Verizon Communications Inc. (VZ) Q3 2010 Earnings Report, Transcript and Summary

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

Good morning and welcome to our third quarter 2010 earnings conference call. Thanks for joining us this morning. I'm John Doherty. With me this morning is John Killian, our Chief Financial Officer; and Fran Shammo, who will be assuming the CFO role on November 1. Before we get started, let me remind you that our earnings release, financial statements, 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. As I'm sure you are aware, we published reclassified historical financial information for the past six quarters for the results associated with the Frontier transaction, as well as the divested wireless trust properties. In addition, we reclassified prior period wireless results for the deferred revenue adjustment that we recognized in the second quarter of 2010. The financial and operating metrics included in our slides are therefore presented on a comparable basis. However, on the balance sheets and segments of cash flows, prior periods were not reclassified for the impact of the divested properties. On a GAAP basis, we reported earning of $0.31 per share in the third quarter. These quarterly results include a total of $0.25 of non-operational charges, which are listed on Slide 4. The largest item is a non-cash charge of $0.19 per share relating to the recognition of pension settlement losses resulting from our workforce reduction and separation plans. Pension accounting rules require that settlement losses be recorded, once prescribed payment thresholds have been reached. In connection with the closing of the Frontier spin-off, we also incurred a charge of $0.04 per share for certain non-operational and transaction related costs. The last item is merger integration costs related to Alltel. During the third quarter, charges related to these activities amounted to $0.02 per share. With that, I'll now turn the call over to John Killian.

Thanks, John, and good morning everyone. Before we get into the details, let me start with some comments on our overall performance and add some of my perspective to our third quarter results. The business is performing extremely well. We had another solid quarter, and we continue to execute well on our key focus areas. We had strong earnings performance in the quarter, showing sequential improvement. On our last conference call, I stated that our goal was to grow earnings in the second half of the year by 5% to 10% from our first half adjusted base of $1.10 per share. Our third quarter results indicate that we are on track to meet this goal, and expect to be at the high end of this guidance. Wireless had a very good quarter, with accelerating revenue growth driven by strong postpaid ARPU accretion. New customer additions and device upgrades once again resulted in higher smartphone sales and drove data revenue increases. And we sustained our wireless EBITDA margin of 47.2%, which remains by far the highest in the industry. In Wireline, we continue to make steady progress. We had a very strong quarter of customer growth in FiOS with our third consecutive quarter of sequential improvement, adding more than 200,000 new customers in both TV and Internet, our highest net add totals since the second quarter of 2009. Revenues in global enterprise were stable, showing modest sequential improvement. And while the wireline revenue picture is essentially unchanged, we were able to improve our EBITDA margin on sequential basis, coming in more than 20 basis points higher than last quarter at 21%. We'll talk more about this in a few minutes, but we feel confident that our workforce and other cost reduction efforts have stabilized wireline profitability, and we should continue to…

(Operator Instructions) Our first question comes from Jason Armstrong of Goldman Sachs.

Couple of questions maybe first on wireless ARPU. The fourth quarter we've seen an accelerating postpaid ARPU growth. I'm just thinking, through these increases in smartphone penetration, which seem to really give you a good runway for further improvements in the rate of ARPU growth from here, I am just wondering if that's how you would think about it as well. And then, second question on FiOS. Good uptick in both FiOS, video and data adds. When thinking about the increase, can you just help us think through, is this attached to seasonal, is it the no contract moves that you've made and ultimately I thing what we're trying to get to is, is this kind of a new level that we should use as a run rate going forward?

I will take the first part of the question on ARPU, and then Fran will cover the FiOS performance. We are very pleased with what's happening with ARPU. When you look at our postpaid ARPU this quarter, we were up 2% from the third quarter. If you look back the last four quarters, fourth quarter '09 we were flat. We went to DOCSIS in the first quarter, we went to 1.5. And you all have seen that I have had on these clauses, we believe there is a lot of upside ahead of us and we have great ability to grow postpaid ARPU because of the explosion in smartphones. We've put a lot of energy, Lowell McAdam, John Stratton, Dan Mead, their team, on enhancing our smartphone portfolio. We've had great success over the last year with the DROID franchise and the Blackberry lineup and others, but we're in a much better position. But the good news here is only 23 % of our customers today have a smart phone. That's up from 20 last quarter. So you think about this I don't know where it's going to end up, but personally I think we're going to look some day back and say 70% to 80% of your customers are going to have a smart phone. So we think there is tremendous opportunity here. And you know better than I do, Jason, smart phone customers spend about double what a feature phone customer spends with you. We also believe on the feature phone side, more and more customers will buy some data plans over time even before as they are getting used to data on the wireless side. That'll start with a plan on a feature phone. So we think there is tremendous opportunity here to grow topline in the wireless business. And you can see that coming through and accelerating revenue growth in the wireless business. Fran, I'll turn to you on FiOS.

So to talk about the FiOS ads and the broadband ads, we are very pleased with the strong performance that we had this quarter. If you look at some of the questions you asked, Jason, on the no contract, as John has spoken in the past, in the MDU space, we were underpenetrated there. We have made a lot of moves, including the no contract. But we also made a move on the contract where we offer Worry Free Guarantee similar to the wireless side of the house. But if you're not totally satisfied, we will let you out of the contract with no early termination fee. We also have launched a triple play in the MDU space, understanding that a lot of this space is the younger adult segment, which if you look at the triple play that we have launched is broadband, it's TV and it's wireless rather than a wireline connection. So we found that that's also stimulating some growth in the MDU segment. When you expand that, the no contract definitely has had a very good growth prospective for us, but we have also launched something new in our enterprise space where we are going to our enterprise customers and very similar to what we do on the wireless side with employee liable accounts, we are signing up enterprise customers to promote our FiOS product within their employee base. So that has also stimulated some growth for us. So to wrap this up, yes, we feel that this level of ads is where we want to continue to be.

Your next question comes from John Hodulik of UBS.

First, on the wireless data pricing strategy, are you guys recently making changes or are there some in the press? And I guess I was surprised that you left the unlimited data plan out there. Is that a part of your strategy to increase the penetration of smart phones, and is that pricing essentially subject to change once you move to 4G and you potentially see data volumes grow? And then secondly on the wireline margins, it seems like you may have arrested the decline and you're starting to see some improvement. It sounds like fourth quarter, you see some sequential improvement. Is that something that we can see improve from here as we head out? Is there enough cost cutting opportunity for us to see improvements into 2011?

Again, I will take the first part of this question and then Fran will talk about the wireline margin. So I think what you're referring to John is some of the blog reports and some of the newspapers stories. We have not formally announced any change in data pricing, but we will be rolling out a data promotion next week focused on the fourth quarter. As we think about data pricing here and just to give you a little things to think about as we position this for the future, our aim here is really at expanding the market opportunity. We think there is a huge opportunity to continue to grow. We have a $20 billion annual wireless data business, $5 billion a quarter. It's hard to describe that as early innings, but we still believe it's the early innings of the data explosion. We're very focused at looking at opportunities to expand this opportunity, bring more of our base into data plans. The other thing to think about here is we believe we have built over time because of what we have done both with network investment, our advertising programs, is superior brand position that allows us to be unique in how we approach the marketplace from a data pricing, unique from what other companies do because of the brand position that we have built over time. Our fourth quarter promotion that we will have will have really two key elements we will continue to have in unlimited plan, the $29 plan, the $30 plan effectively that is unlimited. But we'll also have a $15 plan. And with the $15 plan, you will be able to get 150 megabits of usage. But what we believe is that people who are new to category will probably buy the $15 plan. But over time, you will see much more migration to the higher end, because there will be a lot of usage that will drive above the 150 megabit. So we think we are in a very good position. John, we are encouraged by tiered pricing. We like the concept of tiered pricing. You could interpret this a little bit as a move in that direction, although we had $9.99 plan before, but we will continue to look at this and we probably will have some pricing changes when we roll out 4G and 4G pricing. So there will be more to comment. Fran will now talk about the wireline margin.

So on the wireline margin, John, as John has spoken in the past, we do believe we've stabilized, we do believe that we can continue to expand the margin in wireline business. I would say that this is a two-pronged strategy. One is obviously topline growth. And I think that it's important to know that we've reached an inflection point this quarter where FiOS is now 50% of our customer revenue. So as we continue to improve the consumer ARPU 10% this quarter year-over-year, that will drive bottomline growth. I think it's also important to state that on the enterprises side we're seeing stabilization; however, outside the United States, in our global markets, we are seeing double-digit especially in the Asia-Pac region and some other area parts of the world. So again, that is more topline. But as we get into the cost and productivity and sustainability, as John has spoken in the past, we have an incentive offer for our associates. We had 12,000 associates accept that offer. About 80% of them have left the payroll to date. We will do more of that in the fourth quarter. But it's also important to know that as we attack the cost side of the wireline business, it's more than just the headcount reductions. It's quarter-to-quarter improvement in our operating metrics, especially when you look at FiOS and our cost-to-connect prim and our cost-to-connect video. If you look at our COA, our COA alone year-over-year has gone down 19%. And with that reduction, we've increased our ad. So it's a whole program of cost reduction. I believe it's sustainable. And while we are doing that, we're improving our productivity, so that when the economy in the enterprise restores and we continue on the track that we're in FiOS, we will continue to produce more margin.

Your next question comes from Simon Flannery of Morgan Stanley.

John, it was a pleasure working with you. Wish you all the best for your retirement. You touched on the LTE introduction. Could you help us understand what other impacts there might be in terms of expense recognition or interest capitalization and the things around that? And as you roll out the LTE from $110 million into the sort of $200 million plus, are we at a steady state level here on Wireless CapEx where you're out of a run rate? Or could there be a reduction or a lower intensity in '11 as the heavylifting for the first 38 markets has already been done?

So, Simon, I think we're very pleased with where we are in terms of the LTE deployment. We mentioned getting to 110 pops by the end of this year. I talked to Tony Malone as recently as yesterday to get an update on status and all systems are go. The network will be in extremely good shape. From a normal customer acquisition in maintenance and those kinds of things, I think you're going to see the same kind of run rates looking ahead as you have seen, as we've gone through this year. I don't think you're going to see a major delta at all. In fact, we would argue overtime that there will be more efficiency driven by LTE because the cost of the megabit served is much lower with LTE than it is with EVDO and other technologies. So we think that will position us well. There will be some impact, we have been capitalizing some interest, it's not a huge number. But we will see some impact as we go into 2011, may be a little bit in the fourth quarter, but not a major delta there. From a CapEx perspective, what I would think about here is, on this call we've said we're going to come in at the low end of our range or slightly below. I think we have a good chance of being slightly below our guidance range on CapEx. You should think Wireless at probably at about the same level next year as it's running this year in that kind of a range. When you look this year, all of the increase we've had has really been for the most part, both on LTE as well as capacity for data. There had been other offsets; things like synergy capital will be going down. So I think it will be a very controllable level of Wireless CapEx. The nice thing here is the CapEx to revenue ratio in the Wireless business runs quite a bit lower than the Wireline business. And there is a lot of efficiency from that capital. So I think our cash flow numbers should continue to be strong.

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

Just to follow up on that, more specifically on the Wireline side, how should we think about capital going into next year as the pace of new FiOS home is passed, continues to slow? And then coming back on the Wireless side, I noticed the replacement rate was around 9.5%, and then smartphones become a larger part of your base, and then hence a larger percent of the replacement volumes. How should we be thinking about the incremental cost related to that? And are there areas that you can identify to may be offset some of that upward pressure from just a greater pace of smartphone replacements overtime?

So a couple of thoughts for you here, Mike, and we're not in a position yet to give any guidance on CapEx for next year. But as I think about this, and certainly Fran will be talking about this in January. I think the direction of overall CapEx spending, and we've said this in the past, is down from where we are today. I'm not going to quantify that exactly, but if you think about Wireless continuing to run next year at about the same level, I think Wireline will come down. We are coming towards the end of the FiOS build out. So directionally, I think overall CapEx spending will come down in 2011 from 2010. I think we've had tremendous disappointment within the business around all of our CapEx spending, not only on core network, but on systems and supporting infrastructure. And we've also gotten much more efficient. A portion of our CapEx is labor, it's not just material. And we've gotten more efficient with that. So I think we're in a good position to continue posting very strong cash numbers in free cash flow. The upgrade level, we're very pleased with the upgrade level that 9.5% of our base upgraded in the quarter. Upgrades are a key focus for us. And as I think about it, upgrades right now are all good, and will be all good for quite a while to come, because a lot of times it's a feature phone customer going to a smartphone customer. I'm willing to take that equipment for us and that subsidy when I'm getting 2x the revenue. So it's not an issue that we're concerned about, we see it much more as an opportunity in providing upside to us in terms of revenue growth and profitability.

Your next question comes from David Barden from Bank of America/Merrill Lynch. David Barden - Bank of America/Merrill Lynch.: Just two more if could on FiOs and sorry to beat the horse a little bit, John. But when we've been talking about FiOS winding down, there's been a very specific number that we would save about $2 billion a year in Wireline CapEx. And I guess it kind of sounds like may be you're already starting to realize some of that as you've been winding that down may be sooner than expected. So could you put more specific numbers, as this thing comes to an end in 2010, what the dollar savings should be from that project relative to the $2 billion you guys have been talking about for a couple of years? And then I guess the second part is now that FiOS is 60% of the footprint and 50% of the revenue of the wireline unit, could you give us more color about what are the margins now on this business and how does its growth either benefit or dilute wireline margins as we model that out into the next couple of years?

Let me hit a couple of things here is, we have said in the couple billion dollar range, we are realizing some of that this year because we had been building at a $2 million premise passed roughly, and we're going to build roughly $1 million this year. So in our program this year, we've seen some benefit there. We will continue to see that as we go into 2011 and 2012. But the message here is, I think we become more efficient with the capital spend, our cost per home passed has been very good. We're very pleased with that and I think overall, I think the direction of CapEx spend will be down as we go into next year. From a margin perspective, we're very pleased with where we are. FiOS overall, we're very pleased with. We are up, income-positive here. We continue to grow that this quarter, because we ramped up and had more net adds than we had had in previous quarters. That had some impact in terms of the ability to expand the margin in this particular quarter. It is overall accretive to the margins of the overall business. We don't put out specific numbers and we're not going to do that right now, Dave. But the good news here is, we accelerated penetration with the changes Fran has really led, putting in place. We feel we're in a better position from an acquisition standpoint. There's a lot more buzz around the FiOS capability and the quality of video vis-à-vis our competition. So we think we're very well positioned and FiOS is continuing to do well. David Barden - Bank of America/Merrill Lynch.: Is that 50% of the revenues in the wireline business, is the margins in that higher or lower than the reported margins for the unit?

It's higher than the reported margins, Dave.

Your next question will come from Brett Feldman of Deutsche Bank.

You got a question earlier about how you're seeing this ramp in smart phone adoption. We're still seeing really strong wireless margins. And I think that that has been depriving to a lot of people in that the adoption of smartphones had kind of compressed margins in a lot of other operators, first, because you take (sub-Zs) upfront, and then you started getting a lot of these sort of network abusers who are using more than what they're really paying for under an unlimited plan. So I guess sort of the question here is, what could cause your margins to take a step backwards as we continue to scale in the data world? Could it be an investment you'd be willing to make in a new device category? Is there something incremental you'd want to do on the network side that you haven't done yet or really sort of sketched out for us yet? Or do you think that you can continue to run at these record levels of EBITDA margins even as you see accelerated usage of your data services?

I have to thank you, because you have not broken the record that I've had on every call, a question very much like this. Good question. About the question going to sustainability of our margins in the wireless business, as you know, we're very pleased. Low McAdam whose new President and Chief Operating Officer likes to describe us as an 'and' company not an 'or' company. So it's both growth and profitability, and we've always said that. The 47.2 is 157 basis points up year-on-year; it's comparable sequentially. We believe that really reflects the superior execution and scale of the ethics that our wireless team has built over several years. We've build tremendous scale in that particular business. We're able to absorb more subsidies and continue to do really a very strong job on margins. Now a couple of points here I'd make is, this is not a one-trick pony result. If you look at revenue, we have a very nice improving revenue trend in the wireless business. Service revenue in the fourth quarter was up 5%, first quarter 5.8%, second quarter 6.3%, and third quarter 7.7%. And that's only with 23% of our customers having smartphones today. So we believe as we go through the next several years and we go up that smart phone adoption, we're going to be able to grow revenue, grow profitability. We think our network is very well positioned for the growth in data traffic. We put tremendous time and focus on this, with Lowell and Dan Mead and Tony Malone on making sure we're well-equipped. Our assumptions assume that our handset lineup that we think is very strong today, where we put all the emphasis on again the Droid franchise. And the Droid franchise is unique to Verizon. It positions us very well; in our handset lineup we'll get better over time. It's not going to take a step backwards; it will continue to be enhanced. And is it possible we have a quarter where there's a knockout device that has some impact on margins? There's always a possibility of that happening; we've acknowledged that in the past. And that would be a good thing to have happened because of what you would do from a smart phone adoption in your overall ARPU. Now the other part of this is our wireless team is not only focused on net adds and growth and ARPU, tremendous focus on driving efficiency in the business, they've been working on driving cost out of supply chain. You've seen the tremendous results they've had this year on lowering their inventory level. At a time you have new product introductions focused on driving cost out of customer service, driving more online interactions, eliminating things like other charges and credit OCCs controlling them, retail store efficiency. So we think the scale we built in that business allows us to continue to have the lead in the industry on margins, and we not going to give that up.

Your next question comes from Tim Horan from Oppenheimer. Please go ahead with your question.

What do you think revenue growth can do for next couple of years? You've always been accelerating up. Do you see the business as kind of a 3% or 4% revenue grower? And may be related to that, how much did you wholesale pricing changes impact revenue in the quarter? And I have a brief follow up if you don't mind?

Yes, okay. So, Tim, generally, I absolutely think we can accelerate revenue growth from where we are today. I mean I think the wireless business on a service ARPU at 7% can get up in the high single digits and can touch 10% with data growth. The wireline revenue picture looks a little worse this quarter than it really is. We posted in number of 3.6%, but a major driver on that going a little bit worse from last quarter was, we made some price changes in our International Wholesale business, because we had certain roots out in the world that really weren't driving profitability. So when you look at our International Wholesale revenue, it was down year-over-year by 28%. If you strip that out, our Wireline revenue was only down 2.4% versus the 3.6% that we reported. And then as you cut under that, Consumer is growing at the rate of 1.1%; we saw a better performance on small business. Our Enterprise revenue, while it was negative-0.8%. If you break FX out, it was flat. So the underlined trends, even in the Wireline business, are better than, we think the 3.6% number would show. And I think, we believe, we can get the Wireline business, over the next couple of years with some help from the economy, to flat, and may be to slightly growing. And if we do that, that would be very important for the business overall, because Fran talked about it no question. We still have the lot of ability to drive more and more cost out. But we got to get that business growing again, and we're very focused on that and we think we can. But the Wireless business, there's going to be tremendous opportunity to continue to accelerate the revenue growth on that business.

John, just on your wireless business, you clearly have a premium network out there. Do you think when you get the iPhone, you can charge a premium price either for the device or for the service or some kind of application sharing? We're not asking when you're getting the iPhone, but clearly there would be a huge benefit for subscribers being on your network versus your competitor.

Well, I talked earlier, Tim about how we think about pricing. So we're very focused on the device line up we have today. We think we have a great device line up. The Droid franchise has gone from nothing a year ago, to where it really has a buzz and a lot of momentum out on the marketplace right now. From a pricing perspective, we think the brand that we have built puts us in a unique position from a pricing perspective. We've always been a bit at a premium, and we think the brand will allow us to continue to do that.

Your next question will come from Chris Larsen of Piper Jaffray.

A question back to FiOS, you obviously picked up some share or it appears based on with the cable companies said that you picked up some share both on video and on data. My question is really, there has been a lot of back and forth there, have you begun to see anything so far in the fourth quarter that indicates the cable companies were getting more aggressive either on their video or the data pricing? And then additionally, there were some comments made actually in the New York Post recently that cable is considering a massive increase or a material increase in their high speed data prices to offset some of this over the top video that maybe going on. If cable were to do that, is that something you guys would follow along with that is a large increase or a material increase in your data pricing?

I think, Chris, a couple of thoughts here is, the FiOS video business and internet business, we've always said every quarter it's a very competitive out there. I wouldn't say we've seen anything recently that changes the competitive landscape from an offer or a price perspective. With the changes that Fran has led for us on the worry-free guarantee, the contract, no focus on the MDU, we think we're in a very good possession. We haven't planned any price changes here at this point in time; we would always continue to look at what's happening in the competitive landscape. We think our FiOS offering from, based on the fiber end to end is a superior offering from a quality standpoint. And we've been focused very much on acquisition and getting people to move. So we would continue to evaluate that and look at what the opportunity to accelerate revenue growth.

Your last question comes from James Ratcliffe of Barclays Capital.

One on capital structure and the other on FiOS. On the FiOS side for broadband, where are the ads coming from? I know a material portion in the past have been people being switched from DSL to FiOS, is that continuing? And is the mix changing in terms of DSL switches versus people coming presumably over from cable? And secondly on the capital structure side, if you're looking at dividend in cash up from Verizon Wireless, how much of a buffer do you have in terms of realized and taxed proportional profits of Verizon Communications that haven't actually represented cash dividend is up for Verizon Wireless? So in other words, how much could you dividend end up form VZW before you start to actually have to pay incremental tax on those payments?

Let me just start with the capital structure. We are very pleased with our cash performance. We think the wireless business, you can see it's a cash machine, the cash generation of that business is not going to decelerate, if anything, it's going to accelerate. We're in a very good position from that perspective. We believe that Verizon dividend is extremely safe. There is not a major tax issue here that I'm worried about that's going to have some impact on this. So we think we are in a good position. Fran and his team has had a lot of focus on trying to make the Wireline business more free cash flow positive. We'll continue to work at that. But our cash flow margin is in a very good position, and you can see it from this quarter. Fran will comment on the FiOS question.

On the migration question. Yes, we continue to migrate some of our former DSL customers into the FiOS broadband. But if you look at our net ads, if you take the internet net ads form our FiOS product less our DSL, we're still on a positive take share perspective. The other thing to consider too is, is that when you look at the penetration of our internet at 31 and our TV at 27, what we find is once we convert someone over to our FiOS internet product with the speed that we have and the amazement that they get from that, it's very easy for us to then walk in behind that and convert over the TV because we can bundle it and save them money. So I think that we do have migration from DSL, but we are also taking share.

Just a couple of things then wrap up here. I hope you can see that we feel very positive about the performance of the business this quarter. We had given you some direction that we felt we needed to do about where earnings would be in the second half of the year.And in this quarter, we are at the very high end of that range; that's our focus for the fourth quarter. We will continue to deliver in the fourth quarter the kinds of things we delivered here; strong wireless results driven by continuing ARPU acceleration and stronger smartphone results. We've stabilize the Wireline business from a margin position. We'd actually expanded them slightly in this quarter. We believe that will accelerate as we get into the fourth quarter. and our cash flow position is very strong and will remain very strong. So I thank you for taking the time, I'll pass back to John just to close up the clock.

Well that concludes our call today. Thanks to everyone for joining us.

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