Telephone and Data Systems, Inc.
Q1 2014 Earnings Call Transcript

Published: 2 May 2014

[Operator:]

Greetings, and welcome to the TDS and U.S. Cellular first quarter 2014 operating results conference call. [Operator instructions.] I would now like to turn the call over to your host, Jane McCahon. Thank you, you may begin.

[Jane McCahon:]

Thank you, operator, and good morning everyone. Thanks for joining us. I wanted to make you all aware of the presentation we have prepared to accompany our comments this morning, which you can find on the Investor Relations sections of the TDS and U.S. Cellular websites. With me today in offering prepared comments are, from TDS, Doug Shuma, senior vice president and controller; from U.S. Cellular, Ken Meyers, president and chief executive officer; Steve Campbell, executive vice president and chief financial officer; and from TDS Telecom, Vicki Villacrez, vice president for finance and chief financial officer. This call is being simultaneously webcast on the Investor Relations sections of the TDS and U.S. Cellular websites. Please see the websites for slides referred to on this call, including non-GAAP reconciliations. The information set forth in the presentation and discussed during this call contains statements about expected future events and financial results that are forward-looking and subject to risks and uncertainties. Please review the Safe Harbor paragraphs in our release and the more extended version included in our SEC filings. Shortly after we released our earnings and before the call, TDS and U.S. Cellular filed SEC forms 8-K, including today’s press releases, as well as the SEC forms 10-Q. We invite you to join us or listen to the webcast of our annual meeting. U.S. Cellular’s meeting is on May 20 and TDS’s is on May 22. We also ask that our shareholders support our extremely qualified slate of directors and director nominees, both at TDS and U.S. Cellular. And please keep in mind that TDS has an open door policy, so if you are in the Chicago area and would like to meet members of management, the IR team will try to accommodate you, calendars permitting. Before we turn the call over to Ken Meyers, Doug Shuma will spend a few moments on the TDS enterprise level. Doug?

[Doug Shuma:]

Thanks, Jane. Turning to slide three, TDS continued to execute on its share repurchase authorization, purchasing nearly $4 million of shares this quarter. Given we were in our earnings blackout until the end of February, this represents only about one month of active repurchase. This is in addition to our nearly $15 million quarterly dividend. As we have already announced, U.S. Cellular has sold over $400 million of nonstrategic spectrum. We have said that this represented about 75% of the licenses we identified as noncore that was related to our divestiture markets. Given the significant current valuation of spectrum, U.S. Cellular is continuing to evaluate additional spectrum outside of its operating footprint that it could possible monetize beyond the remaining 25%. Lastly, we continue to move forward on the sale of noncore towers and hope to complete a sale this year. As we have said, we want to complete this transaction before we consider the sale of any noncore towers. And now, I will turn the call over to Ken.

[Kenneth Meyers:]

Thanks, Doug. Good morning. I’d like to talk to you this morning about the progress we’re making against the 2014 strategic priorities that we set forth on the last call. As we discussed, and as shown on slide six, driving subscriber growth is our top priority. This is a function of both increasing gross adds and managing churn. We are having real success attracting new customers to U.S. Cellular. Core postpaid gross additions for the first quarter increased 12% over last year, despite a slower March. Competitively, it was an intense quarter. We ran some aggressive promotions, as you can see in our loss on equipment, but these results give us confidence that our device portfolio and service plans will enable us to compete in our footprint. In fact, at this time last year, before the introduction of the iPhone, our defections research told us that device selection was the second most important reason given when customers left us. With the iPhone and other iconic 4G devices now in the portfolio, the percentage of customers citing device selection as a reason that they leave us has dropped 75%. While the sales team had success filling the top of the funnel, other parts of the organization were intensely focused on addressing churn, and we are making progress. Voluntary churn looks to have peaked in the fourth quarter. Customer service levels are now actually above the levels experienced before we started the billing conversion. While billing concerns still remain with some customers, voluntary churn, though above the levels of a year ago, has dropped significantly, and is expected to continue to improve. As we discussed on our year-end call, involuntary churn, customers we are shutting off for not paying their bills, increased late in 2013 and early in 2014, but as Steve will discuss, it has recently started to move back toward more normalized levels. In the aftermath of the billing implementation, we have been extending payment terms to allow time for customers to clear up any questions about their bills, but we are now starting to catch up on those nonpayers. We believe that we’ve worked through the majority of the collections backlog and have begun to see involuntary churn and thus total churn improve. Improved churn, combined with the success we’re having attracting new customers, will allow us to stabilize and begin to grow our customer base again. In addition to improved customer service levels, we have also made significant progress improving all operational aspects of the billing system, though more work still continues. The key is making that work invisible to our customers. As previously discussed, and shown on slide seven, our value proposition revolves around the network. The quality of our network is core to our strategy and we are continuing to invest in rolling out 4G LTE to more and more of our network to allow us to deliver the data products and services, like shared data plans, and connected devices that our customers want. Notwithstanding our loss in customers over recent quarters, the number of smartphone users on our network has actually grown. In fact, on a year over year basis, we had 16% more smartphone users at the end of the quarter. Another facet of our strategy is to really leverage our local market presence and knowledge to create a differentiated experience for our customers. We’re working to make U.S. Cellular even more relevant to wireless consumers and businesses in Wisconsin, Iowa, Maine, and Nebraska, for example. One small manifestation of this is some new advertising that is customized market by market to drive our local network quality message. We’re confident that all of these components together, with the network at the core, will make the U.S. Cellular proposition resonate with our current customers and be attractive to new customers. Looking to slide eight, in order to improve margins over time, we must turn around our subscriber results. We also must drive additional revenue growth on top of that. Getting the iPhone and other 4G devices to our smartphone portfolio has accelerated smartphone penetration, now at 53%. Our Shared Connect data plans are being well-received by our customers and should allow us to capitalize on skyrocketing data consumption. Connected devices provide an opportunity to increase data usage and thus revenue per account without significant subsidies. All of these activities are translating into additional data usage and average revenue per unit, with core postpaid RPU up 6% over last year, despite the recently volatile pricing environment. We’ll continue to adjust the pricing environment to ensure our customers get not only the best network experience in all of our markets, but also receive a very competitive value. And finally, slide nine, we will look to offset the increase in subsidy amounts caused by the costly 4G devices through programs such as the recently introduced device installment plans. All in all, we believe we have all the pieces in place to stabilize and begin to grow our customer base in 2014. As expected, headwinds related to the 4G smartphone subsidies, including the full year impact of having the iPhone, will impact profitability. Part of the impact, though, on free cash flow will be mitigated by lower capital spending, as our buildup of 4G LTE nears completion. Before I turn the call over to Steve, I’d like to share our current thinking on providing guidance for revenues and profitability for 2014. We continue to navigate significant factors that affected our ability to forecast with confidence, including the unprecedented number of pricing moves that have occurred so far this year. Looking ahead, we continue to believe there is a high degree of uncertainty around future pricing moves. Compounding that uncertainty is the elevated churn we are currently experiencing. We have aggressive plans in place to bring churn down, but cannot predict with accuracy how quickly we will achieve our desired results. Therefore, while we are getting some additional clarity, we still do not have the level of confidence to publicly disclose our reasonable range at this time. But, as we continue to stabilize our customer base, we get closer to a point of being able to reinstitute our past practices. Now, let me turn the call over to Steve Campbell.

[Steven Campbell:]

Thank you, Ken, and good morning. As stated in today’s press release, the year-to-year comparability of our first quarter financial statements is impacted by two significant transactions that occurred in 2013

[Vicki Villacrez:]

Thank you, Steve. Good morning, everyone. On slide 20, we continue to execute on our strategic priorities at TDS Telcom. During the first quarter, we launched two new IPTV fiber markets, bringing total TDS TV markets to 13. The integration of Baja has been very productive. We continue to increase broadband penetration and identify synergy opportunities, giving us confidence in our overall cable strategy. We are furthering this strategy by our acquisition of BendBroadband, which was announced yesterday. Our hosted and managed services business has been combined under the OneNeck IT Solutions brand, and we have realigned our sales force and many other operational functions. If you turn to slide 21, yesterday’s announcement of our agreement to acquire substantially all of the assets of BendBroadband is another significant step in pursuing our cable growth strategy, aimed at creating value for the long term. This strategy is a natural extension of our core wireline business, and builds on last year’s investment in Baja Broadband. BendBroadband is a provider of connectivity solutions in Central Oregon, with 2013 revenues of $70 million and over 79,000 homes past and businesses past, serving one of the most desirable and vibrant regions in the U.S. BendBroadband is a full service communications company with strong market share and penetration rates that exceed industry averages. BendBroadband has consistently invested in technology with fully upgraded DOCSIS 3.0 plant and fiber connectivity, which it leverages to serve both residential and commercial customers. Additionally, the acquisition includes a tier 3 data center, which will be operated by our OneNeck leadership team to further grow the sales pipeline and presence in the western U.S. and allow us to leverage our reputation as a trusted advisor to businesses and our extensive commercial product portfolio. We are purchasing substantially all of the assets of BendBroadband for $261 million in cash, and believe we can create significant value from the transaction. If you turn to slide 22, similar to Baja, these markets have attractive demographics, above national average household growth forecast, and strong economic development. We believe the markets served by BendBroadband will not face significant fiber competition and therefore we will have the best pipe to the home in these markets. BendBroadband has higher penetration overall than Baja, yet we believe the high quality of the services provided will allow us to capture additional market share, especially for data. Given the investment the company has made over the years, we see relatively low capital requirements, and similar to Baja, we believe we can create meaningful synergies through marketing many of our current product sets, deploying existing platforms, tools, and processes, and leveraging central resources and vendor relationships. We are excited about the opportunity to leverage BendBroadband’s talent and expertise to continue to expand and further build our cable operations. We expect to close in the third quarter of this year and will update guidance at that time. Now, before I cover the results in the quarter, I wanted to call your attention to a change in revenue reporting in the telcom financials. We are now breaking out equipment sales and the related cost of goods sold for the consolidated telcom statement in each segment. Equipment revenues are significant in the HMS segment, for which a large component of the business is the sales of technology solutions and hardware. These sales can be uneven, and have significantly lower margins. Segregating equipment sales from services will provide better visibility into the ongoing HMS operations. For the wireline and cable segment, equipment sales are primarily for managed IP equipment and are relatively small. Moving to the first quarter results on slide 23, we had a very solid quarter, with excellent results from our wireline cost control initiatives as expense reductions more than offset declines in wholesale and regulatory revenues, cable operations’ continuing steady growth and HMS producing 8% organic growth in services revenues and equipment sales. On a consolidated basis, TDS Telcom revenues increased 21%, driven from both the Baja Cable acquisition and the MSN acquisition. Adjusting for the impacts of these acquisitions, revenues were down 1% year over year, as organic growth in our HMS business nearly offset the revenue declines in the wireline operations. Adjusted income before income taxes, which is essentially operating cash flow for TDS Telcom, grew 26% year over year, or $14.9 million, to $72.6 million in the quarter, primarily driven by $9.5 million of increased contribution from the wireline operations and the $5.1 million contribution from the Baja acquisition. Without the effects of acquisitions, the business grew its adjusted income before income taxes 16%, or $9.3 million. Looking at wireline results on slide 24, growth in data and IPTV on the residential side and managed IP on the commercial side offset the decline in legacy voice services. Wholesale revenues declined 8%, primarily as a result of changes in regulatory recovery due to the reform order and lower wholesale rates, as well as continued declines in access lines and minutes of use. However, due to cost control initiatives, SG&A declined 19% or $10.9 million, and cost of services declined 3%, or $2 million, from the same period last year. As a result, operating cash flow margins improved 600 basis points, which drove a 17% increase in adjusted income before income taxes. This is the fourth consecutive quarter in which the wireline reported growth in as indicated before income taxes as the entire organization continues to stay focused on cost improvement initiatives. In the quarter, despite our very high ILEC residential broadband penetration of almost 70%, we added 2,400 broadband net adds. This growth was driven by triple play sales in IPTV markets, as well as new data services launched in our stimulus markets. We are nearly complete on our broadband stimulus project, providing service in 37 of the 44 markets. As shown on slide 25, residential broadband customers are increasingly choosing higher speeds in our ILEC, with 36% choosing speeds of 10 Mb or greater, which is up from 29% last year, driving increases in average revenue per connection. As previously mentioned, we launched two new IPTV markets during the quarter. We’ve been very pleased with the overall IPTV uptake and RPU results to date. IPTV connections grew over 75%, adding 6,900 subscribers compared to the prior period. In our newer fiber markets, we are offering up to 300 Mb data speeds. 97% of our IPTV customers are taking a triple play bundle. In the table on the right, average revenue per residential connection increased 2%, primarily reflecting increases from the IPTV rollout and price increases for data services. On the next page, our commercial voice and data communications solution managed IP increased connections 27% year over year, resulting in commercial revenue growth of 1.5%. As you look at the cable segment on slide 27, these results reflect Baja’s second full quarter operations, which was acquired on August 1, 2013. We are pleased with the results to date. In the eight months, we’ve owned Baja, we’ve seen annualized growth exceeding 10% in both voice and broadband connections, more than offsetting the decline in video connections. Additionally, we’ve seen household growth in the market of 3%. As a result of the customer growth, revenues increased to $22.5 million from $21.5 million in the fourth quarter of 2014. Expenses include one-time costs associated with cost reductions resulting in adjusted income before income taxes of $5.1 million, which is on plan. Turning to the HMS segment, on slide 28, we are pleased with the 8% organic growth in our services revenue, which includes colocation, cloud, application management, and managed hosting services. Organic growth in equipment revenues also increased 8% in the quarter. The acquisition of MSN, our Denver-based solutions provider acquired on October 4, 2013, increased revenues by $25 million and expenses by $24 million. As slide 29 shows, 2014 guidance is unchanged from our year-end call. As a reminder, we will update 2014 guidance for the BendBroadband acquisition when it closes. I’d like to close by reiterating how confident we are in the portfolio of companies we are operating today at TDS Telcom. We believe our wireline business can generate consistent cash flow and provide expertise and infrastructure to build our cable business. We are thrilled to be adding BendBroadband to our family of companies. We look forward to continuing to grow BendBroadband’s business and executing on our strategy to expand our cable operations. Our HMS segment is positioned to capitalize on the successful integration of the five companies we have acquired to generate strong revenue growth and increasing profitability. I will now turn the call back over to Jane.

[Jane McCahon:]

Thanks, Vicki. Operator, we’re ready for questions now.

[Operator:]

[Operator instructions.] Our first question today is coming from Simon Flannery of Morgan Stanley.

[Simon Flannery:]

Just had a quick question around the iPhone. Can you give some additional color around the impact to underlying trends such as churn, gross adds, and what you’re seeing on RPU as well?

[Kenneth Meyers:]

I’m not going to break out RPU by phone or churn by phone, but what I’ll tell you is that that was one of the components that has significantly both changed the churn profile. As I said, about this time a year ago, before we introduced it, device selection was the second biggest reason given when we were doing our churn analysis, and that has fallen by 75% over the last year. And that, along with the other 4G LTE devices that we’ve added to the portfolio, all the different smartphones that are out there are clearly the driver to now the 6% year over year increase in RPU, so we’re very happy with its position in the portfolio. It’s about 30% of our smartphone adds right now, and that’s a very nice place for it to fit, neither so big nor insignificant, just one of quite a few very good products in that area.

[Operator:]

And our next question today is coming from Phil Cusick with JPMorgan.

[Phil Cusick:]

First, on the Bend deal, can you tell us if that was a competitive deal? And is it reasonable to assume sort of a 30% to 40% margin given the penetration and the business mix pre-synergies?

[Doug Shuma:]

Yes, it was competitive, and it’s reasonable to assume 30% to 40%.

[Phil Cusick:]

And there should be some level of synergies over and above that?

[Doug Shuma:]

Yes.

[Phil Cusick:]

And then on the churn side, I love that slide 11. Is it fair to say that churn continues down from here?

[Steven Campbell:]

That is the expectation. That’s what everybody is absolutely working on, and we continue to bring that down along with the very nice uptake we’ve seen in gross add. That’s the formula to change the trajectory on the customer growth.

[Phil Cusick:]

If you look at the involuntary churn, at what point do you feel like you’re through that cutting people off who aren’t paying bills? Is Q2 more or less the end of that?

[Steven Campbell:]

Yeah, pretty much the stuff that we’ve looked at says about the end of it.

[Phil Cusick:]

And if it weren’t for that high end voluntary churn, would adds have been positive this quarter?

[Steven Campbell:]

I didn’t do the math. I’d have to take a look at it. I don’t want to speculate.

[Phil Cusick:]

And last, what are you seeing in terms of competitive pressure? There’s a lot of pricing actions out there. That gross add trajectory seems very good, but are you starting to see any weakness there given the overall competitive environment?

[Steven Campbell:]

You’re right, it’s very competitive. And in fact, what we saw was we started off the year hot, and we actually pulled back some promotional activity in March to really see how hungry was the market, how much is it promotional? And the answer is, it’s all promotional. We pulled back and as I said, we were really set. We were above the 12% in January and February, or 12% for the quarter, after a slower March. Going forward, what we’ve said is we will make sure that we stay competitive with our pricing and promotions, but what you’ve got going on right now is you’ve got a unique market where the actual [switcher pool] looks to have opened up more. So we’re going to be active in it.

[Operator:]

[Operator instructions.] Our next question today is coming from Sergey Dluzhevskiy from Gabelli & Company.

[Sergey Dluzhevskiy:]

For the [unintelligible] buyback, you mentioned basically it represents only one month of buybacks, essentially, because of the blackout period. Could you let us know what the average length of the blackout period is, and whether it was longer in Q1? And also in general, is this a good level of quarterly buybacks, or is it going to be somewhat higher? Because I remember last quarter you indicated that your buyback was somewhat modest, and this quarter it was at about the same level.

[Doug Shuma:]

Typically, when we get to a quarter, we’ll have what’s called a 10b-5 in place that allows us to continue to purchase through the blackout. That was not in place at year-end, for various reasons. So typically we’ll buy throughout a quarter. As far as what we can expect in the future, we’re going to continue to be in the market at the right times. I don’t know if I can give you a number as to how much that will be, just given I don’t know what the market conditions are going to be.

[Sergey Dluzhevskiy:]

Was the 10b-5 not in place because you were looking at BendBroadband or was there any other like legal reasons that prevented you?

[Doug Shuma:]

Yeah, I’m not going to answer that question, Sergey.

[Sergey Dluzhevskiy:]

Okay. One question for Ken on the wireless side. Could you share your thoughts and expectations for the AWS3 and broadcast spectrum auctions, particularly in light of Chairman Wheeler’s recent proposal of a two-faced broadcast spectrum auction where some spectrum is going to be reserved for players with low band spectrum holdings? And also, given your current holdings and network roadmap, which spectrum do you think is a better fit for you?

[Kenneth Meyers:]

Complex question. Let me try it at a couple of different levels. One, I fully anticipate that we will be at both auctions. What exactly the outcome will be is a function of structure, which quite frankly is still moving. It was a pretty thoughtful proposal that went out there. A lot of people have got a lot of different oars in the water on this one, and I think there’s still movement on it. So it’s really difficult right now, while the rules are still evolving, to have any specificity around exactly where we’ll play and how, much like other auctions. A certain part of this is definitely a make versus buy decision. It’s about how do we deliver to meet the future demands in our markets. In some cases, we can do it with network assets as opposed to spectrum. At the right price, the spectrum assets may be a more effective delivery mechanism. So right now I can’t give you much more than that. Yes, we like the combination of having low band spectrum and high band in each market in order to aggregate those going forward and get the most out of the speeds. And I think we’ve made a lot of progress in that area. That’s about as far as we can go right now.

[Sergey Dluzhevskiy:]

And I have a couple of quick questions for Vicki. First, on the BendBroadband side, part of the business is essentially a data center business and also there is a broadcast business as well. Could you share with us what percentage of revenues is from data center services or from noncable services out of those $70 million?

[Vicki Villacrez:]

Yes, the purchase price did include value for a data center and cable advertising and broadband business. But cable is the majority of it. We’re not breaking out the components of that at this time.

[Sergey Dluzhevskiy:]

And on the HMS side, obviously you broke out equipment revenues and the expenses starting from this quarter to highlight service components. But still, even if you look at the service, the margins are probably still below the levels you would like them to be. Could you talk a little bit, at what point do you think there’s going to be an inflection point in margins on HMS, and what are the steps you are taking to improve those margins over time?

[Vicki Villacrez:]

Good question. As you know, we’ve acquired our five companies. We have rebranded under one banner OneNeck IT Solutions. And we’ve been in the process of integrating the five companies and working to achieve synergies, both from a top line and an expense standpoint. I do expect profitability to improve over the latter half of the year. And we’re looking to grow that substantially from where we’re at now. And we are looking for higher margins in our service revenues as we achieve these synergies.

[Operator:]

Our next question today is coming from Rick Prentiss with Raymond James.

[Rick Prentiss:]

Ken, first, appreciate the color on the churn chart. I agree with Phil, that’s a very important chart that you’re watching, and we are. Were there any tablet sales in the quarter? Because obviously, as we watched all the other carriers in the market report, a lot of carriers relied on tablets to get to positive adds. Do you have tablets in your mix? And what do you think the future of tablets might be for you?

[Kenneth Meyers:]

We do have tablets in the mix. Quite frankly, they’re a relatively small part of our business right now. That’s because they really got introduced late in the fourth quarter, with the iPad, but that was very constrained in terms of inventory. If I think about it, we’re talking about measuring in the thousands of units. Single digit.

[Rick Prentiss:]

One of the other macro trends in the industry, and you guys have launched it now, the device installment plans. What have you seen in the first several weeks? I know it’s early, but when you listen to the other carriers out there, I think they were quite shocked with their initial thought of how much people would go to the equipment plans and how much they’ve seen a few months later. So maybe just an early indication from you of what you’re seeing and is it kind of surprising so far?

[Kenneth Meyers:]

I really hate, two weeks into something, to try to draw a lot of lines off of it. The way that we’re approaching it is we think of ourselves on the distribution side as being a retailer, and making sure that we’ve got all the different product a consumer wants, and then working with them to make sure they get the right product. So we will continue with the subsidized model, and we’re offering the device financing at the same time. And you know, when we get to the second quarter, we’ll have three months of data that we can really talk about. I mean, there’s nothing that I see that is worrisome at this point in time, but just too early to try to give you a whole bunch of color on it.

[Rick Prentiss:]

And just to help us think through it going forward, I kind of think it’s one of the more complicated accounting issues we as sell side folks have faced. How should we think about modeling this going forward? It’s helping most people, the EBITDA, because of the way you get the revenue in, but you don’t have the subsidy. Maybe I’m just silly, but it seems pretty complicated.

[Steven Campbell:]

I think it is pretty complicated, and you know, we’re working through our close rate, where we’re trying to nail down all the specifics with our auditors to make sure we’re all aligned. But the current expectation is that on a 24-month device installment contract that we would recognize about half of that, or about 12 months of revenue up front, along with an estimate of the trade in value if the customer elects a trade in program. Of course, you’ve got, on the cost side, the full cost of the device at that time.

[Rick Prentiss:]

And I guess one of the things we get a lot of questions on is how are carriers going to get smart on trade in value assumptions, uncollectable assumptions? There’s a lot of moving pieces in becoming the financier of equipment. It helps EBITDA, it stresses cash from the working capital standpoint. Have you guys got enough intel do you think, on trade in value allowance, etc.?

[Kenneth Meyers:]

Well, I think going in, we will obviously make estimates around all that. My expectation is that our estimates will be conservative, and that we will actively manage the risks on both sides of it. But that little question right there, that’s the big issue, 12 months from now, that we’re going to see a lot more visibility to. And we will wind up, probably, taking a little bit more of that cost up front to make sure that we don’t have a surprise on the back end. But that’s one of the things the finance team’s got to manage going forward.

[Rick Prentiss:]

And a quick question on the auctions. What is your understanding as far as when you would be applying to participate? You mentioned you anticipate participating, the rules are kind of in flux. But when do you anticipate you would turn in an application, you’re going to participate in AWS3, and when would you turn in an application for the broadcast auction? Are there firm enough dates to kind of see when those are?

[Kenneth Meyers:]

I’ll give you my estimate on the first one, which is summer for AWS, and I’m not going to make an estimate on the other one, because I think there are not only questions around the complexity of that auction and everything else, but there’s also an increasingly crowded - or at least sounds like an increasingly crowded - regulatory agenda that’s getting built. And how all that stuff moves over the next couple of months is anybody’s guess.

[Operator:]

We have reached the end of our question and answer session. I’d like to turn the floor back over back over to management at this time.

[Jane McCahon:]

I’d like to thank everybody for their participation today, and please call us with any follow up questions. Have a good one.