Verizon Communications Inc. (VZ) Q2 2010 Earnings Report, Transcript and Summary

Good morning and welcome to the Verizon second quarter 2010 earnings conference call. (Operator Instructions) It is now my pleasure to turn the call over to your host, Mr. Ron Lataille, Senior Vice President, Investor Relations of Verizon.

Good morning and welcome to our second quarter 2010 earnings conference call. Thanks for joining us this morning. I'm Ron Lataille. With me this morning is John Killian, our Chief Financial Officer. Before we get started, let me remind you that our earnings release, financial statements, the investor quarterly publication and the presentation slides are available on our Investor Relations website. This call is being webcast. If you would like to listen to a replay, you can do so from our website. I would also like to draw your attention to our Safe Harbor statement. Information in this presentation contains statements about expected future events and financial results that are forward looking and subject to risks and uncertainties. Discussion of factors that may affect future results is contained in Verizon's filings with the SEC, which are available on our website. This presentation also contains certain non- GAAP financial measures. Reconciliations of these non-GAAP measures to the most directly comparable GAAP measures are also on our website. On a GAAP basis, we reported a net loss for the second quarter of $0.07 per share. These quarterly results include a total of $0.65 of non-operational or one-time charges which are listed on slide four. The largest items relates to the recognition of costs in connection with our wireline force reduction initiative primarily for severance, special termination benefits and pension charges. These costs totaled $2.3 billion pre-tax and resulted in a charge to earnings of $0.52 per share. Roughly $1 billion of the pre-tax amount is for additional severance liabilities as a result of the enhanced incentive offer. The remaining $1.3 billion of pre-tax costs are non-cash and relate to the recognition on special termination benefits and pension plan liabilities for the effective employees. We also incurred non-operational costs in connection with the…

Thanks, Ron, and good morning everyone. Before we get into the details, let me start with some brief comments on the business overall and add some of my perspective to our second quarter results. Our results show that we continue to do a good job executing in our key focus areas. In terms of cash generation, we had an exceptionally strong quarter of cash flow growth with continued tight controls on capital spending. We saw a good customer growth in wireless where data revenue growth continues to be driven by smartphone sales to both new and existing customers. As a result, we saw increasing year-over-year growth in postpaid ARPU and improvements to our industry-leading customer retention metrics in this quarter. In wireline, our EBITDA margin improvement was driven by cost reductions. During the quarter, we had approximately 11,000 volunteers for our enhanced separation offer in the East and Mid-Atlantic regions. So this will go a long way toward helping us achieve our wireline force reduction objectives for the year. Broadband and video continue to drive revenue results within the mass markets. Revenue trends in global enterprise improved again this quarter and showed positive year-over-year growth. And while we are seeing stability in underlying trends in the enterprise space, we are still seeing cyclical effects and remain cautiously optimistic with regard to a more meaningful economic recovery. Lastly, we completed the pending transactions that were part of our overall strategic transformation. During the second quarter, we closed the sale of the 105 markets we were required to divest as part of the Alltel acquisition in 2009. And on July 1, we completed the access line spin-off in merger transaction with Frontier. Through the spin-off, Verizon shareholders received $1.85 per share in value in the form of Frontier shares and cash in…

Thank you, John. Brad, if you could open up the lines for questions?

(Operator Instructions) Our first question comes from John Hodulik of UBS.

I guess, John, first maybe a follow-up to some of the guarantees you just gave. So I'm doing the math right; it would sort of suggest that on a non-pro forma basis, you are talking in the 220 to 226 range for 2010 and on a pro forma basis more like 208, 209 to 214. These are sort of quick numbers. But I guess given the 5% to 10% range, is that sort of in the ballpark. UBS.: I guess, John, first maybe a follow-up to some of the guarantees you just gave. So I'm doing the math right; it would sort of suggest that on a non-pro forma basis, you are talking in the 220 to 226 range for 2010 and on a pro forma basis more like 208, 209 to 214. These are sort of quick numbers. But I guess given the 5% to 10% range, is that sort of in the ballpark.

If you take, John, the first half earnings of the $1.13 and then I indicated that you strip out the impact, so if you look at the Frontier contribution, that's in the range of $0.08 to $0.09 in the first half of the year. Trust properties are in the range of $0.03 to $0.04. Combined, it's about 12. So if you strip that away, it's $1.01. What we are saying is we will grow 5% to 10% off of the $1.01.

So $1.06 to $1.11 and that you add that back to the $1.14.

You're doing the math and you can make it work. And add that to the $1.13 in the first half of the year, and you'll get to a range.

I guess my real question is around margins. On the wireline side, you had some nice performance in the quarter. You went through some of the issues there. I know you don't have pro forma out yet for the deal. But given the progress you've made on the cost saving side, are we still expecting about 200 basis point decline in margins on a sequential basis or does some of the cost savings continue to kick in and maybe sort of offset some of that impact on the second half?

We will be putting pro forma result out, as we've mentioned, late August early September. The initial impact as you strip out Frontier is around a couple of hundred basis points. Now, as we've said on the call and we've said on past calls, within the wireline business, we are extremely focused on driving costs out of that business. We had very strong performance in the second quarter. I had indicated on the first quarter call that we thought that was the case. Force benefits, sequentially we had some wage-related savings principally on the over-time side. We did not see any of the benefit really in the quarter from the 11,000 force reduction that we've got with the associate offer. So most of the individuals who went off in the second quarter were late in the quarter. We had some more in early July. That was a little over 7,000 of the 11,000 went off there. We should see those benefits in the second half of the year. So we believe we can improve wireline margin in the second half of the year off of the pro forma wireline margin that we'll be putting out, and we feel good about those initiatives. Every cost line is being attacked in the wireline business; our third-party access cost, our telco cost, our big area of focus, obviously all the headcount items are a strong area of focus. We are seeing improvements in real estate expense. We have vacated some buildings. Most recently, we terminated the lease in Philadelphia on 1717, Arch Street which was a fairly sizeable commitment for us. So we think we have a lot of opportunity to drive cost reduction on the wireline side.

Your next question comes from Mike McCormack of JPMorgan.

Congratulations, Ron as much as I might be selfish, I hope to hear you in October as well. John, on the wireless margin side, can you just give us some sense on what the drivers are for cost reduction? Obviously a very strong net add quarter, gross adds pretty flat sequentially. Looks like a pretty good take-down in SG&A. Is there some part of that that come out with divested property, and what should we be thinking about for a good run rate there? And then secondly, with the Vodafone issue looming at some point maybe next year or 2012, wireline CapEx, looks like it's down year-to-date about $1 billion year-over-year. How far can we get that down over the next year or so?

Okay, Mike, couple of thoughts for you. Clearly, I think you can see from the call that our wireless business is really firing on all cylinders. And we think there is substantial opportunity ahead of us to continue that performance. We are in the early innings of wireless data with only 20% of our base having a smartphone, and then with LTE a whole set of opportunities around video. So we think there's a lot of opportunity to accelerate top-line performance as we go through the second half of the year and into 2011. Now, couple of thoughts for you. The wireless team is extremely focused on all areas of cost. If you look actually at the headcount, they are down year-on-year about 8,000 people. Now a couple of thousand of those are related to the trust properties. There's a little bit of other ones in terms of leave of absence, those kinds of things. But net-net, we're down 4,000 to 5,000 people. They have a series of initiatives within the wireless business that's focused on their distribution side of the business. That's driving more efficiency, more online transactions. Again, an area where we think we are very early in the process of driving that out. Another area that they have a lot of attention is all of the cost and expenses around managing supply chain inventory levels and just the whole process there. So, you know, just about every area of the wireless side. Again, like wireline, they are attacking the underlying cost structure. We are very pleased with the margin performance in the second quarter, and think we are in a good position to continue to drive both growth and profitability in that business.

Okay. And on the wireline CapEx?

On the wireline CapEx, we indicated Mike, our guidance was 16.8 to 17.2 for the full year on CapEx. You can see in the last two quarters, we have had a big shift where more of our spending is going to wireless than wireline. So we are taking wireline down this year. I expect that trend to continue as we go into 2011. I think we can take another fight out of it down next year. I'm not going to size that right now, because we're early in the process. But I think our overall CapEx spending, as we look at 2011 will be down from where we are today, although we will keep a pretty strong allocation to the wireless side. As you know, the wireless side being fueled by LTE and by data.

John, your comments on the wireless SG&A side, it sounds like the bias would be towards flat to down on SG&A for the balance of the year.

Very focused on driving more and more cost out the wireline side on SG&A; absolutely. And on the back of the 11,000 volunteers we had on our East Associate offer, I should mention that we are going to do some additional offers in the rest of Verizon in the second half of the year in our, what used to be the West, which is really California, Texas, and Florida. So we would expect to get some additional force reductions from that.

Your next question comes from Simon Flannery of Morgan Stanley.

On the dividend outlook, you've always had some strong cash flow performance. You've got a positive outlook for the second half of the year. But on the other hand you also distributed a dividend, effectively with Frontier with a lot of cash generation. So how should we think about your upcoming decision in September around continuing that annual dividend increase, or are there some sort of one-time factors this year? And then we've had AT&T with tier data pricing. You've got a lot of smartphone load now. LTE is coming up. What are your current thoughts on tiered data pricing?

So, Simon, just a couple of thoughts for you. Yes, cash flow is tremendously strong, better in the quarter than even we expected. The team has a tremendous amount of effort and attention there. It's driven principally from operating performance. A part of that was, I hope you noticed, the working capital benefits, because the operating team is very focused on managing inventory levels and all of your days sales outstanding, all of the components that drive cash flow in the business. And I think we're performing extremely well here. So on the dividend side, as you know, that's a Board decision. The Board will consider that in September. I think we put them in a position where they have some pretty good alternatives there from the dividend perspective given the cash flow performance. But at the end of the day, that will be their decision. On pricing, we're performing extremely well right now. If you look at our data revenues this quarter, they're up about 24% year-on-year. If you look at data ARPU for our postpaid base, they're up over 19%. Again, as I said to you earlier, a lot of upside potential there given where we are on smartphones and multimedia devices in the future. We have indicated in the past, as we move to an LTE world and LTE pricing, we will probably look very hard at tiered pricing, and that continues to be our thinking right now. So more to come on that. By the way, I should say that all of our assets, all of our plans on getting LTE launched in the fourth quarter are on schedule. We feel very good about that. We think that's going to open up the whole new set of opportunities to continue to grow this wireless business that is again performing very well.

Your next question comes from David Barden of Bank of America.

John, first, could you talk a little bit about the one part of the wireless that seemed to be maybe a little on the soft side, which was the retail prepaid? It seems like you guys have kind of transferred the economics of being a retail prepaid provider in wireless over to your wholesale relationship with TracFone. That relationship has been on for a year now. I was wondering if you could kind of talk to us about your takeaways and some of the experiments you're doing with the $50 unlimited plan in the Southeast.

Dave, overall from a growth perspective in wireless, I'm very satisfied, 1.4 million net adds. On the last quarter call, a lot of people were suggesting that the postpaid market was coming to its end. And we thought there was still a lot of life there for Verizon and we did a lot better in the second quarter than we did in the first quarter. So we feel very good about our position in the postpaid marketplace. That is our prime strategy. The device lineup [roll] and his team have done a tremendous job with the device lineup. The whole DROID franchise is performing extremely well. We introduced the Incredible, as you know, in the second quarter. We just launched the DROID X. There's more devices to come. So we think our handset lineup is very well positioned. Now we've also suggested that we decided to play more of the prepaid marketplace, not exclusively. We have our own prepaid offerings that have benefits in terms of handsets and customer service, but that we were playing more of that end of the market through the reseller opportunity. By the way, not just the Straight Talk offering. There is several different resellers, and we've been very satisfied with that. I mean it's fueled some nice growth for us as we've gone through the past year. The ARPU levels run significantly higher than the traditional reseller offerings we have had. The profitability from the tiered margin percentage basis is pretty good, because you don't have the marketing cost and a lot of the SG&A. So we think that strategy has worked well for us, and we're continuing to do that. There's always some seasonal fluctuation there from a reseller model. Now, on the prepaid offering that you said, it's just a trial in the South. It's targeted to a specific geographic area. There's not a plan at the moment to bring that nationally. From time-to-time, our e-readers do different things to see what kind of reactions, kind of experiments, and that's what that is all about, nothing more than that.

If I can just follow-up on the tiered pricing also, obviously you had a good quarter in postpaid. The new iPhone and the pricing changes came out at the end of second quarter. Now that you've had some time to assess the market and what the tiered pricing plan has been for AT&T versus you guys now without it, how compelling an offer do you feel it is, how competitively imperative is it that you do something along those lines? Or is it mostly just a capacity management.

It's very early days since that change went in. What I would tell you is our business continues to reform extremely well. Our smartphone lineup is being very well received. Our DROID lineup, we have been keeping the DROIDs in stock, by the way. We don't have a big supply problem here. There's a little bit of a delay in fulfillment, but we're in a good position there. So our business is continuing to perform extremely well, you haven't seen us rush out to make any kind of a change. We'll continue to monitor the situation of course and look at opportunities that will say what's the best equation for us to drive long term shareholder value and we'll be very focused on that. I can't say enough though about the opportunity we see ahead given where we are today with smartphone penetration. I mean I think 20% of our base today, where's that number going, ultimately is it 80%. Some people could argue everyone is going to have a smartphone ultimately, because that's the kind of device that's going to be. So I think there is tremendous opportunity to continue to drive and create value through Verizon wireless.

Your next question comes from Michael Rollins of Citi Investment Research.

Just wanted to follow on the cost side, I think it was the last call. Started to decide the opportunity for cost cutting over the next two year and if I remember correctly, it was the comment was at least $1.5 billion to $2 billion. Based on the efforts you've made in the second quarter, can you give us an update in terms of the size of the opportunity and what percent of that you think you can realize in 2010 versus 2011?

So, Mike, I'm not going to resize the number for you. What I would tell you is, is our confidence on the ability to drive cost out of the entire business, both wireline and in the wireless business too, has never been stronger. I mean I think we've come off a quarter where we've had very good performance. If you look at our business year-over-year, we're down about 24,000 people in total from an absolute basis, a big chunk of those coming out in the first half of this year, more coming out in the second half of the year. By the way we also transferred a little over 9,000 people with the Frontier transaction that we just completed. So I think we're in a very good position. The organization knows how important it is to resize the cost structure. So we feel very confident about our ability to do that.

Your next question comes from Jason Armstrong of Goldman Sachs.

Maybe a couple of questions, first on enterprise trends, the results seem to indicate share shift in your favor. I'm wondering, you obviously talked about the macro, but can you talk about what you're saying in the competitive marketplace? And then maybe second question just on wireless ARPU, good progress on post paid ARPU growth, accelerating the rate of growth as you moved up to 1.2%. But with the device refresh you got going on, it seems like we have a lot more upside. So I'm just wondering if you could talk about the trajectory from here and we can see at least one tier in the industry approach 4% growth, do you think that's realistic for you?

Okay. Jason, a couple of thoughts for you, I mean yes. Enterprise we had better performance this quarter on a reported basis we were up which was very good. Now we had a couple of things that helped us there, we had a very strong CPE quarter. A lot of demand for equipment out there, which is good, I mean it drives some margin. We are doing some pricing change on the CPE lineup. We did a late second quarter early third quarter to drive a little bit of margin that might temper down the volume just a little bit as we go through the third quarter. When you underlie and strip out CPE and some of the other things, we did see improved performance in enterprise although it was still a little bit negative year-over-year. I wouldn't say we're seeing any big change from and economic standpoint at this point. I think you're hearing that from every call that's out there right now as maybe in the first quarter there was a little bit of an uptick with everything going on in Europe and other issues that's probably been a little bit of a pause in terms of purchase decisions. Right now we're hoping that will pick back up in the second half of the year, but from up here enterprise perspective, we were pleased with our performance in the quarter, but we have a little bit of caution as we go through the rest of the year in, again why it's so important to drive more and more cost out of the business, but at the same time very focused on driving more profitability in enterprise. In fact, as I look at our deals we signed in the second quarter versus the first quarter, margin was up about 250 basis point on those deals quarter-to-quarter. So I think that was a very good sign. From a wireless post paid ARPU, we think there is upside as we go through the next couple of years. our smartphone line up if you think about it over the last year we solved the problem with the DROID franchise where we were a little bit behind in terms of the smartphone lineup that is paying dividends for us right now. We expect those dividends to accelerate, that our lineup is going to do extremely well. I would love to see 3% to 4%, I think we will get better. I think the other company that you indicated, they do have a higher concentration of smartphones in their customer base than we do today. But that gap is going to close, because we've got great devices, great lineup and of course our distribution is a machine quarter-after-quarter. So I think you're going to see improving performance there. And it just comes back to the issue I said earlier is we believe there is tremendous opportunity to continue drive shareholder value in this business field principally on the wireless side.

Your next question comes from Brett Feldman of Deutsche Bank.

First of all, I just want to congratulate Ron on the great opportunity and wish you well. Just want to go back quickly here to wireless margins. You gave a lot of color earlier about what you're doing particularly on the cost management side. You come in there I think at an all-time record this quarter in terms of EBITDA margin. And I just want to get a bit more color on what the ultimate goal here is. The cost savings initiative, is that designed to help you guys sustain what is a margin level that may be 200 to 300 basis point higher than normally people would have expected? Or are you really just trying to create capacity so that you can keep your foot on the gas in terms of driving data in terms of incurring the subsidies that you would get from higher smartphone sales and maybe the higher costs you're actually going to incur from running the LTE network?

I think from a wireless perspective, we've always been a very balanced company in terms of not just looking at top-line, not just looking at growth, really looking at all the levers to drive shareholder value. We still are in the same place. Since I've been on this job, I've said I think there is opportunity to continue to grow the wireless business very nicely. And we think growth is going to accelerate. We think there is not going to be a deceleration in growth. There is actually going to be a next wave fueled by data and video where growth is going to get better. But at the same time, we have the opportunity to take costs out of the model and become a more efficient provider. And Lowell and his team are extremely focused on that. So I like our position here from the wireless perspective and where we have the ability to go.

You're doing a great job in smartphones. You're a little bit over half of your sales in your direct channel now or smartphones or other integrated devices. But based on your lineup, you can easily see that at 70% or 80% and notch it just in future. You're probably going to be incurring some additional costs as you get ramped on LTE. I am just trying to set expectations here in that should we assume that at some point that might create a little bit of incremental pressure on the margins or do you really feel comfortable the way you've done from the cost management side and kind of keep things in a range even as you ramp in those areas?

I feel very comfortable that we can both grow the top-line of the business and just continue to deliver the industry-leading profitability that we have delivered. There is no question there is going to be a higher take-up of smartphones and multimedia devices, but we're very well positioned for that. There is also a nice return from that, because they are higher ARPU-based customers. So I don't think anyone's network, anyone's distribution is better positioned to take advantage and drive it to the bottom-line than we are. And we're very focused on that.

Your next question comes from Tim Horan of Oppenheimer.

John, sort of beating the dead horse here, but one of your major competitors, when they started rolling out smartphones, they saw the margins getting depressed quite a bit. You're not seeing that now, and it sounds like you don't expect to see that. Is it because the DROID maybe has a lot lower subsidy than the DROID lineup than some of the other high-end smartphones are our there? And on that point, it sounds like you're saying that you're not going to see any supply chain problems with the DROID lineup in the second half of the year. Could you maybe just comment on that? And then just lastly, can you give us a bit of a regulatory update? Are you guys talking to the SEC about ways to avoid the Title II regulation discussions that are ongoing?

Because smartphone devices cost you more money, COGS is up. It's a nice trade-off here. And if you look at our machine in terms of what we built over time, we have the ability to manage that and absorb that and still drive good margins. And we believe we can. Now, if we had one quarter where we had 3 million DROID net adds, there is probably going to be a little bit of an impact, but I would take that impact because of what it's going to do ultimately for value and shareholder value. So we're focused, as we've always said, both on growth and profitability. We will continue to be focused on that. We are taking costs out of our supply chain process and we will continue to do that. We're managing inventory levels extremely tightly, which is appropriate. From a supply chain perspective on supply of smartphones, we need to manage through it, which we are. These are kind of global issues with certain devices, but we're in a good position here. We think we can fulfill the requirements we have as we go through the second half of the year. We're working extremely closely with all of our manufacturers, and we think we're extremely well positioned. The other comment I'd make, Tim, on the Washington front, yes, we're actively engaged, including Ivan and Tom Tauke and Randy Milch on all of the issues, both with the policymakers as well as other industry participants. We'll continue to watch this, and we're optimistic that this will come out in the right place for us and for the industry. But time will tell on that. So not a lot more that I could comment on there right now. We did complete the Frontier transaction. I know you're all anxious…

Thank you very much, John. And, Brad, that concludes our call today, and thanks everybody for joining us.

Ladies and gentlemen, that does conclude the conference for today. Thank you for your participation and for using Verizon Conference Services. You may now disconnect.