Alaska Communications Systems Group, Inc.

Thank you. Welcome to the Alaska Communications Third Quarter 2018 Conference Call.

I'm Tiffany Smith, Manager of Investor and Board Relations. With me today are Anand Vadapalli, President and Chief Executive Officer; Laurie Butcher, Senior Vice President of Finance; and Leonard Steinberg, General Counsel.

During this call, we'll be using a slide deck that we'd encourage everyone to have available. For those listening to this call via the webcast, the presentation will be displayed on your screen.

For others, you can go to our investor website, www.alsk.com, click on the Events section, go to the third quarter 2018 earnings call event and click on the PDF version of the presentation. We will indicate which slide we are discussing, so you can follow the presentation material throughout the call.

Now, as we get started, please review Slide 3 for our safe harbor statement. During this call, company participants will make forward-looking statements as defined under U.S.

securities laws. Forward-looking statements are statements that are not historical facts and may include financial projections, estimates of shareholder returns or other descriptions of the company's business plans, objectives, expectations or intentions.

You are cautioned not to put undue reliance on forward-looking statements as actual results could differ materially from expectations as a result of a variety of factors, many of which are outside the company's control. Additionally, any non-GAAP measurements referred to during this call have been reconciled to their nearest GAAP measure.

You can find these reconciliations in the appendix to our presentation. Following our remarks, we will open the line for questions.

With that, I would like to turn the call over to Anand. Anand?

Thank you, Tiffany. Good day and thank you for joining us.

We are pleased to report solid performance for the quarter and year to date. Once Laurie reports in our financial results, I intend to undertake a fulsome conversation of our business performance and shareholder value creation.

But first let me turn the call over to Laurie Butcher, who will review our quarterly and year-to-date performance. Laurie?

Thank you, Anand. Turning to Slide 5, let me start with our year-over-year performance for the quarter and year-to-date periods ended September 30.

Total revenue increased 2.7% in the quarter and 1.1% year-to-date. Business and wholesale representing approximately 62% of our total revenue, grew 4.2% in the quarter and 1.5% year-to-date, with business in wholesale broadband showing a decline of 1.4% in the quarter and 1.7% year-to-date, reflecting the impact of lower Rural Health Care revenue, in which I'll elaborate on in a minute.

Consumer revenue, representing approximately 16% of our total revenues, declined 0.5% in the quarter and increased 0.7% year-to-date. Consumer broadband grew 3.4% in the quarter and 2.7% year-to-date, while voice revenue declined 8.9% in the quarter and 3.9% year-to-date.

Regulatory revenue, representing approximately 22% of our total revenue remained relatively flat for both the quarter and year-to-date. We continued to show growth in business and wholesale, both for the quarter and the year.

This growth has been largely driven by our performance in several verticals, including federal, education, oil and gas, and commercial, more than offsetting the anticipated declines in Rural Health Care. Let me cover the Rural Health vertical first, as I believe it's best to compartmentalize this line item.

Rural Health Care year-to-date is about 8% of our total revenues compared to 11% for the same period in 2017. For the full year, we expect Rural Health Care to close out at approximately 7% of total revenues, reflecting a decline of about $4 million over the prior year.

Importantly, the FCC and the USAC have processed substantially all of our contracts for 2017 funding year that ended on June 30, 2018. This is a positive development on several fronts.

First, we've received a substantial portion of the outstanding cash related to that funding year, and second, our methodologies for rate setting for the 2018 funding year, which began on July 1 of this year, are consistent with the approach we took for the previous year, giving us confidence in receiving approvals for the current period. I'll also note that we've conservatively projected not receiving any further cash related to this program for the rest of the year, and we anticipate remaining in full compliance with all of our debt covenants despite such assumptions.

This is an aberration in our steady march forward and not an indication of any downward trend or pressure in our market performance. This is demonstrated by the fact that business and wholesale grew about $1.6 million or 1.5% for the first nine months, fully offsetting the $5.2 million reduction in the Rural Health Care revenue.

This highlights growth of $6.8 million or 6.4% in all other aspects of business in wholesale market. Verticals like commercial, federal, state and local government, education, and oil and gas, are all performing well.

And the continued improvements in the Alaska economy provide macro-level tailwinds for us. We're directing our sales and our CapEx resources where we see the most opportunity.

These market opportunities are reflected in our Board approving the additional success-based capital expenditures for this year in support of customer contracts. In fact, for the year, we expect success capital to be at approximately two-thirds of our total capital expenditures.

Turning to Slide 6, all of our financial metrics are performing to plan. Total revenue was $58.2 million in the third quarter and $173.8 million for the first nine months of the year.

Adjusted EBITDA reached $14.8 million for the quarter and $46.1 million year to date, an increase of 12% and 8.9% compared to the same periods in 2017. This also highlights our performance in terms of cost management.

Our SG&A is down year-over-year by 5.6% for the first nine months of 2019. As Anand will discuss in his upcoming remarks, this reflects our continued attention to cost management over the long-term.

I'm proud of our employees who have supported the various measures we've instituted, and continue to serve our customers with the utmost diligence and care. For the quarter and year-to-date respectively, net capital spending was $8.4 million and $25.4 million.

And adjusted free cash flow was $2.4 million and $8.4 million. Looking at our balance sheet at September 30, total debt was $171.8 million and net debt was $159.1 million, compared to $186 million and $177.2 million, respectively at December 31, 2017.

Cash was $18.9 million compared to $16.2 million for the same periods. As I discussed earlier with additional investments approved by our board in growth capital, we are increasing our guidance for net capital spending to $37 million to $39 million.

As Anand will note, we've had meaningful returns on our growth capital, and we anticipate similar or higher returns going forward. We are reaffirming the rest of our financial guidance for 2018 for total revenue, adjusted EBITDA and adjusted free cash flow.

We look forward to reporting our progress to guidance in our year-end call. With that, let me hand the call back to Anand.

Anand?

Thank you, Laurie. Our strong results for this year reaffirm my conviction about the strength of our business plan and the opportunity to create value for all of us, our shareholders, our customers and our employees.

I also acknowledge and share some of the frustrations of our shareholders. I hope this discussion about our business plan performance will demonstrate the significant opportunity for value creation in front of us.

Turning to Slide 8. Let me first start with revenues.

This is a telecom sector. We must deal with our legacy as telephone companies and the legacy of our investments in technologies like copper.

You will note that Alaska Communications is not immune to these secular trends. Our legacy revenues have declined at about 4% annualized rate over the last several years.

That said legacy revenues have also come down from about 53% of our total revenue to about 42% of our total revenues. The most positive thing about our sector is that broadband consumption is exploding with no signs of abating demand.

While price compression in our sector mitigates revenue growth, nonetheless, revenue opportunity continues to expand. Investments in technology like fiber, and more recently 5G technologies, including fixed wireless access, have fueled our growth revenues with close to 7% CAGR over the last five years.

Our group revenues now represent close to 58% of our total revenues, more than offsetting our legacy revenue declines and supporting total revenue growth of about 1.6% CAGR. In fact, if not for the RHC-related matters Laurie discussed earlier, we would have demonstrated even higher growth.

I'll note that we are one of the few companies in our sector to accomplish this milestone of sustained top line growth. We expect this trend to continue, driven by a combination of our unique market dynamics, our network and technology innovation and our deep customer relationships.

This ties into the question that I know is top of mind for many shareholders. The question on capital expenditures and returns thereof.

Turning to Slide 9. We've consistently said we have two broad categories of CapEx: maintenance and success.

Maintenance CapEx has varied between 30% to 50% of our total CapEx. Maintenance CapEx supports the relevance in the market.

If we do not protect the integrity of our network, I'm afraid there is not much business for us to protect either. Success CapEx, on the other hand, is directed towards the fulfillment of customer opportunities and fuels our growth revenues.

Success CapEx improves our competitive positioning in the market. Today, Alaska Communications has about 25,000 fiber submarine miles and about 106,000 fiber terrestrial miles in our network.

We have about 865 buildings lit with fiber-entrance facilities. Over 75% of buildings with more than 50 employees are within 500 feet of a fiber splice point.

We have one of the most modern IP networks with clear technical differentiators in the market. Success CapEx has fueled the increase in growth revenues, while positioning us for future growth.

The EBITDA contribution from every marginal dollar of new revenue is generally in the 75% range. Using that as a proxy, you can infer very meaningful returns on the success capital invested by the company.

Lastly, this slide also offers another perspective on CapEx by comparing annual capital expenditures to our annual depreciation and amortization where you will note the general alignment between annual DNA and CapEx. Turning to Slide 10.

The bottom line is EBITDA performance. This is a function of both top line performance and cost management discipline.

Success CapEx-fueled growth revenues have allowed us to outpace secular declines in post-net top line growth. That is important as we are seeing the impacts of declining top line for other companies in our sector.

The other lever is disciplined cost management. Since we first reported stand-alone wireline EBITDA in 2015, we've demonstrated a 5% CAGR in wireline EBITDA, while we have demonstrated a 7.8% annualized reduction in our SG&A.

Now we had to take some of these measures in the last year to offset the unexpected declines in Rural Health Care that impacted our growth numbers. As we return our company to higher growth levels over the next several years, I fully expect us to make investments in our business to fund that growth and drive EBITDA expansion.

Going forward, while I don't expect further SG&A reductions in this magnitude, success CapEx-fueled growth revenues will be the driver of EBITDA expansion. Turning to Slide 11.

This is the last slide providing some historical context before I discuss our future opportunities. Historically, the board emphasized debt reduction as a priority in our capital allocation decisions and tight management compensation to deleveraging.

This chart reflects our execution to the directions set by the board. We have reduced our leverage ratio to very healthy levels and strengthened our balance sheet.

This sets the stage for future growth and shareholder value creation. Our balance sheet today allows us flexibility to consider investments in our business and returns for our shareholders, which leads me to a discussion about the opportunity ahead of us.

Turning to Slide 12. Broadband growth is robust.

Our competitive position is strong. The underlying drivers for broadband growth are unabated and will fuel increasing demand for years to come.

Increasing strength in Alaska's economy provides good tailwinds, and our market share provides opportunity via multiple mechanisms: share gain; growing with the market; and increasing share of wallet. Turning to Slide 13.

We have a fiber asset-rich network. We are leading the charge with fixed wireless access or FWA in our sector.

This is a platform for further growth as we leverage the deepening of fiber in our access network. Our record of technology innovation provides strong differentiation in the market, particularly for the larger Enterprise & Carrier customers.

Turning to Slide 14. Most importantly, we have superb customer relationships.

We see great opportunity across several verticals. On the Enterprise & Carrier side, 5G wireless backhaul, federal opportunities, growth with state and local government, education and oil and gas sectors will all be strong performers for us over the next several years.

Our investment in FWA allow us to offer high-speed Internet to the mass market consumer and small business customers at affordable rates and in a very capital-efficient manner. We are leading the charge working with our network suppliers to leverage and test technologies like Facebook's Terragraph platform for millimeter wave deployments.

An example of our success in mass market consumer is demonstrated in our multi-dwelling unit or MDU strategy. With fiber into several buildings on local military basis, we are demonstrating a penetration of about 50%, which is an astounding number to achieving our first year of operations in this area.

All this leads to the all-important question of how this creates value for you, our shareholders. Turning to Slide 15.

First, strength in our organic business performance and our balance sheet position allows our board to consider capital allocation strategies that shift emphasis to rewarding shareholders, while ensuring we continue our growth platform. In all candor, had it not been for the aberration we experienced with Rural Health Care this year, we would have been executing for the board approved share repurchase program.

Our commitment in that regard remains strong. Second, we've said time and again that scale and diversification are an overhang on our stock price.

I will reiterate my conviction that we need to be part of a larger platform. I cannot sit here and say what form that will take or when something will happen, neither can I sit here and speculate on hypotheticals.

But what I can emphasize is that our board is prepared to consider a variety of options, some of which I'll illustrate on this slide. It's more important to do this right to enhance your value as a shareholder.

In fact, if you look at changes made to management compensation programs over the last couple of years, with the most recent changes management long-term equity performance compensation is directly tied to stock price performance. There is full alignment of our interest at multiple levels.

I will state exclusively that creating value for you is our focus, and the board and management team have a great group of advisors to help us evaluate a full range of options. We are running a quality business.

There is value to be had in diligently pursuing our business plan. All while, we continue to assess all our options for value creation.

Thank you for joining us today. With that let me open the call for questions.

Operator?

Hi, Anand, this is [Bob Gruvan] [ph]. How are you?

Bob, good afternoon, I'm well. How are you?

Good, good. I guess, I wanted to drill down a little bit on some of the - what you said about the growth CapEx and that's been, kind of, a pinch point for some of the shareholder base over the last several years.

Now your board has just authorized another $4 million, and I was kind of curious, I mean, you've been very consistent in this $14 million of maintenance and another $20 million of growth CapEx. Why here at the end of the Q4 was this authorized?

And I'm only bringing that up, because we're going into the winter of Alaska. And I'm wondering why this capital allocation couldn't have been made in 2019, especially with a leverage test that we have coming up pretty shortly?

I know Laurie had mentioned that during compliance through the end of the year, but the way I calculate this, you've really tight if you spend this $1 million on meeting that leverage test in 2019? So it seems to me fixed at first, allocate the capital in 2019, and then you start a dividend or a stock buyback?

So I'm kind of curious what was so exciting about this $1 million allocation that had to have been pulled in through Q4?

Yeah, Bob, thank you for the questions. So let me first start with the leverage test and the covenant calculations.

We remain very comfortable with our ability to have - not just comply with those covenants, but have adequate cushion that's something as you can expect that we monitor closely that the board monitors closely. So on that front, I believe, we are in good shape.

And I think as Laurie also mentioned, we certainly are taking a conservative view in terms of cash receipts from Rural Health Care where we are not projecting any further receipts through the end of the year. Though of course, we continue to work with the FCC to make sure that they release the money as soon as possible in this year as well.

So that's as far as the covenant analysis goes. With respect to your question on growth capital, so you're right.

I mean, we've said typically that you should think about our CapEx in the $35 million to $40 million range. We've said that often times in the past.

We've also said that typically we tend to allocate about half of that towards growth and about half of that toward maintenance. In fact, what we are seeing though, Bob, is in more recent years, there is an increased allocation towards growth over maintenance.

Part of it is reflecting the opportunities in the customer contracts we are signing. And part of it also, the more we invest in newer technologies like fiber, the more we deploy fixed wireless access.

What you will see over time is a reduction in our need for maintenance capital, because we are upgrading our network. And candidly, in the capital program, the more we can allocate towards growth CapEx, the more it drives growth revenues, and the marginal dollar EBITDA contributions from growth revenues are very material.

They are meaningful. And as to the timing of this CapEx, please keep in mind that this is all a function of - as in fact Laurie said in her remarks, this is not on spec.

This is actually in support of signed customer contracts, which we believe are very accretive to the business. And from a construction and deployment perspective, we've been pretty engaged in the field with respect to deployment and which is why we expect to see elevated levels of CapEx in the fourth quarter.

So we think we are generally tracking to this increased guidance. It is in support of signed customer opportunities that we have, that are going to create returns for all of us going forward.

And I think 2019 will bring more opportunities. I mean, in all candor, what we have is what I would characterize a good problem where the opportunities are so significant that to some degree we're capital constrained in going after the opportunities we have.

And I think from my vantage point, that's a good problem to have. But…

Sticking with that - so sticking with that for a second, Anand, this $4 million, and I would expect it to be only versus signed contracts, can you give us an idea what the breakeven time is on that $4 million?

So, Bob, without specifically mentioning the specifics of individual business cases of what goes into this incremental CapEx, what I can tell you is what I've said before, where typically we evaluate success capital for IRRs in the 20% range, and for payback periods, typically the 3 to 5 year range. And I'll give you the rationale for the 3 to 5 years, typically that's the duration of our customer contracts.

And we try and work very hard to try and keep the payback within the term of the initial customer contract though we know we'll get a lot more benefit and run rate from that going forward. But also, if I may, if I could point you to some of the charts that I put up earlier in my presentation, if you look at the increase in growth revenues over the last 4 or 5 years and you look at the deployment of success capital, and again, as I mentioned in my prepared remarks if you assume that the EBITDA contribution on a marginal dollar of revenue is in the 75% range, we've run the math, I'm sure you can do that as well probably better than us, and you will see that the returns on growth capital are actually very meaningful.

And we are very diligent about payback as well. So this is something that, again, clearly, when we took this request back to the Board, it was with all of the analysis of where the capital is going and what customer contracts were driving this, et cetera.

There was a fair bit of governance and oversight behind this.

Okay. So the $60 million to $80 million that we spent over the last 3 to 4 years, can you break down how that actually - what the payback periods have been?

I mean is it all in the 36 to 48 month range? Do you have anything that's in the 18 to 24 or 24 to 36 month payback period?

Or - because as we look at the spend, it looks like it's coming in slower than we would expect. But can you break that down for us?

We actually break that down as we analyze our own capital expenditures. We evaluate that regularly.

And what I can tell you is, obviously, not every contract is 36 months or 48 months or 60 months, some are less, same can be a little bit more. But that's the general range as what we look at.

And we are actually very comfortable that the payback period for the capital expenditures that we've made are generally in the ranges that we are looking at.

Okay, okay. So you're confident than that for 2019 we won't need a modification of the credit line or a waiver to meet our leverage test?

As we are thinking about where we are, Bob, with respect to our credit agreement, we are very comfortable with the credit agreement and the cushions thereof.

Okay. I'll let somebody else ask a question.

All right, thank you.

Thank you.

Thank you. So we always welcome the opportunity to speak with our shareholders.

If you are interested in having meetings with us by phone or in person during future road-shows, please do reach out to Tiffany Smith and Investor Relations. Also, I'll note that I will be on schedule to speak at the LD Micro Conference on December 4.

And I look forward to meeting any shareholders who may be attending that particular event. With that, thank you all for joining us today and have a great day.