Qwest Communications Q4 2006 Earnings Call Transcript

Feb. 08, 2007 3:11 PM ETLumen Technologies, Inc. (LUMN)
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Qwest Communications International (Q) Q4 2006 Earnings Call February 8, 2007 9:00 AM ET

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Stephanie Comfort – Vice President of Investor Relations

Richard C. Notebaert, Chairman and CEO

Oren G. Shaffer, Vice Chairman and CFO


David Barden - Bank of America Securities

Michael McCormack - Bear Stearns

Jonathan Chaplin - J.P. Morgan

Frank Louthan - Raymond James


At this time I would like to welcome everyone to the Qwest fourth quarter earnings conference call. All lines have been placed on mute for preventing any background noise.

After the speaker's remarks, there will be a question and answer session. If you would like to ask a question during this time, simply press star and the number one on your telephone keypad. To withdraw your question, press star and the number two on your telephone keypad.

Thank you, I would now like to turn over the call to Miss Stephanie Comfort, the Senior Vice President of investor relations, please go ahead.


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Stephanie Comfort

Thank you. Good morning everyone and welcome to our call, we're here to discuss our fourth quarter and full year results. With us on the call this morning are Dick Notebaert our Chairman and CEO and Oren Shaffer our Vice Chairman and CFO.

Before I turn over the call to Dick, I'd like to remind everyone that we will be making forward looking statements. These statements contain risks and uncertainties which can cause actual results to differ materially from those expressed or implied here on the call. Theses risks and uncertainties are on file with the SEC.

In addition we do not adopt analysts’ estimates nor do we necessarily commit to updating the forward looking statements that we make here. I'd also like to mention that in all of the quarter supplements, our reporting of our consolidating financial information…the company will discuss certain non –GAAP financial measures including EBITDA, free cash and net debt.

We have a full reconciliation of non-GAAP measures included in the quarterly earnings section of our website.

With that, I'd like to turn the call over to Dick.

Richard C. Notebaert

Thank you Stephanie, good morning everybody. I'm really pleased to report our results for 06'. ‘06 was a year of milestones and significant achievements for Qwest. We continue to progress toward our long term goal of value creation through a steady focus on the fundamentals. Those fundamentals are to deliver exceptional service to customers, to operate efficiently, remain disciplined with spending, grow free cash flow and reward shareholders.

We delivered our financial objectives in 2006. The objectives were modest revenue gains, sustainable earnings per share, margin improvement towards our target in the mid 30% range, growth in free cash flow, and return of capital for shareholders.

We also achieved new highs in customer service levels across the board, and I am the most proud of this accomplishment. As I have said many times, we must differentiate Qwest based on superior service to customers to win in this competitive industry.

Our progress and performance continue to demonstrate that our strategies are working and our intention is to carry that momentum into 2007.

As we look to the future we continue to invest in growth and value for our constituents. We believe our strategy is one that produces competitive returns and is consistent with our disciplined approach.

We will continue to reinvest in areas that drive revenue, customer retention, and compelling returns on investment.

At the end of the day, we made steady progress over the last four years, and our goal is to continue to do that.

Let me hit some highlights from 2006.

At $13.9 billion, revenue posted modest gains. There's higher value, higher ARPU growth products, and improved bundle penetration offset retail line losses.

I should add that we reported the seventh consecutive quarter of year over year revenue improvement.

Customer demands and a clear value proposition for our portfolio of growth products including: long distance, broadband, advanced data products, VOIP, video, and wireless are driving volume, ARPU, and bundle penetration.

Adjusted EBITDA increased to $4.4 billion in 2006, with our quarterly run rate at just over $1.1 billion.

Our adjusted EBITDA margin, on the same basis, improved to 31.5% for the full year. That's a 250 basis point improvement year over year marking our tenth consecutive quarter of year over year improvement.

Our goal remains achieving a very competitive mid 30% margin, with the progress we made in 2006, I think we're well on our way.

We achieved our goal for free cash flow in 2006 and we generated $1.4 billion, before one time payments. With much of that increase driven by improved EBITDA margins.

We reduce our net debt by over $12 billion from its peak in 2002, to $13.4 billion at year end.

As well our leverage ratio improved and our credit ratings were upgraded.

In November, we initiated our program to return a significant amount of cash to shareowners. As of the end of January, we completed approximately 25% of our authorized share repurchase. Our progress to date should reinforce our commitment to complete the program. At the same time, our board continues to evaluate all opportunities to reward our shareholders.

Finally, based on our performance and prospects, we were able to deliver a total return to shareholders of 48% in 2006.

Oren will review the fourth quarter details with you in a few moments.

But first, my comments again, this quarter will focus on how we believe we are creating sustainable value for our constituents.

Successful financial transactions and the elimination of obstacles are certainly important. And there is much we have accomplished in these areas but we recognize that long term value creation is based on delivering, sustainable, competitive growth in revenue, earnings, and cash flow. And this is our ongoing focus.

As I have shared with many of you before, the components of value creation for Qwest include: top-line growth, continued cost reduction including productivity improvements, improving EBITDA margins to competitive levels, reaching profitability and sustaining it, and the free cash flow growth driven increasingly by operating performance.

We believe the dynamics in the industry are changing and in many ways industry fundamentals are improving.

Customers are increasingly demanding products and services that leverage our unique asset base that are consistent with our focus on customer service and that are aligned with our strategy to fulfill customers’ needs.

And while there is more competition and more technological change; we believe the opportunity and potential have grown as well.

We believe our strategies and our priorities are consistent with the opportunities and our capabilities.

Our strategies include: superior service, solutions that address when, how and where our customers prefer to do business and a just in time investment approach to optimize our platform and product transition from Legacy to next gen., an ongoing operational and financial discipline.

We believe these strategies will drive modest revenue growth and solid returns as we continue to invest in products and services that drive growth, customer retention and competitive return on investment.

Our broadband investment is a great example. In the past two years, we have expanded our investment in broadband. This allowed us to more than double, more than double high speed internet availability in our footprint and dramatically increase the speeds that we offer customers.

We have increased our penetration to more than 17% from less than 8% just two years ago.

Our subscribers and revenues grew at an industry leading pace of nearly 45% year over year. And we did this while maintaining our overall capital investment discipline and our focus on strategic priorities: The products and service that the customers want.

Price For Life is another exciting example. We listen to customers, and what they wanted most of all was protection against price increases. They don't like having their prices jacked up. We rolled out our Price For Life in mid 2006, guaranteeing customers that their high speed internet price would not increase as long as they maintain the same service.

In the fourth quarter, we delivered our products available to customers at premium speeds. The bottom line, nearly half of new subscribers are now choosing Price For Life. Our high speed internet term rates are significantly lower and we believe these customers have a greater tendency to purchase our triple and quadruple play bundles, thereby, driving a measurable and positive impact on our overall ARPU, revenue, and our profitability.

We have many examples across the channels that we could talk about. Let me hit a few. We rolled out our solutions driven IQ networking and our VOIP offering in '05. We quickly tripled revenues in the subsequent four quarters. We have continued upgrading our ultra long hall, or for those that like technical terms, our OC768, on a targeted basis and within our stable capital budget to satisfy growing demand for our higher bandwidth products. This positioned us with leading edge solutions of both the enterprise and wholesale markets.

One example, we have installed over 100 kiosks. This is another case where we listened to customers. We did this to make it easier for our customers to do business with Qwest. And while initially sales of this convenient channel were dominated by wireless transactions, today more than half of those sales made in those kiosks are for wire-line products and services.

These examples may reflect basic blocking and tackling, but they reinforce our diligent focus on providing the right products when, where, and how our customers need them; delivered at great value and with superior service. The discipline we bring to this process is balanced with the discipline we bring to operating efficiency, capital investment and balance sheet management.

As we continue to implement our strategy our priorities for '07 are as follows:

First, continued success in growing our mass markets channel revenues through increased ARPU and increased bundle penetration.

Second, return the top line growth in our enterprise business by leveraging our state of the art long haul network and solutions driven product suite and high growth data and internet products that are becoming an ever more meaningful part of our product mix.

We should note there is part of our transition from Legacy to next generation products and services. In 2006 there continued to be some adverse impact from a phasing out of Legacy services such as Dial which no longer meet our return criteria.

Let me just draw an analogy. This is similar to the strategic pricing diligence we implemented in the wholesale channel beginning in 2004 and into 2005. We know that this is the right decision for the business. Our migration away from these lower value services masked underlying single digit growth in our enterprise business as we finished 2006.

Third, we will continue to effectively manage our wholesale channel for profitability.

Fourth, we will invest in areas that drive revenue; customer retention and appropriate returns on investment.

And finally we will continue to focus on delivering outstanding customer service.

In summary, we know what we have to do. We are doing it. And in an industry that is converging and consolidating, an industry facing integration and investment risk as well as significant opportunity, our strategy remains consistent and focused, based on a commitment to service, discipline and efficiency. We will continue to provide customers with industry leading growth products and services that they want while we improve our performance and our financial flexibility.

We believe we have the resources to execute our strategy. We will continue as we have in the past to scan for acquisition opportunities in a way that makes sense for our business and that makes sense for our shareholders while leveraging our assets, our brand, and our service capabilities. Now let me turn the call over to Oren for more details. Oren?

Oren G. Shaffer

Thanks Dick and good morning everyone. We are very pleased to have recorded a full year of net income and earnings per share as part of a year during which we achieved a number of other important financial milestones.

In 2006, in addition to four quarters of profitability, we significantly increased our free cash flow, brought our balance sheet in line with investment grade metrics and started a $2 billion share buyback program to begin returning additional value to our holders. We made steady progress on each of the elements of our financial strategy.

A momentum we gained in our key growth products made it possible to grow annual revenue in our mass market channel by 2.4% in the face of increased competition. The continued strong growth and business data products held quarterly business revenue steady as we bridged to the next generation product.

As Dick noted, our migration away from certain lower value services, maps the growth we are seeing in this area. Strong data revenue growth in the wholesale channel offset the anticipated local revenue declines. Modest revenue gains, coupled with our cost containment efforts, drove a 250 basis point margin expansion in 2006.

We made significant progress toward achieving our EBITDA margin target in the mid 30% range and continued to see ample opportunity to improve further in 2007. Revenues totaled $3.5 billion in the quarter and $13.9 billion for the year. We saw improved costs across key growth products which more than offset the impact of local losses, industry consolidation and increased competition.

The targeted investments that we're making in people, process, capital, and marketing are driving the strong trends we are seeing in data, internet, and video services across all channels. We spent nearly 40% of our capital dollars in 2006 on increasing the speed of our network. This investment enabled revenue expansion in higher growth products such as high speed internet, VOIP, high capacity networking solutions, data integration, and hosting.

Annual data, internet and video services revenue grew by more than 9% year over year. Quarterly revenue for these products grew more than 12% compared to the same quarter of last year with data and internet now accounting for 35% of overall revenue. The mass market channel revenue in 2006 grew $130 million or 2.4% over 2005.

Fourth quarter revenue was flat sequentially and up 1.4% year over year, was restrained by universal service fund rate changes and some regulatory orders that affected the quarter. Excluding these regulatory impacts, the year over year increase would have doubled.

Access lines declined 6.3% on a year over year basis. But ARPU continued to grow at an even faster rate. Consumer ARPU grew to $51.25 up 6.8% from a year ago. The success of our bundles has been enhanced by the rapid growth of Direct TV and high speed internet. Increased bundle penetration and migration of voice, wireless and internet subscribers to the higher priced offerings is driving the higher consumer ARPU.

Our full product suite allows us to sell more products to existing bundle customers even as we increase the number of customers choosing the bundle. Our bundle penetration increased to 57% from 51% last year. Nearly 30% of our bundle customers have three or more products in their bundle, up from approximately 20% a year ago.

Each product added to the bundle especially above the three product mark, increases our ability to retain these most valuable customers. We expect our ARPU and revenue to continue to improve as customers consolidate their communications and video services with us and upgrade or take an internet connection product for the first time.

We are pleased with the significant progress we made in 2006 and we believe we still have considerable opportunity to drive growth through improved ARPU and bundle penetration. High speed internet continues to be a great success story for Qwest. In the fourth quarter, mass market data and internet revenue grew 45% year over year and 12% sequentially, this driven by continued strong demand in the high speed internet area.

We surpassed 2 million subscribers in the fourth quarter ending the year with 2.1 million. We added 658,000 subscribers in 2006 representing an increase of 44% growth, up from 43% growth in 2005. We estimate that there are two to three million dial-up users in our footprint. Our broadband penetration increased to 17% from 11% a year ago, leaving significant room to grow our base. We continue to see strong migration from dial-up to broadband, and still have a significant opportunity to capture dial-up users.

Our customer mix continues to improve as well. We’re also just beginning to benefit from increased take rates of our premium speed offers, meaning three megabits or better. The ratio of customers taking our premium speed products increased 50% from a year ago. This is a small percentage of our base. We believe this gives us a substantial potential for further ARPU growth in this product.

Our digital voice offering of integrated local and long distance service coupled with the benefit of pricing increases implemented earlier this year, continued to annual long distance revenue growth of 14%. Digital voice remains an important part of the bundle, as we grow penetration to 40% from 37% a year ago.

Total customer connections, which include consumer and small business lives, high speed internet subscribers, wireless and video customers, grew 116,000 in the quarter, and approximately 300,000 year over year, marking the fifth consecutive quarter of year over year increases.

Our Direct TV alliance continues to be a strong contributor to our bundling success. We now have 366,000 customers on Direct TV, adding nearly 80,000 in the quarter, and nearly tripling subscribers from a year ago. We expect this offering to become increasingly attractive to our customers, and we have recently improved the Direct TV offering included in our triple-play bundle.

Our business channel continued to see strong revenue trends in key growth products, although this improvement continue to be masked by the customers’ migration off of Legacy products. Data and internet revenue in our business channel grew approx a 1.5% year over year, for both the year and the quarter.

Growing and emerging data products such as high speed capacity networking, VOIP, our IQ suite of services and data integration more than offset the drag of Legacy product migrations off of Frame and ATF. By continuing to invest in and develop solutions that meet the challenging need of our customers we have the opportunity to grow the business channel in 2007.

We saw strong growth in our hosting services in 2006 through expansionary efforts at all of our data centers. We added the equivalent of one new hosting center in 2006. This allowed for revenue in a quarter to grow nearly 30% compared to last year. We recently announced the addition of a new hosting center in the Seattle area, and expect to continue our expansion efforts in support of growth in hosting.

Our annual whole sale channel revenue was down 2.9% as anticipated pressures from local competition and industry consolidation were largely offset by growth in data traffic revenue.

For the quarter, revenues were percentially flat sequentially, compared to previous prior year. Our revenues from data and internet products were up 8% for the year. Revenues for the quarter were up 4% sequentially, and 14% compared to the prior year.

We improved the overall contribution of our whole sale channel consistent with our goals. We continue to focus on selling capacity at high value customers, such as re-billers, cable, wireless, and VOIP providers. Our program to upgrade our ultra-long hall or OC768 network on a targeted basis and within our overall stable capital budget will provide opportunities for growth in both our business and wholesale channels.

Annual wireless revenue grew 6% year over year, and subscribers passed the 800,000 mark this quarter. Subscriber growth in a quarter was driven by our new shared plans, promotions, new phone introductions, and successful bundling efforts. Wireless continues to be a significant part of our bundle offerings and our strategic positioning.

When wireless is added to a bundle, it reduces our risk of losing that customer on an average by 10%. We’re also looking at ways to provide customers with a solution they want by selectively adding wireless to our triple-play bundle.

We improved our annual adjusted EBITDA margin to 31.5%, a 250 basis point improvement over the prior year. Our margin in the quarter was 31%, marking our tenth consecutive quarter of year over year margin expansion. Adjusted EBITDA of $1.1 billion for the quarter was down sequentially as our results in the fourth quarter were affected by compensation related cost, facilities cost, and major winter storms in several of our metro areas, all of which we do not expect to reoccur.

Barring unusual items we ended 2006, and entered 2007 with adjusted EBITDA margins that more closely approximate our third quarter results. From here we continue to believe that we can improve our margins toward our stated goal of 30%. We expect margins to benefit from traction and revenue growth as we increase the penetration of key products and improve our ARPU while we diligently control costs through productivity improvements, network optimization, and facility cost reductions.

Through these efforts we have the opportunity to increase our 2007 EBITDA by as much as $400 million. Our investments in productivity improvements continue to positively affect results in all facets of our operations. From investing in improved call center management technology, to giving our technicians the tools they need to get more done faster, we’re finding ways to reduce cost while increasing efficiency and improving the customer experience.

Productivity continues to be an important part of our strategy to drive further improvement in the EBITDA, and sustain profitability at Qwest. In addition to our improving customer service scores, the results of these productivity improvements can be seen in our operating results. We reduced operating expenses by 5.2% in 2006. Cost of sales and SA&G were down $336 million year over year, when we exclude realignment and severance charges in both years.

Our productivity initiatives continue to gain traction and we’re just beginning to show their potential in our results. The sequential increase in operating expense in the fourth quarter was largely driven by unrecovered facilities’ cost rate increases, which we expect to begin recovering in the first quarter of ’07, and the non-reoccurring compensation-related charges.

As a result, we’re entering 2007 with EBITDA margins that more closely resemble those we achieved in the third quarter. We ended the year with approximate 38,000 employees – that represents a reduction of about 3% year over year. This decline is due to our in-sourcing of critical call center functions last quarter and our expansions of overseas IT operations.

In both cases, these changes are expected to reduce our operating expenses, while we improve service and operations. At the same time, we continue to benefit from our wire-line facilities cost optimization initiatives. We reduced wire-line facilities cost by more than $240 million in 2006 even while volumes increase from our growth products.

In 2006 we significantly decreased our average cost per DS1 as well as our average interns cost for DS1 nearly 10% as a result of our ongoing growing efforts. We can achieve further savings in 2007 as opportunity still remains in this area. In addition to these fixed cost savings we also realize sustainable improved variable cost through changes in routing and contract terms.

We believe there is still opportunity to reduce cost and improve efficiency with a focus on our long hall facilities. We are encouraged by the progress we made in many of our grooming and hubbing initiatives and believe they will translate into further facility cost improvements.

For the year, diluted earnings per share total $0.30. Diluted earnings per share were $0.10 for the quarter, up a penny from last quarter, and this reflected our continued emphasis on sustaining profitability through improvements in productivity, operating efficiencies, and network optimization initiatives; as well as lower interest expense and depreciation.

Both the current quarter and the third quarter included one time items that equated to a net benefit of $0.03 per share. CapEx for the year total $1.63 billion – up slightly from the $1.61 billion last year.

For the quarter Cap-Ex was $406 million, a slight sequential increase. For the year, over 70% of our capital spent was dedicated to growth and increased speeds as we focused on disciplined spending where we can realize a return. We generated significantly improved adjusted free cash flow of $1.4 billion for the year, a 55% increase over last year. Free cash flow for the quarter of $495 million was a sequential increase of $236 million with the majority of the increase attributable to the seasonal nature of our interest payments.

The balance sheet ended up being a use of cash for the year as payments in the quarter somewhat exceeded our expectations and seasonal items also affected results.

We had the opportunity to generate growth in free cash flow before one-time items in 2007 as we modestly grow revenue and continue to benefit from our cost savings initiatives. With growing revenue and shrinking costs, the balance sheet could be expected to be a use of cash in the year. But we will employ our usual diligence in improving day sales outstanding and days payable outstanding, the balance sheet…some variability can be expected as we experienced in the fourth quarter of ‘06.

Considering all of these factors, we have the opportunity to increase our 2007 adjusted free cash flow by approximately $400 million over the 2006 level.

During 2006 we continued to reduce debt and improve liquidity. We ended the year with net debt of $13.4 billion, that’s an improvement of about $1 billion versus the prior year end. We expect to be opportunistic in continuing to reduce our leverage, most likely as debt becomes due. Because of past initiatives on debt near term maturities are relatively modest and very manageable.

We ended the year with $1.5 billion in cash and short term investments, giving us a solid liquidity position. We have utilized some of this liquidity to continue our stock buy back program in the first month of 2007. Through January 31st, we’ve executed on approximately 25% of the announced $2 billion program and we expect to continue to opportunistically execute on this program up to the full $2 billion, while reviewing on a regular basis all opportunities to reward shareholders.

We also improved our balance sheet by addressing pension and benefit issues. As a result of strong returns on our assets during the year and changes we made to our benefits plan, we significantly improved our funding position in 2006. The improvements we made in our business and balance sheet are reflected in the upgrade we received from the three major credit rating agencies during the fourth quarter.

In closing, we are very pleased with our annual and quarterly results. We maintained momentum in our P-growth products while driving higher ARPU and improved revenue. We’ve continued to eliminate cost from our business while investing in the development of products and solutions that our customers want. With improving customer service always at the core of what we do, we continue to see opportunity to sustain profitability and grow our free cash flow.

With that, I turn it back to Dick.

Richard C. Notebaert

Thank you Oren.

If I could just take a minute and take a look at 2006, I think it really is a turning point in the journey that we’ve been on. The results compared to prior years were really excellent and such as that when we look to 2007 we can continue to focus on our priorities. They are to drive modest organic revenue growth, to improve EBITDA margins especially through optimization, and productivity initiatives, and to increase free cash flow.

In closing, we have done what we said we would do, and we will continue to do that. We will keep our word. Our strategies are working. Our progress is demonstrable. We have momentum that is tangible and we have a positive outlook to the future.

Now operator we’ll stop and we’ll take questions.

Question-and-Answer Session


At this time I want to remind everyone that if you would like to ask a question, press star and then the number one on your telephone keypad. We’ll pause for just a moment to compile the Q&A roster.

Your first question comes from David Barden from Bank of America Securities.

David Barden - Bank of America Securities

Hey guys, thanks a lot and congrats on 2006. I guess my question is kind of looking out to the balance of 2007. Just one quick housekeeping item. Oren, I think you were trying to answer to some of the concerns about the costs in the fourth quarter and the margins, a lot of one-timers. If you could get a little more specific on the magnitude of the costs in the fourth quarter so we could get kind of a run rate as we look into 2007.

And then I guess the $400 million of incremental EBITDA expansion we’re expecting to see would probably put us somewhere in the low $4.7 billion for EBITDA in ‘07. You mentioned changing pension variables and things like that, if you could talk about what, if any contribution to that $400 million is the pension costs, that’d be great.

The last thing, there’s just tons of speculation as you guys know about…some of the RP work you might be doing on fiber to the premise and whether you’re sitting back and looking to be a fast follower on AT&T’s IPTV strategy. If you could just kind of set the record straight, what is the path that Qwest is following and how much are you earmarking from a capital standpoint to follow it?

Thanks a lot.

Richard C. Notebaert

Let me do the last one first and give Oren the chance to ponder those first two questions.

I mean, we’ve been very consistent in what we’ve said. Our facilities, our cable does not require a complete change-out in the last mile. We have on the average and on the whole good facilities, therefore we will follow a path where we will continue to upgrade the speeds, and you’ve seen the investment that we’ve made, and currently over 25% of our customers can get 7 meg, so we’ll continue to run fiber to the node or to the remote terminal. This has been very consistent with what we’ve done. We’re not investing in Legacy product; we are investing in increasing speeds of bandwidth.

On the IPTV situation that constantly comes up, we are watching, we are learning. We are letting other people work with the issue and we’ll benefit from their investment in future technology. We believe that with time shift that you can do on video and the fact that you can content on demand, those of you that watch “24” that you can pull it down the next day, we’re on the right path to do what customers want. So fast follower, OK, that’s good, but we aren’t following anybody as far as deployment of fiber to the node. And so the RP’s that somehow got in the media is our continuing effort to find and determine whether we can get a lower cost on the purchase of that fiber, which we are and have been laying and reinforcing the RT.

And just one other comment there’s an article today in the Wall Street Journal that was in error. There’s a paragraph in there that talks about profitability in the first quarter of 2006 because of an asset sale. We did not have an asset sale in the first quarter of 2006, that was the first quarter of 2005. There was also an implication in that article that we are not laying fiber. We have been consistently doing that and reinforcing the RT’s.

So Oren, if you’re ready. I took that a long time on that one.

Oren G. Shaffer

Yeah I appreciate it!

Richard C. Notebaert

So now if you’re ready, now you can go to “one” and “two”.

Oren G. Shaffer

David, first of all good morning. On the fourth quarter, you’re correct. I was trying in fact to lay a little bit of work out there so that people could visualize what may have happened to us in the fourth quarter. But I think the key statement we made about the fourth quarter margins is the one that we’re concerned that we’re coming out at the year at a level much similar to the third quarter margins which you’ll recall were closer to the 32.5% level.

And what occurred in the fourth quarter…and let me just say one thing…Dick and I had said a few quarters ago that we weren’t going to get into listing out the adjustments of things that went right and wrong. But basically in the fourth quarter we did have storms up and down the West Coast here, so we had a lot of additional compensation related expenses in the repair area, and that’s just the way it happens.

In addition we had some adjustments to not only the revenue but also to facilities cost. But just lumping all that together we’re coming out of the year at what I would term a run-rate that is actually slightly better than what we had coming out of the third quarter as we go into 2007. And that’s the reason we feel fairly comfortable talking kind of million dollar nominal dollar increase and the accompanying cash flow improvements. Your right, we’re moving into 2007, I’m actually feeling very good about how we’ve come out. And Dick, I don’t know, do you want to add anything?

Richard C. Notebaert

The other thing I would add is if you look up in the state of Washington and the state of Oregon, and you look at the mass of storms we had in December which covered the national media on snow and stuff, people looked at that and said your expenses went up because you were working around the clock to provide outstanding service. That’s true.

But what’s sometimes missed is that we had to back off of the installation of new services. So it didn’t just affect the cost, it also affected the revenue, because we had to push the intervals out for what we were trying to do for the installation for some of our services.

We would not expect to have - global warming aside - that kind of impact on an ongoing basis. That’s why Oren in his comments said that we didn’t expect those to recur. And no nice way to say it, but if it affects your top line and your expenses then obviously it affects your EBITDA margins. So Oren, do you want to go to the other question?

Oren G. Shaffer

I think on the pension thing, we did have a good year on the pension results next year, obviously that’s if you look closely at the balance sheet you see that the shareholders equity improved by slightly more than a billion dollars on the balance sheet, a lot of that coming out of both not only the benefit changes but also the returns.

As far as what we get through the profit and loss statement or through EBITDA next year, we’re looking today to be slightly better than what we did in 2006. And if there was something that would go right in 2007 it might be that that number gets a little larger than it was in 2006 but right now we’re expecting it to be just slightly better.

David Barden - Bank of America Securities

So maybe more of a tailwind than a material contributor to the $400 million?

Richard C. Notebaert

I think that’s a fine way of saying it, I’ll put that in my script for the next call.

David Barden - Bank of America Securities

Any time, Dick. Take care guys. Thanks.


The next question comes from Michael McCormack with Bear Stearns.

Michael McCormack - Bear Stearns

Thanks guys, maybe just a couple of comments on the enterprise space. Verizon’s been out there talking about trying to save some costs by bringing more access on their own networks. Maybe some discussion on what the impact might be for you guys. And then, maybe another comment on line loss and sustainability of ARPU trends, you’re saying an increase in competitive losses there and is it wireless substitution?

Richard C. Notebaert

Our line loss, if you look, we’ve always said this, is both wireless and non-wireless. You know cable competition is real. And I would point out if you look at our percent growth on high speed internet of 44.5% year over year, and if you pick another high speed company at random like Comcast, and if you say what was their growth rate in high speed internet and you get single digits.

And you say what was their growth in telephone and you find it’s about the same as our growth in high speed internet. What we are working very hard to do is a migration from Legacy voice into the world of data, internet, VOIP. As long we can do that at the speed we are doing it, then it off-sets any revenue loss because you get a higher ARPU and a higher margin and a greater opportunity to be successful.

I think our goal is to continue that in the mass-market area. On the enterprise space, we made a decision just like we did in wholesale. It was a hard decision. We moved away from selling our Dial platform for various companies, and we can’t get into specific because of our NDA’s.

We looked at our dollar revenue and said, what’s our margin on that? It was the same thing we did on wholesale on what we were charging a minute and we made a hard decision to move away. That cost us some revenue and I would tell you flat out, it was a pretty good chunk of change on the revenue side in the enterprise space. However, that’s the right decision to do.

Why would you want a $100 million of that type of revenue - that’s just an example, that’s not a specific - that loses money? Wouldn’t you be better off focusing totally on data, VOIP and those types of services?

If we take that Dial platform decision we made and we move it out, we actually had growth in the enterprise space. And we continue, as Oren pointed out, to groom and attack the sole needs costs. As we said in the prior calls and the conferences we both go to, I think the company has done a very good job at reducing on the long hall the number of cents we pay per dollar of revenue for facility costs. We will continue to groom that.

On the wholesale side, what that company said about bringing things on net, they’ve already migrated away from us. That happened a long time ago and more importantly our wholesale groups already made that up. And we will continue to look at that rationalization.

We also…that’s why we bought on fiber, we want to move some stuff on net. And if we can find some more bolt on acquisitions that makes sense for the shareholders to reduce our costs, we will give that serious consideration.

Oren, you want to add anything on either one of them?

Oren G. Shaffer

Well said.

Michael McCormack - Bear Stearns

Oren, you mind if I just ask you one question. You mentioned balance sheet being of potential use in 2007, could you give us a sense of the magnitude there?

Oren G. Shaffer

Hopefully, I said we anticipate it to be a slight user of cash in 2007, if I didn’t I’ll say it now. And you remember last year I thought we would be more neutral as we went through the year.

In fact I said, I thought the balance sheet would be more neutral in the cash flow, as it turns out in the fourth quarter, we had a bit of a dislocation between our receivables, i.e. payments received and our payables made. And the only thing I can figure out is that we were probably less proned to probably use the bad weather as a reason not to pay our bills than some of our customers were.

We got our payables out on time but unfortunately I guess some guy didn’t make it to work because of a snowstorm or something on the side that he was supposed to pay us. So you can look at the end of the year, we coughed up a couple of day sales and receivables but our payables went down almost five days.

And obviously that’s not a good thing and we would expect to get that straightened out in 2007.

Michael McCormack - Bear Stearns

So it doesn’t sound like it’s going to be a meaningful use then of working capital?

Oren G. Shaffer



The next question comes from Jonathan Chaplin of J.P. Morgan.

Jonathan Chaplin - J.P. Morgan

Good morning guys. A couple of quick ones if I may. Oren, you mentioned in your comments modest revenue growth in 2007. I am wondering if you can give more details on what modest revenue growth means, and kind of map your aspirations of 3-4% revenue growth over time.

And then in terms of the one time pressures for 4Q, it seems like they fall into three categories. There were facilities costs or rather un-recovered access charges, compensation related expense and some storm related expense. It looks like they sort of together amounted to somewhere between $40-50 million in costs.

I’m wondering if you can sort of apportion the short falling costs between those three items and sort of give us some more color around the un-recovered access charges. I’m not sure I fully understand what was involved there.

And then I’m wondering, given that the balance sheet was a greater use of cash, a $200 million greater use of cash in 2006, how does that factor into your expectation for 2007? Shouldn’t you be recovering the working capital short fall that you had in 2006 and 2007? And isn’t their an opportunity for the balance sheet to be a source of cash in 2007?

Richard C. Notebaert

Jonathan, your numbers are pretty good, pretty good analytics. I’m going to do the first one instead of Oren. If you looked at our strategy in terms of where the modest growth will come from, if you go back and re-play what we said on the call, mass-market was growing at around 2.4%, we would expect that to continue in that range. We have that opportunity.

We also have an opportunity to keep our wholesale business basically flat with increasing margin improvement and that’s what we should do. But the real opportunity for us, the key to success this year is to focus on our enterprise mid-market space.

As we have said at the conferences and on the calls, we’ve got a pretty good shot on that with the consolidation of the industry and with people focusing on some other issues, customers are looking for us in that enterprise space. We’ve got about 4-5% market share, approximately to move that up.

And you can do the math on what 50 basis points means across of growth, or 100 basis points of growth, could mean across the sector. So, the real key is right in there, and that's the sweet spot for us this year. We spent a couple of years retooling that part of our distribution. And that will make it.

Oren, you want to do the other?

Oren G. Shaffer

And Jonathan, if I happen to miss any of them as I'm going through this, don't hesitate to ask me again. But on the shift of the...on the costs we incurred in the fourth quarter that weren't expected, they were, you know…In the compensation side, we had some performance-related pay, and then of course the additional charges that we were getting from overtime, and a redirection of people away from activities in our installation and maintenance crews that would have been normally capitalized installation or something like that going into repair. Those two things together on a compensation side probably were pretty-much around $40-45 million.

On the facilities-cost side, what happened to us there was that, late in the month, we discovered some traffic activity which, of course, we believe was untoward. But, in any case, it did run up our facilities cost, and when we closed it off – and that's why we consider that these things will not reoccur, because we in fact are not going to transmit that traffic. But our systems did not allow us an early enough warning system to get that out. And it was probably something on the order of $10-15 million, probably.

Richard C. Notebaert

We've fixed the systems now, so that I can tell you that if we get a little spike like we did from some spots that inappropriate traffic that we could immediately block it. And we have talked to all of our wholesale costumers concerning doing that, and they have agreed. And so the systems that the wholesale group, Roland Thornton and team have put in place, on about a day's notice. Whereas Oren said, we just didn't pick it up quick enough, and that's unfortunate. That was too bad.

Oren G. Shaffer

And so I think that's why my comments were that I felt pretty comfortable indicating that in my mind at least, we're coming out of the year on an EBITDA trend that is even more represented by the third quarter than what we reported in the fourth quarter and therefore feel fairly good about the kind of EBITDA increases going into '07.

On the question about the balance sheet, you know, it would be pleasant if you will, if in fact, the increased use of cash on the balance sheet in '06 actually reversed itself in '07. I'm maybe being a little bit conservative, but it's just my nature to be that way. I'm assuming that that will be the balance sheet that we begin the year with. And we'll go from there.

The reason that it used the cash in '06 are obviously temporial, and therefore, you know, may in fact reverse themselves in '07. But right now, I would say we'll just assume they don't, and that the balance sheet going into '07 will be a slight user of cash. But in spite of that, I think we still have the opportunity to improve cash flow in the order of $400 million across the year, which, you know, we'll see how the year develops.

Richard C. Notebaert

We're better served by being conservative.

Oren G. Shaffer

Probably so.

Jonathan Chaplin - J.P. Morgan

A quick follow-up if I may: It looks, you know, based on the costs – and thanks for giving us that, Oren – it looks like it's more sort-of $50-60 million in one-time pressures. It seems like, you know, if you back those out, actually EBITDA margins might have been up a little bit sequentially. I just want to make sure I'm doing the math right there.

And then, Dick, just getting back to the revenue growth: Is, you know, when you put all that together, does it get you to sort-of 2% revenue growth, you know, halfway towards your aspirations of 3-4%?

Richard C. Notebaert

No, that opportunity is there, and I don't think we want to get into a habit of, or get into a pattern of giving guidance on that. But it does move us directionally towards our goal. It's just like, I think your first comments right, and again that's a layman's position – that our goal of hitting the mid-thirties on our margin, we still feel that that's very doable inside. And Oren, why don't you answer his question directly on, he took that 50-60 or whatever that number is?

Oren G. Shaffer

Your math is very accurate, and as you can see, that's why I think the momentum and the growth and the level that we were experiencing in the third quarter is probably more representative of what actually happened in the fourth quarter, and that's what I think our comments about '07 are kind-of based on. In other words, we're... Dick's comments about continued momentum on the revenue side, continued momentum on the growth and EBITDA numbers, and also the cash flow. So that's all kind of third quarter, drawing a line across the third quarter is more representative than drawing a line on the fourth quarter.

Jonathan Chaplin - J.P. Morgan

Excellent. Thank you very much, guys.

Oren G. Shaffer, Vice Chairman and CFO

Yeah, operator, we'll take one more question.


Your last question comes from the line of Frank Louthan with Raymond James.

Frank Louthan - Raymond James

Great, thank you.

Oren G. Shaffer

Good morning, Frank.

Frank Louthan - Raymond James

Good morning. You mentioned a couple of things on the enterprise side. The business lines were down a little bit more. I just wanted to... two questions there. Could you characterize some of the business-line changes? Are you seeing increased competition from some of the CLEX, or is that a function of customers moving to higher capped or optical circuits, that come off the line count?

And then, you know, continuing to see trends going away from Frame ATM, you mentioned ramping down some of that business – what is your exposure to Frame ATM, and how quickly do you think that's going to transition over to IP-based services in your enterprise unit? Thanks.

Richard C. Notebaert

On the first part, we looked at where the line loss is. It is where we are not the ILAC. It would be in those parts of the country at the low end of the mid-market. And that's where we're losing the lines.

And the second thing I would add is, it is also the fact of customers moving towards higher speeds, higher utilization of the asset. If you think back to the mid-90's when we were moving away from T1 or DS1 and moving to DS3, or moving away from a private- line circuit to a DS1, we were getting high growth, but we were losing the lower end. People were migrating up.

Which gets me to the second part of your question. On the Frame and ATM, we still do a sizeable business in that area. We have been aggressively pursuing our MPLS, and our IP network. In fact, Tom Richards isn't here, he runs our business and marketing group, we have consistently, quarter-over-quarter, month-over-month, seen record growth, or higher and higher growth – that's a better way of saying it, in our IT sales.

And we have had to, as we talked about on the call, we have been investing in our long haul network, and moving it from 192 to 768. And, by the way, the good news is for us, that's a plug-and-play thing, because we spent billions of dollars back in 2000 for the newest technology, so the upgrade is not nearly as time-consuming, several times quicker, and the costs are much lower than had we been with older, Legacy technology.

But customers are moving there, and it's a good opportunity for us. Our IQ networking and our data sales, as Oren pointed out with his statistics, have been very strong for us. And so we like the migration.

It also – one last comment, because this is a little bit self-serving – but we like it because now the costumer is going to change from one technology to another, and therefore staying with a Legacy provider is not as meaningful. And it gives us, as the hungry, new entrant, small, nimble player, a chance to go up against the big guys, and the customers are appreciating that. And we've had some pretty good wins at SuperValue, and some other places that reflect that position that we have in the marketplace.

I'd like to thank everybody for being on the call today. I would just reiterate, I think for us, '06 as we look at it as a team, and as a company, was just a very critical year for us that proved that the strategies in the direction we were going, were correct as we reduced debt, improved profitability, got the highest customer-service numbers we've ever had, from J.D. Powers and from other third parties.

And so I think the momentum is there for us to continue this as we look through the windshield at '07. I think, as Oren said, we are well positioned to do that, and our expectation is that, with that opportunity in front of us, we'll be able to execute and accomplish that goal.

Thanks everybody. Thanks for being on the call.


Thank you. This concludes today's Qwest fourth-quarter earnings conference call. You may now disconnect.


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