Alaska Communications Systems Group, Inc.
Q4 2015 Earnings Call Transcript

Published: 4 Mar 2016

[Operator:]

Good day, and welcome to the Alaska Communications Systems' Fourth Quarter and Year End 2015 Earnings Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Tiffany Dunn, Manager of Investor and Board Relations. Please go ahead ma’am.

[Tiffany Dunn:]

Good morning, and welcome to the Alaska Communications fourth quarter and year end 2015 conference call. I am Tiffany Dunn, Manager of Investor and Board Relations. With me today are Anand Vadapalli, President and Chief Executive Officer; Leonard Steinberg, General Counsel and Laurie Butcher, Senior Vice President of Finance. During this call, we will be using a slide deck that we’d encourage everyone to have available. For those listening to this call via the webcast, the presentation will be presented on your screen. For others, you can go to our investor website at www.alsk.com, click on the Events section, go to the fourth quarter and year end 2015 earnings call event, and click on the PDF version of the presentation. We will indicate which slide we are on so you can track the presentation material throughout the call. Now as we get started, please review Slide 3 for our Safe Harbor statement. During this call, company participants will make forward-looking statements as defined under U.S. securities laws. Forward-looking statements are statements that are not historical facts and may include financial projections, estimates of shareholder returns, or other descriptions of the company's business plans, objectives, expectations, or intentions. You are cautioned not to put undue reliance on forward-looking statements as actual results could differ materially from expectations as a result of a variety of factors, many of which are outside the company's control. Additionally, any non-GAAP measurements referred to during this call have been reconciled to their nearest GAAP measure. You can find these reconciliations on our website. Following our remarks, we will open the lines for questions. With that, I would like to turn the call over to Anand. Anand?

[Anand Vadapalli:]

Thank you, Tiffany and good day and thank you for joining us today. Starting with Slide 5, I'm pleased with the really strong operating and financial performance in what has been a transformative year for the company. We achieved our financial goals for the year, coming in at our guidance for total wired line revenue of approximately $220 million and for run rate adjusted EBITDA exiting [2016] at $55.4 million. Once again we continue our track record of industry-leading broadband growth at 9.4% driven by our focus area of business and wholesale with growth of 9.3%. As you may recall we have talked about long-term directional annual growth in business and wholesale of about 8% and I'm delighted that we exceed this target in 2015. 2015 was a pivotal year. We successfully concluded the sale of wireless operations and achieved all of the targeted synergies related to its wind down. We accomplished all of this either on or ahead of schedule including an early settlement of escrow amounts. This transaction enabled us to focus on our areas of maximum opportunity, private broadband and managed IT services, exiting 2015 with one of the best net leverage ratios in our sector. At the same time we expanded our presence on the North Slope by acquiring a fiber optic network from ConocoPhillips. We did this transaction in partnership with Quintillion Networks. Since then we have integrated the North Slope network into our network and delivered on our service agreements establishing ConocoPhillips as an anchor tenant on this asset. As we move the company forward, our priorities are clear; margin expansion and in particular cash flow expansion driven by top line growth. Over the next few slides I will address our path to delivering on these priorities. Moving to Slide 6. Let me begin the conversation with a brief commentary on macro factors related to the price of oil and its impact on the Alaska economy and my perspective on what this will mean to our business. The Alaska economy is tied to resource extraction, more specifically the vast majority of the unrestricted revenues of the State of Alaska are tied to the price of oil, oil production and taxes thereof. With oil trading at about $30 a barrel, for fiscal 2017, the state is looking at a deficit of $3.5 billion. To put this in context, at the start of fiscal '17 which is July 1, 2016, the state is expected to have reserves of about $14 billion. This is in addition to the about $50 billion provident fund which also generates interest the earnings for the state. The state needs a fiscal policy to address the situation for the long-term and there is significant attention to this from both the administration and legislature. Leaders in the state have several tools at their disposal, starting with lowered spending on government to certain options for raising revenues. For example we're the only state that has neither a state income tax nor a state wide sales tax. Also the state can consider how it uses its earnings from the provident fund. The state has choices and credible ones at that. So what does all mean to Alaska Communications? Is this is an overhang for our business? Quite to the contrary, I strongly believe that this macro situation is creating opportunities for us over the next year or two. Let me start with some data points. Currently we have a limited presence in the two most exposed sectors, state government and oil. Less than 5% of our total revenues come from these two sectors combined. Importantly we have less than a 10% wallet share in the technology spend for both these sectors. Furthermore we are not the incumbent and we are able to create value for these sectors and others by offering savings from the high rates they pay in their old contracts while bringing in new revenue to our company. When oil is $100 a barrel, companies have little reason to do something different. When oil is $30 a barrel there is every incentive and then some to get innovative and look for efficiencies. As the challenger in this field I'm confident of our ability to drive value for our customers. Last year I made a comment that we will not allow oil prices to be an excuse as to why we cannot make our numbers. I repeat that assertion for 2016. Where this again, oil prices will not be an excuse for not making numbers. I'm optimistic about the opportunity in front of us. Turning to Slide 7, a reminder of our market opportunity as we have discussed previously. We operate in $1.5 billion market growing 3% to 5% a year. Over 85% of the opportunity is with the business and wholesale segments our focus area. You will see four major categories of our market segment, each with a profile of opportunity, margin and competitive situation. Let's start first with opportunity, which is a combination of expected growth in that segment and our ability to take share. Except the one segment which is subject to secular declines we see excellent opportunity for growth everywhere else. Next is margin, which of course is not the same for every dollar of revenue. Clearly the telecom and broadband side of our business has much higher margins compared to the managed IT services side of our business. Yet one without the other is an incomplete offering and an incomplete value proposition for our customers. For customers seeking a trusted partner and simplicity, a solid mix of product goes a long way in creating the most opportunities for both acquisition and retention. And lastly there is the competitive perspective. As we have previously noted broadband is largely a two player market, while managed IT services is a very fragmented supply market. Particularly the limited competition for broadband is a dynamic that is unique to Alaska and is an important driver of our continued growth. Moving to Slide 8, the basis for our performance is our ability to acquire and retain customer relationships and take share in a growing market. As we noted on the previous slide, we assess our market growing at 3% to 5% a year. However business and wholesale at 55% of our revenues is growing at over 9% or twice, clearly we are taking share. This is exemplified in our roster of customer relationships we are adding and equally important the customer relationships we are retaining. Just in the past year, we added strategic relationships with the State of Alaska, Akeela, a healthcare organization and the Federal Agency. This is supplemented by what we're doing in the small and medium business space where we added over 600 new relationships in the last year. We value new relationships but place equal importance on retaining current relationships. For example in 2015 we executed contract extensions with a leading national carrier, a national federal contractor among several other customers. As you can see from our customer quotes, the value we add to our customers goes beyond technology or price. We win because of our service capabilities. Moving to Slide 9, let me spend a little time discussing the strong set of capabilities we are adding for our customers both through product deployment on our network and also with partnerships with leading technology providers. A big driver of broadband consumption is the increased migration of business applications to the cloud. Large providers like Amazon, Microsoft, Acronis, CyrusOne, et cetera are making sizable investments in the cloud and business adoption and migration is not a question of if but when and how. Businesses need a reliable and trustworthy partner to help with their curve migration strategies and plans, one who can securely connect them to the cloud. That is our play. Our set of capabilities will increasingly position us as the leading cloud enabler for businesses in our markets. We have long discussed the strength of our network as the only Metro Ethernet Forum certified network in the State of Alaska. We are developing a robust set of capabilities around our network. From managed security to cloud we are partnering with leading organizations to deliver state of art services to our customers. While we have listed several partnerships on this slide, in particular I'd like to draw your attention to our secured Internet Exchange connection with CyrusOne. With the security of a private connection to public cloud hosting providers our customers no longer use unsecured public Internet for their connectivity. We now offer secure and private links to the CyrusOne data centers and already an important energy sector customer is using that service. Moving to Slide 10, I will wrap up this section with some commentary on our operating and service capabilities. Our commitment to lean helps eliminate waste while improving capacity and scale. We have added several new technologies to drive service improvements. I am particularly pleased with the progress we are making in our online capabilities. We will continue that investment, further driving our mobile interaction capabilities for our customers. We want to give our customers ways to interact with us that meet their needs. Our investment in this technology drives scale and capacity for us. We have great technology, we have better people. Our commitment to service shows as we measure service at every interaction, and in fact, tie in management compensation to customer service. Ultimately our investment in service drives top line growth. Our commitment to lean drives organizational capacity. Collectively we see this as our path to margin expansion and shareholder value. With that let me hand the call to Laurie. Laurie?

[Laurie Butcher:]

Thank you, Anand. As shown on Slide 12, we are pleased to report performance for the fourth quarter and the year overall. Focusing on the quarter on the left hand side of the slide, total service and other revenue increased 5.8% on a year-over-year basis. Business and wholesale representing 57% of our total service and other revenues were 15.7%. Consumer revenue representing 17% of our total service and other revenue as expected declined. The 6.3% decrease reflects general industry trends as well as planned reductions in lower fee connections. Other revenue made up of equipment, access and high cost support representing 26% of our total service and other revenue declined 4%. On the right hand side of the slide you can see our full year revenue performance was strong with total service and other revenue up 2.2%. Our revenue performance continues and our focus on business and wholesale drives our growth. As you can see in our peer group comparison we continue to lead our industry in top line performance. Turning to Slide 13, you can see a deeper dive into a key area of our growth, broadband revenues. In this area we consistently performed well and posted growth of 10.4% for the quarter and 9.4% annually. As you can see as the total revenue will continue to outpace our peers. It remains core to the value proposition we deliver to our shareholders. Slide 14 highlights our 2015 financial performance. I am pleased to report that we met our guidance for revenue, capital spending, net debt and for run rate adjusted EBITDA exiting 2015. Importantly 2015 was a transformative year for our balance sheet. We used the proceeds from the sale of our wireless operations to significantly delever our balance sheet reducing our total debt by over $240 million. During the third quarter we refinanced our term loan thereby pushing out our earliest maturity to 2018. We entered 2015 with a net debt leverage ratio of 4.4 times and exited 2015 with a ratio of 2.9 times. Additionally subsequent to year end we repurchased $10 million in convertible notes below par. This is a very deliberate decision to continue to delever while we focus on EBITDA margin expansion. This action puts us one step closer to achieving the net leverage targets in our current credit agreement that serves as a threshold for shareholder friendly action. Moving to Slide 15, I will now turn to the future, starting with 2016 guidance. We are targeting total service and other revenue of approximately $228 million, a 3.7% increase over 2015. Adjusted EBITDA is expected to be approximately $59 million, which represents a year-over-year increase of 18.1%. Capital spending is expected to be approximately $35 million consistent with prior year. Our free cash flow is expected to approximately $5 million which is a significant improvement over 2015's free cash flow. Turning the page to Slide 16, let me now provide some additional color on our longer term directional view of our business performance. Starting first with our revenue mix. We closed 2015 with business and wholesale representing 55% of our total service and other revenue, achieving 9.3% growth on this line of business. As we move in 2016 and beyond we expect to close to be at or above 8%. On the consumer side we do expect to see continued softness in revenue during 2016 so moderate compared to 2015. We have dramatically simplified our product with one price which resonates in the minds of different customers. We expect to stabilize the consumer segment in 2017. Finally let me take a few minutes to discuss the various components of our other revenue category. This represents 27% of our total service and other revenue. We think about these revenues in three broad categories. First, our high cost support which represents about $19.7 million a year or about 9% of our total service and other revenues. This revenue stream is currently provided under the FCC's Connect America Fund or CAF Phase I. While the second phase of the CAF -- of the program CAF II is active in the other 49 states the FCC has yet to issue an order implementing CAF II in Alaska. Our CAF II proposal implement the FCC calls for a continuation of the existing levels of support for 10 years in exchange for extending broadband services to various currently un-served. We remain optimistic that the FCC will constructively work with us on our proposal and we expect to see action in this regard this year. The second category in other revenue is access, this revenue stream was $33.6 million or about 15% of our total service and other revenue in 2015. This category can be further broken down into switched and special access of $5.8 million and surcharges of $27.8 million. We expect access revenue collectively to continue to decline 4% to 5% a year. The third category in other revenue is equipment sales and installation. This represents $6.4 million in 2015 or about 3% of our total service and other revenue. The primary driver of this revenue is the sale of equipment to customers as part of our IT managed services business. We expect this category to grow though with some variability typically associated with normally occurring revenue streams. Further this is driven by customer activity and beginning in Q1 of 2016 we intend to move this revenue stream to our business and wholesale segment under service revenue. On the preview for next year and in addition to this change with equipment moving out of other revenue to service revenue we intend to realize further breakout of our regularity revenues to provide more transparency in our makeup and trends. Proactively when you add out the various parts of our revenue stream and consider their respective profiles we expect that total service and other revenue will continue its growth trajectory at the rate of between 2% and 5% annually over the next few years, which we consider to be industry leading levels. This growth will be driven by our continued performance in business and wholesale. Now moving to the bottom line. We expect our focus on operational initiatives to help improve our customer service capabilities while we expand operational capacity and manage our cost structures. This is the basis for margin expansion. You will note that for our 2016 guidance our adjusted EBITDA margins improved to about 26% compared to about 21% in 2015. While we are not setting a long term target for adjusted EBITDA margins we expect adjusted EBITDA to improve every single year and grow between 4% and 8% over the next few years. Moving onto cash flow. Let me briefly discuss the three main elements that drive free cash flow; capital spending, interest expense and cash taxes. Starting with capital spending, we expect $35 million a year to be a reasonable view of the investments needed to drive our growth. We continue to look at opportunities that drive additional growth. Examples include our previous investments in TekMate and fiber on the North Slope. We expect any additional investments to improve our growth and margin trajectory and be accretive to long term shareholder value. Second given our current debt structure we expect total cash interest expense to be about $13 million a year. And lastly moving onto cash taxes, with the sale of our wireless business utilizing the significant portion of our outstanding NOLs the company currently has approximately $38 million remaining and with the exception of being subject to AMT we expect cash taxes to be de minimis for the next couple of years. When I put all these various elements together to the long term I expect that we will demonstrate strong free cash flow building on the positive free cash flow for 2016. Now I would remind our investors that when we started this journey of transformation five years ago, our wireline business was cash flow negative and almost all of our cash flow came from wireless running and CETC. Since then we have addressed the strategic issue with wireless. We have focused our business on areas of maximum opportunities, fiber broadband and IT managed services and most importantly converted our wireline business to a cash flow positive business that we expect to grow. So what does all this mean to our shareholders. As the management team we are committed to creating the conditions that offer our Board the maximum optionality to create long term value for our shareholders. Our profile of revenue and adjusted EBITDA growth combined with positive and growing free cash flow should position the company for a better valuation in the market. We know we are undervalued and we are optimistic that the investors will see the long term merits of our story. An improving equity value combined with improving cash flows truly gives our Board tools for value creation that may have been previously constrained. We are focused on driving fundamental performance in our business and our Board is committed to capital allocation such that it drives shareholder value. With that let me hand the call back to Anand. Anand?

[Anand Vadapalli:]

Thank you Laurie. Let me wrap up with Slide 17. Our business plan is one of margin expansion driven by top line growth. We believe we will continue to drive this growth with a combination of market dynamics and our investment in products and partnerships. Furthermore our operational focus will drive margin improvement while improving service levels. We have demonstrated we can take share and grow revenues. We have paid down our debt to create solid balance sheet. With the simplification of our business, we turn the corner in 2016 with positive free cash flow and growth in both adjusted EBITDA and free cash flow on a go forward basis. I believe we have one of the most positive stories in our sector. I am confident that investors will see the value in our business creating the basis to achieve the upside that exists in the hugely undervalued stock. With judicious capital allocation we fully expect to drive further improvements in our valuation over time, creating long-term shareholder value. Thank you for joining us today. With that let me open the call for questions. Operator?

[Operator:]

[Operator Instructions] We will take our first question from Barry Sine from Drexel Hamilton.

[Barry Sine:]

Good afternoon. It's Barry Sine with Drexel Hamilton. Hey. I don't fully understand how you drove the growth in the fourth quarter in the business and wholesale. It was above what I was looking for, and I think, above what you have for long-term guidance. So a couple of questions, if it could help me there. On broadband I think revenue was up over 20%. Was there anything unusual in the quarter there? What were you selling? Was it enterprise sales of fiber circuits? How are you getting to that growth? Are you still expanding the size of the sales force, and if so, what is that growth in the sales force?

[Anand Vadapalli:]

This is Anand. So if you recall we talked about the record sales that we had in the third quarter and we talked about in our previous calls that we sold close to $8 million in annualized revenues in fact in a single month in the third quarter. Some of these were large sales that took us several months to deliver and turn them into service and in fact we fully expected that the fourth quarter would begin to see the benefits of those sales and what you see in those numbers reflects some of those very large sales that we made in the third quarter. And frankly if you carry that forward this year we begin to realize full year benefits on many of those sales as we go into 2016. So when I think about 2016, in a lot of ways, we see a very clear trajectory to continuing our growth profile in '16 driven in part by the strong performance we had in '15 and of course we intend to continue the good sales performance in '16 as well. Hope that helps.

[Barry Sine:]

Okay. That's helpful. If I could also zero in on the wholesale part of revenue, that was quite strong. I know industry-wide that fiber to the tower is a strong driver of wholesale for a lot of carriers. I'm wondering, if that was a driver there. And I also believe, in the past you've talked about the potential to win back some of the fiber backhaul contracts that you had sold to GCI as part of AWN. Wonder if we're seeing that, and maybe if you could give us a sense of, if there were some win backs, the mix of new customers or new towers versus win backs? And then last lastly on that topic, GCI has announced a sale of their towers, so how does that, if at all, impact the business opportunity for ACS to sell fiber backhaul to those towers?

[Anand Vadapalli:]

So in terms of the trends on the wholesale side from our perspective fiber backhaul remains a very creditable opportunity for us. As I mentioned I think on one of our calls last year we did win back certain sites for fiber backhaul from one of the national carriers. And we will continue to compete vigorously for that business. And frankly I did see the announcement from GCI about the sale and leaseback transaction for -- or their intended sale and leaseback transaction for their some towers and we look forward to competing for that business and see if we can add value there. But the wholesale business goes beyond that. We do serve other national carriers usually federal customers as the end customer and in fact last year we talked about some significant wins that we had where we were the subcontractor for national carriers in serving probably large federal opportunities. And we had certainly more than boots on the ground. We participate actively in opportunity development and winning that business in partnership with our national carrier partners. So what you see in that segment Barry is reflective of all these actions and we expect that to continue to be a driver of our growth in '16 and beyond as well.

[Barry Sine:]

Okay. That's also helpful. My last question is just to get a little more color around potential EBITDA margins. Laurie, you mentioned that the guidance implies about 26% EBITDA margin for 2016. Just trying to understand how you're going to get there. I'm assuming there's still some left over overhead costs that you have to take out associated with the wireless business, and I'm assuming that will probably, that margin expansion will probably ramp, and then after that beyond 2016, where do savings come from? Is it just more revenue on a fixed cost network or what other, are there other savings potentials?

[Anand Vadapalli:]

The wireless synergies and overheads in large part substantially complete and behind us. So I wouldn't say that there is anything that we are looking to from that perspective. This is -- the margin expansion for us really is the comment you make towards the end which is funding growth within our existing cost structures and allocating resources to where we see the most growth opportunities. We are heavily committed lean as a philosophy in the company and one of continuous improvement. We put a lot of effort in training our people in that and we have expectations from our leaders that we will look at continuous improvement opportunities. And these are small and at the departmental level, at a workgroup level all the way to cost functional initiatives that drive big change in the company. So for us as I look at our future going forward, this is really about managing our cost structures largely where they are while we fund growth. And that we believe that we have capacity in our network and we believe we have capacity in the organization to fuel more growth and that's where we see the margin expansion playing out. And you see that in our long term directional view where the growth rates that we have for adjusted EBITDA is higher than the growth rates that we have for our total revenues and we intend to continue that divergence between those two curves.

[Operator:]

[Operator Instructions] We will take our next question. Caller please go ahead.

[Jason Bernstein:]

Hi, guys, Jason Bernstein with Odeon. Great quarter and great guidance. Just a question on the CapEx, Laurie. Can you break down how much of that is sort of growth versus maintenance related?

[Laurie Butcher:]

Absolutely, thanks for this question Jason. Our -- the breakdown between the categories is basically 50-50. We think about 50% of it being success based and about 50% being maintenance. We are really closely of course at that success base. We have got targets out there for return and payback thresholds and then of course we are always looking at strategic opportunities as well. Of course any strategic capital investment will be subject to forward capital allocation policies. So it will be looking for incremental returns to our shareholders.

[Jason Bernstein:]

Great. One more question, if I could. Anand, you said the oil revenues wouldn't really have -- wouldn't be an excuse, but let's play the flip side of that coin. Is there potential for faster growth when, and if, the price of oil goes back up?

[Anand Vadapalli:]

It's an interesting question. It's hard to predict where that will go. I think we have opportunity today just based on the low share that we have in many of these segments and I expect that to continue. Is there an upside as oil prices tend to go up, again it depends to what levels. Frankly I see continued upside from the increased adoption of cloud, increased adoption of more richer collaboration technologies, increased adoption of video in business. Those are the underlying trends that drive greater broadband consumption and currently drive greater efficiencies in how business is conducted. So I put a lot more stock into those trends of where technology and business is headed and of course if oil prices go up and that gives more revenue to us, more upside to us we will take it all day long.

[Jason Bernstein:]

Great. And just one more. Are there any new data center builds going on in any of the major metro areas?

[Anand Vadapalli:]

Not that I know of. We have a couple of our own data center spaces that we have invested in the past. One here in Anchorage and one in our operations center in Hillsboro, Oregon. But again as I mentioned in my prepared remarks, when I see where the trends are headed, large organizations, some of whom I mentioned in my remarks are investing billions of dollars in creating high quality hosting facilities. From where we are I do not see too much merit for us in investing capital in data centers. I see merit in being the premier partner, the trusted partner for our businesses to help migrate them to the cloud. We can offer them secured connections and we can migrate their applications to the cloud and that's where you will continue to see us invest in our capabilities across the board.

[Operator:]

[Operator Instructions]. And there are no further questions at this time.

[Anand Vadapalli:]

Well thank you. We appreciate everyone joining us on the call and as a reminder I expect to be out meeting with investors the week of March 15 and I will be on the East Coast in a few cities so please do reach out to Tiffany Dunn who is our Manager of Investor and Board Relations and we will see if we can schedule something. And we look forward to reporting progress to our plans. Thank you for joining us.

[Operator:]

That concludes today's conference. Thank you for your participation.