team that occurred in Q1. So that is the first and probably the most prominent aspect of that cost decline. The second is fees, and to a lesser degree as we have some professional fees, in Q1 that will not reoccur in Q2 and in going forward so those cost reductions in the G&A category are driving a margin improvement for both the ILEC and broadband.

Operator

Your next question comes from Jonathan Levine - Jefferies.

Jonathan Levine – Jefferies & Company, Inc.

Yes, you gave some color in terms of the integration but I was wondering if can give a little bit more in terms of what you have left during regards to the integration for Kansas City and timing and whatnot? In addition, if you could also give us what your thoughts are now for the towers and a potential sale of them that would great, thanks.

Fred Arcuri

We continue to look at things like the obvious, the call center integration, IT integrations, but quite frankly they were running pretty lean at the time of the acquisition so there would not be any really large integration opportunities there. As the Company grows; however, we will leverage the fact that we have significant IT in California as well as call center opportunities that we can leverage in Kansas City.

Steve Oldham

And with regard to the towers, we are looking right now at the best way to maximize the value of those 50 or so towers that we own and will continue to own. And we hope to have an announcement on where we are going with that in the not too distant future.

Operator

Your next question comes from Tom Watts - Cowen and Company.

Thomas Watts – Cowen & Company LLC

In terms of the business revenue you mentioned the possibility of long-term that business EBITDA could be more than 50% of EBITDA if I understood that and do you have any time frames in your mind? Second, could you just remind us of why business customers declined year-over-year even though they were flat sequentially? And then third, could we just have a little more of an update on the sales force expansion for the business market in Kansas City and what are the costs for that near term pressure on margins, what sort of progress have you seen there and how soon do you want that to be paying off?

Dan Bessy

I just want a point of clarification, when we talk about the expansion of the EBITDA, we were not necessarily talking about just business. But we were talking about our overall broadband segments that we expect that that segment will be the significant driver of revenue and EBITDA.

In terms of a time line, we want to achieve that obviously sooner rather than later and with the growth that we are seeing in the business components of that segment, we are certainly optimistic that it will be sooner rather than later.

Fred Arcuri

On your question about business decline, within the region here we are seeing an awful lot of very small business declines, mostly cottage industries related to the housing market, things like small mortgage companies or real estate companies, that sort of thing and since we count all of our business subscribers in one number we have business customers who have one phone and we have business customers who have 10,000 phones. So when we lose, the customers we have been losing are really the small customers related to the building industry.

With regards to the sales force in Kansas City you will see some short term impacts on expenses and EBITDA relative to the wrap up not just in sales but also in the support of business customers. We are going to be doubling the number of business customer adds in less than six months. And so you are going to see short term impact on EBITDA as revenues trail.

Operator

There are no additional questions at this time.

Misty Wells

Since there are no more questions this concludes our call. Thank you all for attending and have a nice day.

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