EarthLink, Inc. (NASDAQ:ELNK) Q1 2010 Earnings Call April 27, 2010 8:30 AM ET
Brad Ferguson - CFO
Rolla Huff - Chairman & CEO
Joe Wetzel - COO
Michele Sadwick - VP, Corporate Communications
Louis Alterman - VP, IR
Youssef Squali - Jefferies & Co.
Ingrid Chung - Goldman Sachs
Mike Crawford - B. Riley & Company
James Cakmak - Sidoti & Co.
Sri Anantha - Oppenheimer
Scott Kessler - Standard & Poor’s
Ed Einboden - Wm Smith & Company
Rick D'Auteuil - Columbia Management
Good morning, everyone, and welcome to EarthLink's first quarter 2010 earnings conference call. Today's call is being recorded. At this time, I would like to turn the conference over to Mr. Brad Ferguson, Chief Financial Officer, for opening remarks and introductions. Please go ahead, sir.
Thanks and welcome to our call. This morning I'm joined by EarthLink's Chairman and CEO, Rolla Huff; our Chief Operating Officer, Joe Wetzel; our Vice President of Corporate Communications, Michele Sadwick, and our Vice President of Investor Relations, Louis Alterman, to discuss our first quarter 2010 results and updated 2010 guidance. Following our comments there will be an opportunity for questions.
Before we continue, I'd like to point out that certain statements contained in our earnings release and on this conference call are forward-looking statements rather than historical facts that are subject to risks and uncertainties that could cause actual results to differ materially from those described. With respect to such forward-looking statements the company seeks the protections afforded by the Private Securities Litigation Reform Act of 1995.
These risks include a variety of factors, including competitive developments and risk factors listed in the company's SEC reports and public releases. Those lists are intended to identify certain principle factors that could cause actual results to differ materially from those described in the forward-looking statements, but are not intended to represent a complete list of all risks and uncertainties inherent to the company's business.
In an effort to provide useful information to investors, our comments today also include non-GAAP financial measures. For details on these measures, including why we use them and reconciliations to the most comparable GAAP measures, please refer to our earnings release and the Form 8-K that has been furnished to the SEC, both of which are available on our website at www.earthlink.net.
Now I’ll turn things over to Rolla.
Thanks, Brad, and good morning, everyone. I’d like to make a few opening summary comments about the quarter then spend a bit more time on a few specific areas. Clearly, our Q1 financial results were ahead of our expectations. Over the past several months, we experienced a number of positive changes in key underlying business drivers that resulted in better results in our historical trend lines would have predicted.
As a result of our Q1 performance and the trends we continue to see into April, we have increased our full-year 2010 guidance. I’ll talk more about what we saw in Q1 versus in key trend lines in a few minutes.
As we’ve noted on several occasions, we run our core Internet access business as a cash generation vehicle. We use historical trend lines to predict future business performance, we continue to believe that strategy will optimize long-term shareholder value, while our top line revenue in that business continues to decline, the rate of decline continues to attenuate.
As a result, we believe continuing to run this business with that strategy can and will continue to generate meaningful amounts of cash for sometime to come. We're continuing to be vigilant stewards of our balance sheet, while we look for investment opportunities to apply the skill sets we have in our company, our management philosophy and our business discipline in a way that can create more long-term shareholder value.
As in the past we’re keeping everything on the table including acquisitions, dividend increases, large special one-time dividends and equity buybacks as we consider strategic alternatives for our cash.
Today's announcement that we are increasing our regular quarterly dividend by 14% is consistent with other desire to create value for our shareholders and should not be interpreted as an unwillingness to consider any of the other alternatives we have on the table over the coming months and/or quarters.
So with those introductory comments, let me spend a bit more time on some of the trends we saw in the first quarter that impacted our results and our expectation. As I mentioned, this quarter we benefited from a number of positive changes to key drivers within our business including network and product performance, customer churn, customer contract rates and bad debt.
These changes are all interrelated and work together to create a positive operating performance loop. A more reliable product, more tenured customers and more effective customer support drive satisfy customers. And satisfied customers call us less, they churn less, they pay us more and they demand fewer refunds and discounts. All of these items cumulatively built on each other and resulted in a meaningful positive impact to the P&L.
The main catalyst of these drivers is the continuously increasing tenure of our customer base, and the resulting positive impact on customer churn across all product categories. Let me give you some examples to put this in context, within premium narrow band more then 90% of our customers now fall within the two plus year tenured cohort and nearly 75% in the five plus year cohort.
Now historically our data base tells us that these cohorts typically experience seasonality and churn increases by approximately 30 basis points from Q4 to Q1. While our premium narrow band churn did increase this quarter over last quarter in mini cohorts as we would have expected, the increase was closer to only 10 basis points. And year-over-year premium dial churn actually decreased in the two plus year and five plus year tenured cohorts by 39 basis points and 34 basis points respectively.
Within PeoplePC, less than 10% of the base is now in the under one year tenured cohort, so early life churn continues to be less of a factor. 82% of PeoplePC customers have two plus years of tenure versus 57% just one year ago. Not only is the base becoming more tenured, but the churn behavior within tenure cohorts has actually improved from what we've seen in the past.
In every PeoplePC tenured cohort beyond three months churn was down year-over-year and the up-tick in churn we historically experienced in Q1 turned out to be much smaller in 2010 than in prior periods.
The same patterns can be seen within the DSL product line. Over one-third of that base now falls within the five plus year cohort versus less than one quarter a year ago. Within that cohort we saw a churn drop 24 basis points on an annual basis. For the 83% of DSL customers in the two plus year cohort, churn fell year-over-year by 23 basis points and bucked the quarter-over-quarter seasonality trend with the sequential churn improvement as well.
We are sort of in uncharted territory in terms of the age of our base. Never before have we seen over 86% of our customer narrow band in DSL based having been with us for more than two years are over 46% from more than five years. The increasing tenure trend is one we accounted for and expected to continue. However, the improved performance within the tenured segments we saw in Q1 that is contributing to our favorable results and improved full-year guidance.
While we’ll remain cautious we don't see anything in the April results that suggest this new developing trend will change. So we have upwardly adjusted our guidance to reflect this new trend line.
Today we raised our 2010 adjusted EBITDA guidance by $13 million at the midpoint. We look at this versus our internal budget expectations $8 million of this $13 million increase appears in the revenue line, and $5 million of it reflects a further reduction in cost structure that we had planed than what we have planned. Approximately $2 million of the higher revenue is driven by volume, in other words, customer churn improvements as I just described within our customer base.
Premium narrow churn fell 2.6% in Q4 to 2.5% in Q1. PeoplePC held flat at 5.4% sequentially. DSL fell from 1.9% to 1.8%, cable fell from 3% to 2.9%. In addition to the increasing tenure of the base I just discussed, we also attribute the positive change to a number of steps we’ve taken recently, including enhancing our offers within the safe channels and minimizing service interruptions. The $2 million impact for the year assumes the positive churn results we’ve seen year-to-date will continue.
Beyond subscriber volume, another $4 million of this year’s guidance increase in the revenue line is driven by lower subscriber discounts. In the first quarter, we recorded a positive change of $1.5 million due to a higher ARPU on broadband products that our prior run rate would have suggested.
For the rest of the year, we see an additional $2.5 million in revenue from a continuation of that trend, which is driven by a number of factors including lower discounts that we’re getting on new adds, a more positive mix of customer adds in regions and products, where we have the most favorable economics, and also the fact that last summer spike in cable gross adds are now roll -- those customers are now rolling out of their promotional pricing periods.
In addition to the items that I’ve mentioned so far, Q1 revenue was higher than we internally budget and we expect the full year revenue to be roughly a $1 million better due to lower customer refunds credits and chargebacks or what we call RCCs.
Based on the historical trends, we originally forecasted that Q1 RCCs would be slightly higher and Q4, ’09 as a percentage of revenue. However, given our strong network performance and our improvements in customer support, consumer RCCs held flat at 1.2% of revenue this quarter over the seasonally low Q4. The $1 million impact of full year RCC assumes we’re able to build on this improvement over the rest of the year.
Now let me move on to the cost structure component of the improvement. As I mentioned, our revised guidance reflects $5 million in cost structure improvements versus our original budget. The improvements reflect a combination of the components that I am going to describe now in addition to this new technology rollouts increasing tenure of our support reps and improvements in quality assurance.
There are three main components driving this reduction in cost structure. The first component relates the customer support activates. As we existed 2009 we were taking significant steps to consolidate call center queues and agent skill sets. This new approach was unproven, but we made reasonable assumption regarding the expected favorability of the change.
The impact of consolidating queues and skill sets have been much greater than we initially expected. We transfer customers less, they are able to self service more and we are able to deliver greatest satisfaction at lower cost. The use of new tools and process has launched during the fourth quarter of last year improved customer service beyond our expectation.
Customer contact rates, which historically experienced approximately at 10% seasonal up-tick from December to January actually fell another 1% in Q1 after declining 12% from Q3 to Q4.
DSL contact rates which typically consist of the most complex calls fell 18% in the fourth quarter and then another 11% in the first quarter, calls per customer cancellations are what we call face call were similar story. The reduction in face calls from Q3 ’09 to Q4, ’09 was two times the reduction we experienced the year earlier and expected it to tick back up this quarter as it has seasonally done, but the face calls volume actually stayed low in the first quarter.
The second component of our lower cost structure relates to new contract negotiations with yielded better than expected results. We have been assuming that scale reductions would give us less negotiating leverage and to some extend that have been true. However, our team was able to creatively partner with vendors to create win-win situations where we both share in lower cost. This involves changing how we do things and changing our approach, but this have absolutely benefited us across a number of contracts.
As I said before, in this business our employees add value through a 1000 little things everyday and this is a perfect example of that point. The third component of our improved cost structure has been our ability to lower bad debt cost. It goes without saying that our products are performing and customer calls are handled more efficiently and our customer base is more tenured, bad debt cost will fall as a result and that’s precisely what we’re seeing.
However, the pace of bad debt improvement has accelerated beyond our expectations in recent months. Customer write-offs had been flat for three quarters setting into the end of 2009. Write-off fell in late Q4, but it was too early to account the better trends were an out outlier.
In Q1, the trends continued, plus we saw success in a number of process changes implemented to collect the higher percentage of our revenue in a lower cost manner. In addition, the overall economic environment seems to be improving. As a result, bad debt write-off fell even further in Q1.
So to wrap up this topic, we work everyday on dozens of initiatives to improve our results and importantly, we compensate our people on these results. We expected a moderate degree of success in Q1, but the extant of the positive developments all interconnected contributed to first quarter results that surpassed our expectations.
Moving on -- a second point that I’d like to make today is to reiterate that despite the fact that our reported adjusted EBITDA increased quarter-over-quarter. The EarthLink access business is not a growth business. We’re not going to change the way we manage the business. As we’ve discussed on our prior calls, our results have been and will continue to be lumpy. We focus on long-term cash generation rather than quarter-to-quarter results.
As you recall, in the fourth quarter of last year, we recorded several one-time unfavorable expenses, including significant severance expense and a legal settlement. However, in this quarter, we didn’t have any unfavorable one-time items, nor did we record any severance expense. As a result, we reported a sequential increase in adjusted EBITDA despite the declining top line revenue.
Going forward, you should expect this lumpiness to continue as for example, we continue our efforts to variablize the remaining fixed cost items in our cost structure such as data centers and proprietary systems, as we talked about in the past. As we explore opportunities around outsourcing, the correct decision may require and increase in short-term investments to gain long-term cost structure benefits and we won’t hesitate to make those investments even if it does sit on one quarter in particular. We are focused on optimizing longer term cash generation.
Now as you all know, our consumer access customer base will continued evolve to lower margin broadband products. As this evolution takes places in parallel with the continuing declines in our top line, we continue to expect margins to compressed overtime. However, we continue to see nothing in the near or mid term that should jeopardize this business stability to continue to generate meaningful amount of cash in the future.
I’ll turn the call over to Brad, to walk through our operating results in more details, then I’ll take you through one last topic that I’d like to address today, which is our balance sheet and just a quick summary of our current strategic thought process. Brad.
Thanks Rolla. During the first quarter, we generated adjusted EBITDA of $57 million, a 17% decrease from the first quarter of 2009 and 13% or $6 million increase from the fourth quarter of 2009. As we discussed last quarter and as Rolla just mentioned, the fourth quarter of 2009 included severance charges in expense for the settlement of lawsuit.
EarthLink’s net income during the first quarter of 2010 was $27 million or $0.25 per share, compared to $32 million or $0.30 per share in the first quarter of 2009. As for the balance sheet, we ended quarter with $708 million of cash and marketable securities, up $12 million from the fourth quarter of 2009.
During the quarter, we paid down our accrued liabilities by approximately $18 million, which included the previously mentioned legal settlement from the fourth quarter, employee severances and lease payments on exited facilities. In addition to some seasonal items such as our annual employee bonus payments. We also paid $15 million in dividends, $3 million for capital expenditures and $3 million for an early conversion of our convertible notes.
From a tax perspective, while we expect to record non-cash income tax provision of just under a 40% for the year, we continue to utilize our federal and state net operating loss carryforwards, which will result in an effective 3% to 4% cash tax rate. As announced today, our Board of Directors approved another quarterly dividend and increased the amount to $0.16 per share, which will be paid in June of this year. Management also has the authority from our Board of Directors to buy up to an additional $147 million of it shares under our share repurchase program.
Now, I’ll discuss some of the operating results and metrics in more detail. In the first quarter, our total gross ads were up slightly as we added a total of 77,000 new customers compared to 74,000 in the fourth quarter of 2009 and 116,000 in the prior year quarter. Our new customer mix continues to shift towards broadband and in particular cable as narrowband ads have decreased and broadband ads have remained relatively steady. Consumer broadband ads accounted for 56% of total gross ads in the first quarter of 2010, up 35% of total gross ads in a year ago quarter.
As Rolla mentioned, despite what has historically been a seasonally high churn quarter, churn in the first quarter improved compared to prior quarters. Churn for the first quarter of 2010 was 3.1%, down from 3.2% in the fourth quarter of 2009 and 3.9% in the first quarter of 2009. As we continue to see the benefits of our increasingly tenure subscriber base and did not see the typical seasonal increases, while we do expect the seasonal factors were influenced some of the quarter-over-quarter trends in the future, we expect both gross ads and churn to decrease overtime.
Total revenue for the quarter was $157 million, 21% decrease from the first quarter of the prior year and 4% or $7 million decrease from the fourth quarter of 2009. We generated 79% of our revenues from our consumer services segment with a remainder in our business services segment. Our business services segment revenue declined 15% from the prior year first quarter, as we saw pressures on the top line throughout 2009.
However, the decline was only 2% from the fourth quarter 2009 to the first quarter 2010 were approximately $800,000, compared to the average sequential declines of over 4% each quarter in 2009, as we are starting to see the benefits of a positive sales traction at New Edge.
Our total cost of revenues declined 20% from the prior year first quarter and 2% or $1 million, compared to the fourth quarter of 2009. We had a 61% gross margin rate in the first quarter of 2010, compared to 62% in the prior year first quarter and fourth quarter of 2009; due to the continuing shift in the mix of our customer base to broadband services, which have lower gross margin rates.
Operating expenses, which include customer support, operations, G&A, and bad debt expenses, but exclude sales and marketing expenses with $34 million for the first quarter of 2010, down 27% from the first quarter of 2009 and down $10 million from the fourth quarter of 2009; this was due to the fourth quarter severance charges and legal settlement we’ve mentioned, in addition to our ongoing cost reductions in the various operating efficiencies and favorable contract negotiations highlighted by Rolla earlier.
Sales and marketing costs were $11 million in the quarter, down 34% from the prior year first quarter and down 20% from the fourth quarter of 2009, due to the employee severance expenses recorded in the fourth quarter of 2009 and lower discretionary marketing spend in sales and marketing employee costs in the first quarter of 2010. As we’ve discussed in the past, we continue to invest modest level to marketing dollars in programs and channels that provide a sufficient financial return.
Now for the updated outlook for 2010, as Rolla said earlier, the first quarter exceeded our expectations as the underlying drivers of our business outperformed to historical trends. Factoring in this performance and assuming we can continue to deliver at these trends. We are increasing our guidance for 2010 adjusted EBITDA and free cash flow. In addition to increasing the guidance, we’re also narrowing the range on both the adjusted EBITDA and capital expenditures projections.
For 2010, we are increasing our previous guidance of $180 million to $190 million, and we now expect to generate the full-year adjusted EBITDA of a $194 million to $202 million. We are maintaining the low end of the expected capital expenditures of $10 million and decreasing the top end of the range to $16 million, which is down from $20 million in our previously issued guidance.
The $194 million to $202 million of adjusted EBITDA and $10 million to $16 million of capital expenditures translates into a projected $178 million to a $192 million of free cash flow for the total year 2010. This guidance reflects the continuation and improvement on the favorable trends we experienced in Q1, the continuation of our marketing spend and profitable channel such as cable, a moderate decline in total gross ads from Q1 levels and the expectation that consumer churns rates will remain stable by cohort and reasonably predictable through the year. Over the long-term, we still expect a gradual decline in adjusted EBITDA margins from the Q1 levels, but for the business to remain profitable for the years to come.
I would now like to turn the call back to Rolla for some concluding remarks.
Thanks Brad. Just to note again, we ended the quarter with I believe very clean balance sheet that included $708 million in cash and marketable securities. Liabilities are down to a fraction of what they were in the not too distant past. I wanted to make a few comments around our progress at New Edge.
We’re beginning to see sales traction for the first time in the past two years. We’re seeing signs that the SMB market is slowly starting to recover. The effort we put into creating a more robust product set and consistent network performance is fueling the improvement we’re seeing. This is contributing to increase sales, a robust opportunity funnel and a lower cash burn rate. However, New Edge remains substantially under scale and it is not clear that scaling the business organically will create shareholder value. New Edge needs substantially more scale and we’re open to alternatives that can create value for our shareholders by creating increased scale.
We believe that being patient while continued to delivered more improvements at New Edge will likely allow us to optimize the value of that business. We evaluate all of our strategic opportunities with the same patience and discipline. We bought back over a $148 million in stock. Since I’ve been here, we paid out over $45 million in dividends over the past three quarter and today’s dividend announcement represents of 14% per share increase, that means we’ll pay approximately $70 million in annualized dividend payments beginning in June.
As we’ve long said, if we can’t deploy our capital in a more value creating manner than shareholders could individually, we remain committed to returning it. We have not changed our view. Having said that, we believe there are opportunities out there to use our cash in such a manner to leverage our strength and providing service to subscription model sets of customers and running those business models with low class efficiency. We continue to pursue those opportunities.
I’d like to conclude by thanking the EarthLink management team that I work with everyday and it’s a fine group of people that includes Joe Wetzel, Kevin Brand, Brad Ferguson, and on and on, but they have the biggest groups of people. Our shareholders in my judgment are in indeed fortunate to own a company that has engineering people, customer service reps, product marketing people, and administrative people that are all dedicated to shareholder value creation and this business would not be performing at the level it is without their attention everyday to the details that they manage.
So, thank you so much to the EarthLink team and operator, I think we’re ready to go to questions.
(Operator Instructions) Your first question is from the line of Youssef Squali with Jefferies & Co.
Youssef Squali - Jefferies & Co.
A couple of questions, so Rolla you gave a lot of details around churn, but I’m still not very clear as to how much of the drop in tenure cohorts, churn is macro. How much of it just not doing anything and just having the macro environment improving has helped versus things that you guys did, that are in your control and then maybe how much or how low do you think it may go by year end? In other words, what are you guys baking in your guidance, and I have a follow-up?
I think the answer to the last point is that, we project this business around historical trend lines and as we’ve shared with everybody in the past, we have a lot of history in the business and so the thing that I think was most remarkable about the first quarter is that, we actually saw the trend lines on a by cohort basis improve and that’s really what I wanted to communicate.
We’ve always know and we’ve been talking for two years about the fact that as our customer base has a higher mix of more tenured customers that churn would be better, but we’ve also said that, churn with any tenure cohorts by product is remarkably flat, and what we saw in the first quarter was something that looked a little bit different than that and so, when we are issuing our guidance, we’re sort of assuming that the improved trend line will continue. We’re not expecting it to change materially, but we focus on trend lines in the company. So that’s probably the best answer that I can give it to.
We had already expected that our churn rates would drop Q4 to Q1, because of mix, but we had also expected that they would pop-up on a cohort basis because of seasonality, and what you heard, I’d say is we didn’t see that and that surprised us.
Youssef Squali - Jefferies & Co.
Then using that it looks like the Q2 should probably see a sequential improvement and then so we’re really talking about the churn rate with a two handle on it. I guess the other question I have for you is related to the balance sheet. The slight increase in dividend to us would imply that you are not giving up on finding that, that M&A opportunity to grow again. If I look at the dividend payout, it’s around the third of your free cash flow generation today.
So maybe is the M&A market better or worse today than it was six months ago? I guess just from an opportunities standpoint, from a valuations standpoint and then what areas again seem the most interesting? I guess outside of the New Edge, which you clearly, I guess just made the case for consolidating?
I don’t think it would be fair to say, that the M&A environment for us is better. In fact, I would probably say the opposite. I think as equity prices have gone up and that liquidity has comeback into the market. Overall, I think that made it a tougher environment for us to get to transactions that we think would create value.
Having said that, we are talking right now with particular situations and I’m not going to get into anymore details on that, but particular situations that we believe we would create value for our shareholders at that price that we’re discussing right now. They won’t necessarily be massively transforming, but they will be good things for our shareholders, if we able to get them done.
So what you saw is, we recognize that we’re building cash, we’ve increased the dividend accordingly, but I hope that everybody paid attention to what I said at the beginning, which is no one should assume that all of the alternatives that we’ve had on the table or being taken off the table.
You could still see us to a one-time special dividend, you could see us continue to increase our dividend to get more and more cash back to our shareholders, you could see us the opportunistic around share buyback and certainly that we can close on transactions that make sense for us, we’ll continue to do that. We tried to be very thoughtful here about what we do, but I would tell you that in this environment the chances of us getting a big transforming deal done at a value that we feel good about for our shareholders does not helped by the stronger market.
Youssef Squali - Jefferies & Co.
I guess lastly, Brad I notice, you guys didn’t make any buyback at this quarter, can you just kind of speak to that?
Well, I think Rolla really discussed on that, and we always look at our alternatives and what we can do and had a return in cash back, and that’s one of the things that we evaluate and then we’ll continue to do so, but we will be opportunistic about buying back shares and we think it makes sense for our shareholders.
Your next question is from the line of Ingrid Chung with Goldman Sachs.
Ingrid Chung - Goldman Sachs
Rolla, I was wondering if you could speak to ARPU and pricing. You said previously in your comments that discounts are decreasing, would you also think about price increases this year for either consumer for business now that the economy is in better shape than a year ago. Also I was wondering if you experienced any sort of pricing pressure from your main cable wholesale partner or is pricing based on long-term agreement?
I think as far as pricing flexibility, everything remains on the table there. We have the ability to do a lot of testing of various ideas along those lines and you should assume that we’re doing that. So everything remains on the table as far as how we would think about price increases in particular product lines or pricing platforms.
I don’t think that we felt any particular pressure from our cable partner in terms of that pricing, I think it’s holding up quite nicely actually. We’re requiring less use of customer discounts to bring in new cable customers and we are seeing it show up in our results.
Your next question is from the line of Mike Crawford with B. Riley & Company.
Mike Crawford - B. Riley & Company
Thanks a couple questions on New Edge. So one, you’ve seen kind of an up tick in overall SMB market, you also have some new initiatives like this partnership agreement with [Eight by Eight] try to mine their customer base, can you talk a little bit about initiatives such as our?
Sure, we think that New Edge has, over the last two years, we try to put together a product platform that leverages that you ubiquity of the platform and maximizes the number of applications that an SMB customer can use if they are a customer at New Edge. So in a way we are saying it’s all about the apps that we offer. So one of the things that as we’ve launch the AX platform, one of the things that we talk about is that we’re application agnostic. We want to use our platform to let all of the application providers like in [Eight by Eight] reach their customers and we believe that’s a business model that is more cost effective for us, because we simply can’t deploy sales people in every market around the country that we actually have access to via our network. So we are using other people’s sales organization and their products and we’re basically the glue that holds it all together. So we think it's the optimal strategy for what New Edge is today.
Mike Crawford - B. Riley & Company
Okay, thanks. And then Rolla just the second half of the New Edge, I guess strategic part gets back to what do you want, do you have the assets, so you think it needs quite substantially more scale, that doesn't necessarily have to be owned by you, it’ll be owned by someone else. So you're saying that the M&A environment is making it tougher to get a deal done, but at the same point time it’s got to make it easier to get a deal if you were to decide to sell it so.
I think you make a good point. I think that as we see the business in New Edge improve combined with a healthier M&A market, it will probably get as better value for New Edge if we partner it with somebody to try to get them that scale. We don't necessarily have to be the ones that are our buying the (inaudible), but my point is and our point has always been that regardless of the structure that we do it within New Edge means more scale as a business. And that’s what we are pushing towards, but we’re not giving up on the idea of improving the business everyday making many multi location customers that we have happier everyday and we’re seeing traction, New Edge is a popular platform out there and we don't want to do anything to slow that down. We know that everyday that we improve the business we create more value on the business. I’ve got the tell them, escape the reality, but it's under scaled and we were looking so ways to address that.
Your next question comes from the line of James Cakmak with Sidoti & Co.
James Cakmak - Sidoti & Co.
We got gross customer adds and they did trend nicely Q-over-Q. Can you talk about the drivers of that and how sustainable would you see that currently it is going forward given that broadband customers are making up a larger part of the mix?
Well, I think even our results, because we don’t deploy a sales force and we acquire a lot of our customers through more indirect way, whether it’s Search Engine Marketing, or acquiring customers and selling more products as they’re calling in our service centers. They’re going to be lumpy, our acquisition cost [worth] the profitable customers that we bring on, so we start trying to predict what our gross adds would look like. It really has been very lumpy, I mean we saw last summer a big up tick in cable asset, we never saw upcoming and then more recently they got soft again.
What we try to do is just make sure that every customer we add, we make money on, and after we get a customer we take care of them and make sure that we do everything we can’t to not to lose them, it is tough really. I think our top line management is really more driven along customer retention then it is about any program to try to cause more gross adds, because generally in these kinds of businesses, my experience is, that the more you try to cause gross adds, the weaker of the business model gets and you start spending a lot of money that you don’t get.
James Cakmak - Sidoti & Co.
Coming back to the New Edge business, how much urgency would you see you feel to that it is operating roughly cash flow to neutral? How much urgency, do feel and how much longer do feel that you can now here resources to it and before making a deal?
We tried to do everything with the sense of urgency here, but we also try to mix a sense of urgency what they with a base of thoughtfulness and patience and we have been for a good long time in active dialogues around ways that we could improve that business through the partnerships and that sort of thing and let’s face it, we’re just coming off an absolute debt margin that CLECs face, and if not like there are a lot of CLECs out there that are well funded and hitting on our cylinders, and we are fairly particular about who we would partnered this business with, because the idea of partnering with somebody and having them sort of finish the business off, because they’re overleveraged and they don’t run businesses out well, doesn’t help our shareholders at all.
So we are investing some cash in this business. We hope that there’s a payoff, but I would tell you that we do feel a sense of loyalty to the very large customers that use New Edge today, and whatever we do, we need to take care of our customers and take care of our shareholders, and we’ll be patience until that happens.
James Cakmak - Sidoti & Co.
Then lastly, obviously the variable revision of your cost structure is trending well, if you had to quantify what stage of that process you are at? Where would you be?
Well, you know that’s a tough one to answer. I think when we took out half of our people back in late 2007, we thought that we had done, we got in a whole bunch of the heavy listing out of the way, but this business continues to surprise quarter-over-quarter in terms of our ability to find different ways of doing things that are actually better for customers and less expenses, and every time I’d made of prediction I think, 11 of the past 12 quarters, my prediction has been wrong.
I don’t know what to say other than we’re just going to continue to try to run the business, our level of detail that allows us to optimize whatever is available to us out there. Clearly, there is not going to be the opportunity to take $50 million out of our cost structure, because we don’t have $50 million to take out, but anything that we do around that keeps our customer longer allows us to sell them another product or makes it easier for them to not call us, but to be able to take care of themselves in a lower cost way get all accrues to the bottom line and that is what we saw in the first quarter. There is a combination of all of those things.
Just talking about some of those long range evolution projects that we talked about, we’re still in a very early stages of those kind of wind out over the next several years, but certainly there is a big focus and big offer right now on executing on those points.
Your next question comes from the line of Sri Anantha with Oppenheimer.
Sri Anantha - Oppenheimer
Rolla, just going back to the mix of business you said that’s becoming more broadband. Could you just give us a sense on where the broadband business margins are relative to year ago? Where do you see that trending going forward? Secondly, in that context, Joe, could you also talk about your efforts trying to broaden the availability of your audit, whether it’s a cable or a DSL service throughout U.S.?
Yes, Brad you can help me with that, but I think our broadband margins, we’ve seen them stay relatively flat. I think we’ve talked about broadband generally yielding about $8 to $9 amount in cash and that is for cable.
DSL is better, so it’s in $11 to $12 range. So it doesn’t yield as much cash as narrowband the margins are less, but they’re still very, very healthy. We continued to work define more channels of distribution and we’re looking at and actually have the signed some agreements that I won’t get into with national players to as distributors of our broadband product.
We shouldn’t assume just other cable companies, but there are other channels of distribution that we’ve been approaching. I think another potential area for us that we’re pursuing more is, there are lot of multilevel marketing company out there that have very low cost of acquisition and we’re in a very, very early stages of looking at how we can support them with the range and variety of our product platform to use them as a low cost channel of distribution, so we’re not confining ourselves to just the other cable providers.
Sri Anantha - Oppenheimer
On the expenses front, I know you guys have taken a lot of cost out, especially, if I look at sales and marketing, even compared to year ago, it’s definitely down nearly 35% plus and to you is a good start substantially. I’m just curious, like how sustainable is that, or is this just a function that where you guys are being extremely careful and how you allocate your sales and marketing dollars, or is that just not enough opportunities out there for you guys to profitability deploy your sales and marketing dollars?
It’s really sort of our continuous effort to just assure our self. We would love to spend more in sales and marketing, and we did that past year on the cable front, when we saw the up tick cable ads last summer as you’ll recall on our quarterly calls, that we were increasing at what we intended to spend in sales and marketing and in fact, we did, quite really with all driven by the return that we get on the sales and marketing expenditures and while, I would love carry a bit that there are a lot of distribution channels out there that are available that we could make that’s a growth business for the type of products that we have, there are a lot of distribution channels out there that we feel like we can get a return on the sales and marketing investments. So we just have to be very, very disciplined about where we spend our money, but where we can spend that and get a return were allover.
Sri Anantha - Oppenheimer
One last question, I think I missed it in your prepared remarks. How much of the upside in the guidance on adjusted EBITDA as I take the [midline] to jump $13 million came – it is coming from high volumes?
I think the higher volume piece with about $2 million of the $8 million revenue upside and with the balance of it being a combination of lower discounts and just not (Inaudible) having to give as much customer credit or something and that sort of thing.
Your next question comes from Scott Kessler - Standard & Poor’s.
Scott Kessler - Standard & Poor’s
Well, I think at the beginning of the call, I kind of came in a little late, so I apologize for that. You highlighted the notion of the outsourcing or the potential vehicle to further reduce your cost and expenses. Can you talk a little bit about that and what your plans on that regard? I have a follow-up?
Sure. So what we put together something that we definitely call our long range evolution and that’s really sort of a five years out view of what our business needs to look like when we have different levels of subscribers. So as you know, the whole secrete of a business like this is to be in front of the cost curve rather than chasing it.
So, we spend a lot of time thinking about what we need to look like when we only have a 1.5 million customers, and what we need to look like when we only have a million customers, and so the outsourcing that we are paying the most attention to right now, is really around IT platforms and proprietary applications.
Where we have proprietary applications, it has a higher mix of maintenance that we have to keep on staff, because if we keep those applications up in running and maintain to the extent that we can outsource those to more open standard platforms it gives us the ability to us to use outsourcing at least to cover some of the maintenance of those types of applications, so and we have a variety of applications, but we use here.
Beyond that, we run two data centers now, without question as our number of subscribers go down, we will not need two data centers, we will consolidate into one. We own a data center in Atlanta, we lease a datacenter in Pasadena, and so we’re looking up couple of years into the future and we know that we’re going to consolidate into one, but we’re taking that may be a step further and saying, do we need to own data centers at all, are there ways for us to outsource that type of platform.
So that’s what we’re looking at, we run a pretty lean organization right now, I think everybody would believe that and so, the ability to take easily outsource and have everybody make a lot of money on it, because we just got so much cost wrapped up into it is limited. I mean we have to really work hard to find ways to get somebody to run what we do a better cost structure than what we do today, but clearly as our revenue gets smaller the opportunities to do that goes up.
Scott Kessler - Standard & Poor’s
My follow-up involves your broadband partnerships. In your 10-K, you described the relationships, and the contract expirations none of which really occur or schedule to occur until late this year. I’m kind of wondering, those haven’t changed much over the last number of years and I’m wondering, if you see any additional opportunities to partner with some new larger broadband providers at this point? Or if, as you alluded to, you are looking at different types of opportunities from a distribution perspective?
We have a continuous dialogue going on, at any point in time with most of the broadband providers out there, whether they are DSL providers, or whether they’re LEX cable companies, wireless companies, we talk to everybody and, I would tell you that, we feel very good about our partnership with Time Warner, and I think importantly, Time Warner feels good about the partnership too.
What we find at sometimes, now overtime, but often times, there’s a view from a lot of the broadband providers that they’re going get the customers anyway. They don’t need to partner with it, I think that view is subsiding a little bit; and I think there’s no broadband partner out there that doesn’t feel like they’re under attacked from a lot of different folks and there is no question in anybody’s mind that our brand, there is a positive out in the marketplace.
So the conversations continue, we’re not going to do it just for grant, the economics have to be right for us, but those dialogues continue, and there are a couple of things that we have just started actually in the last 30 days that I’m not going to name, but I feel for making some progress there.
Your next question comes from the line of Ed Einboden with WM Smith & Company.
Ed Einboden - Wm Smith & Company
Just I had a quick question, I know you guys had talked about some of the cost savings strategies and they may have less than impact we have seen, but it seems like as you alluded to before, the cost savings seem to surprise you each quarter. Do you still believing that those cost savings are going to be I guess, less impactful going forward or are you a little more optimistic that you guys can cherry pick new opportunities out there?
I think we’re optimistic that we’re going to continuing to improve the business. I think that we get a lot more reserve about promising and making commitments to big stuff function changing. As we always talked about, we are investing in a business right now too. I mean, sometimes this outsourcing arrangement is such a prime example of that. There are investments that we make that actually heard our results for the next quarter, or two quarters, or three quarters, but will absolutely help us in 2011, and 2012, and 2013.
So we have to be a little bit balancing, it’s been a lot of money getting into a position to see now, how to see the results that we’re seeing in customer service. We spend a lot of money, redoing processes and consolidating call center partners and it’s paying off for us now. Our results could have been better four quarters ago, if we weren’t doing any of those things we were just slashing the cost and not doing anything to deploy new processes.
So I do think there are ways that will continue to improve the business, but I think our nature is, we try to run the business in one year, in one year chunk and really not try to run it around quarters, and which is very difficult for me to give you a view that you can expect to see our expenses go down every quarter from here on out, because there will be some quarters, but they won’t and it will make perfect sense and we’ll continue to make decision to make investments.
Just one thing on the perspective on the cost savings around increased guidance, $5 million of that was for expenses. Again we still have opportunity, but it’s probably not to the magnitude certainly that we’ve seen historically. Yes, if you can think about it, two years ago, we were talking about $25 million, $30 million, $40 million opportunities, we’re talking about $5 million opportunities now, but what’s exceptionally important is, we’re now looking at revenue accumulation going from $30 million a quarter, two or three years ago to $6 million or $7 million a quarter now.
So we don’t need the big cost stuff function cost changing, because our revenue is decline as attenuating. I think that’s the point that may be a lot of people have never fully appreciated. When we talk with everybody in October of 2007, we told everybody we were going to go through a big decline in customers and revenue; and so we have to drive cost out quickly, but it’s attenuating and so our cost reduction will be able to attenuate.
Ed Einboden - Wm Smith & Company
I guess on the acquisition of subscribers, can you may be give us sort of a macro sense from how you’re looking it? How the cost structure you guys have become and I guess acquiring new subscribers. Has that equation changed in your mind, so that when you bring on new customers, out of positively or negatively you would be able to bring them on and the return metrics would be better, or worse, or kind of talk to that, because you guys have driven a lot of cost such as cost centers? Or our customer service centers and things out of the mix?
Yes, we’ve started talking more and more about our interest in subscriber basis, where we can leverage our management philosophy and just how we approach the business. We’re looking at more and more of those kinds of basis and some of them could be, or we hope our ISP basis, but they can be customer basis beyond that hosting basis anything with lots of customer relationships, we believe that our approach to how we run these businesses would play, but and so we have sort of expanded our view there, but we’re just simply not going to go out and pay big multiples for businesses like that, and as a result, we may not get one of them done I’d be just as concurrent if we need to, to just keep returning cash rather than going out and buying something like that, where we think that it will take a 900 foot shot over the left field wall to get a return on the investment (Inaudible) one more.
Your final question comes from the line of Rick D'Auteuil with Columbia Management.
Rick D'Auteuil - Columbia Management
My question has been answered, and I appreciate it. Thanks.
Thanks so much. We appreciate everybody getting on phone with us. We feel good about the quarter and we look forward to talking to you here in the next couple of months. Take care.
Thank you for participating in today’s conference. You may now disconnect.
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