Lumen Technologies, Inc. Q1 FY2023 Earnings Call

Greetings and welcome to the Lumen Technologies First Quarter 2023 Earnings Call. During the presentation, all participants will be in a listen-only mode. Afterwards, we will conduct a question-and-answer session. As a reminder, this conference is being recorded Tuesday, May 2, 2023. I would now like to turn the conference over to Mike McCormack, Senior Vice President, Investor Relations. Please go ahead.

Thanks, Darcy. Good afternoon, everyone, and thank you for joining Lumen Technologies first quarter 2023 earnings call. On the call today are Kate Johnson, President and Chief Executive Officer; and Chris Stansbury, Executive Vice President and Chief Financial Officer. Before we begin, I need to call your attention to our Safe Harbor statement on Slide 2 of our first quarter 2023 presentation which notes that this conference call may include forward-looking statements subject to certain risks and uncertainties. All forward-looking statements should be considered in conjunction with the cautionary statements on Slide 2 and the Risk Factors in our SEC filings. We will be referring to certain non-GAAP financial measures reconciled to the most comparable GAAP measures, which can be found in our earnings press release. In addition, certain metrics discussed today exclude costs for special items as detailed in our earnings materials, which can be found on the Investor Relations section of Lumen's website. With that, I'll turn the call over to Kate.

Thanks, Mike. Good afternoon, everyone, and thanks for joining us today. Before I turn the call over to Chris to discuss our first quarter results, I want to give you an update on our company's turnaround plans. As I shared on our last call, we've established a new mission for Lumen to digitally connect people, data, and applications quickly, securely, and effortlessly. We assembled a new executive leadership team and created five core priorities for the company. We then set financial expectations that included the funding of a portfolio of change programs to deliver on our revenue and EBITDA stability goals. It's still early days in our transformation journey. We're staffing up the change programs with the right talent. We're standing up an agile project framework to standardize how work gets done, and we're implementing business analytics across the company to help drive execution rigor. These things have the basic scaffolding needed to support our transformation efforts. Now that said, in addition to an improved revenue story this quarter, we're seeing early signs of progress in several areas. I'll share some of the leading indicators with you now aligned to our core priorities. I'll start with the first two priorities, to develop company-wide customer obsession and to invest and innovate for growth. Obviously, these priorities go hand in hand. We're immersing ourselves in our customer challenges and using that proximity to guide our innovation investment decisions. It's helping us pivot to an outside-in mindset and accelerating our speed to market. We already have an in-market example of high-value innovation using this new approach. On April 20, we launched Lumen SASE with Rapid Threat Defense, our company's proprietary threat detection and remediation platform powered by our very own Black Lotus Labs. Now, you might be asking why is this innovation example interesting? Because we sat side-by-side with customers and heard their feedback clearly. They have enough threat detection reports. What they want, what they need, is an automated threat detection and remediation capability. So with Lumen's intellectual property, we co-innovated with our partner, Fortinet, to leapfrog traditional threat protection offerings. And from concept to commercialization, it took just a few short months. Enterprise customers like Huitt-Zollars, a full-service multi-disciplined design firm with extensive construction management expertise, are seeing the value. We call this new VC-style approach to innovation the Lumen Growth Operating System or the Growth OS for short. And it's not only helping us become more customer-focused, but it's also driving tighter alignment with important ecosystem partners while uncovering new problems where Lumen's proprietary offerings can drive value. For example, we're excited to announce that we're partnering with Microsoft using tools like digital twins and large-scale 3D environments that need edge-to-cloud capabilities to support NextGen operations. Together, Microsoft and Lumen are collaborating with great companies like Sunbelt, a global leader in the equipment rental industry, to solve complex business problems ranging from emergency response and supply chain management to fleet optimization and environmental risk assessments. Our partners and customers alike see the value of our network, security, and edge compute capabilities, and even more, they recognize and appreciate our appetite to co-innovate. Building a reliable execution engine in both Mass Market and Enterprise is another core priority for Lumen. Here too, we see several indicators of progress on our path to growth. Let's start with Enterprise. You may recall that beginning in January of 2023, we changed our sales incentive plan to drive a laser focus on growth. In the first quarter, we outperformed our internal revenue target for Grow products with strength in IP, wavelength, SASE, managed security, and UC&C. It's clear, when we focus, we win. At the start of the new year, we established a dedicated mid-market sales team, augmenting both direct and indirect selling resources to drive new logo acquisition, and in Q1, new logo additions were up 5% sequentially, and importantly, these new customers have about 30% higher sales value than the new customer cohort added in the prior quarter. Now to stem organic customer churn and revenue decline in legacy voice products, we established a dedicated outbound calling team to migrate customers to modern UC&C platforms paired with Lumen network offerings, of course. Early results show that strategic migrations of these legacy customers increase the average spend by about 10%, reduce the risk of churn, and give Lumen a modern platform through which we can continue to upsell NextGen offerings. The powerful combination of customer obsession and focused go-to-market execution is starting to bear fruit. We have several recent wins with customers like Byline Bank, Proliance Surgeons, and iHeartMedia, all of whom trust Lumen with their mission-critical applications as they seek to modernize their digital transformation. Now, we recognize that we have a lot of work to do on our Enterprise sales execution. Over the next few quarters, you will see us continue to galvanize our sales readiness programs, refuel our digital marketing campaigns, refine our analytics-driven sales platform, and upscale our talent across our field organization. I'm going to turn to Mass Markets next. As you know, we did a reassessment of our Quantum Fiber buildout plan during the fourth quarter of last year. We pivoted away from focusing on accounting-enabled locations and instead we're targeting locations that have the greatest potential for penetration. This move required significant business process and planning changes, but will deliver superior returns for our shareholders. Our fiber build factory is now up and running fast with planning yield approaching 90%, up from as low as 10% last year. In the first quarter of 2023, we saw net enablement growth accelerate with March enablement eclipsing January enablement by more than double. This gives us confidence that we'll meet or exceed our 2023 enablement target of 500,000 locations. What's more, fiber installs have exceeded copper installs this quarter, and that gap should widen, accelerating fiber subscriber growth and revenue growth going forward. We're proud to share that our fiber customers, the majority of whom choose our one-gig offering, are enjoying Quantum's world-class experience, driving a Net Promoter Score of above positive 60. Look, I hope these impressive execution results make it clear that the Quantum Fiber business is core to our strategy. You're going to see us continue to lean in hard as we ramp our build pace and increase our subscriber additions moving forward. Our priority to radically simplify Lumen comes in many forms, from rationalizing IT applications to reducing SKUs in our product portfolio, and so much more. We're making material progress on this key priority, which will not only help reduce costs, but will also be the foundation for how we create quick, secure, and effortless digital experiences for our customers, partners, and employees. I'll share a few quick examples for you now. First, we established an evergreen program called the Stop List, where our 29,000 employees can share ideas for driving simplification by shutting down business practices that don't seem to add value or align with our strategy. So far we've shut down 45 non-value-added processes, saving the company about 120,000 people hours and removing tens of millions of dollars of operating costs, which we're now redeploying to support our growth agenda. Next, we've made great progress in dramatically simplifying our product portfolio. We started the year with more than 12,000 Enterprise SKUs and retired more than 60% of them so far just by eliminating legacy products. This simplification positions us well to reduce our Enterprise ordering systems from 10 systems down to three, which will dramatically improve our billing accuracy, reduce customer care costs, and, of course, improve customer experience overall. There are many more examples of simplification at Lumen, such as unifying the company onto one communication platform, down from five, or upgrading our ERP system to reduce our bespoke, complicated business processes. Our simplification agenda is aggressive, and it's going to yield material results, and I'll continue to share progress with you throughout the year. Okay, finally, I've been very public about our core priority to rebuild this company, starting with our greatest asset, our people. We're building a culture based on team trust and transparency, one that celebrates clarity, customer obsession, a growth mindset, and courage; basically, one that enables change. We have a lot of progress to share in this space. First, Lumen is being recognized by the industry for several reasons. In the past few months, we were named as one of America's Most Trustworthy Companies. We were recognized for championing diversity and celebrated for excellence in providing employees with remote work flexibility. Second, we're making bold investments that demonstrate our commitment to building a diverse and inclusive company. Over the past 90 days, we launched initiatives to revamp our performance management systems, systematize courageous leadership skill building, and drive greater transparency and remediation of pay disparities with the pay equity platform, Syndio. When you take industry recognition and the people investments I just described, they seem to be paying off. We're seeing lower employee turnover, higher engagement within our workforce, and more outside interest in joining the Lumen team. In fact, we've had a greater than three-fold increase in employment applications year-over-year. It's clear that we're building a company and a culture that people really want to be a part of, and I'm so proud of the team for making progress across all of our priorities in such a short period of time. And with that, I'm going to turn the call over to Chris to discuss our first quarter results.

Thanks, Kate, and good afternoon, everyone. As Kate described, this is a year of rapid change at Lumen. We are aggressively upgrading systems, processes, and our culture as we seek to modernize Lumen to win in the marketplace and return to growth. While it's early in our journey, we are pleased with the improvements we're starting to see. A specific callout is a significant improvement we're seeing in our Mass Markets execution. Our Quantum reassessment allowed us to adjust our plan, and as we move forward, it is proving to have been an excellent decision. As Kate said, we're back and running fast. Before moving on to our first quarter results, I'd like to discuss a few actions we've taken to strengthen our balance sheet to position our company to return to growth. In mid-March, we announced an exchange offer for Lumen's senior notes. This deleveraging action was a win-win. During Q1, we reduced our principal debt balance by $620 million, and Lumen senior noteholders that participated in the exchange received a higher coupon, as well as secured debt in the Level 3 silo. In the first quarter exchange transactions, we issued $915 million in Level 3 secured bonds, and Lumen's annual interest expense remains relatively unchanged. This exchange, combined with the expected proceeds from the EMEA transaction, will allow us to focus on executing against our two-year turnaround plan, which we expect will return Lumen to growth. We will continue to pursue additional opportunities to enhance our capital structure to support our long-term plan, which we expect will provide strong returns for our stakeholders. With that, I'll discuss the financial summary of our first quarter. This quarter, we have expanded our reporting to include Grow, Nurture, Harvest, and other business channels. This structure includes a subtotal with Grow, Nurture, and Harvest giving visibility to our primary focus within the business channel results, excluding other. As a reminder, the Other category revenue includes equipment and IT solutions, which tend to experience fluctuations due to the variable nature of these products. Additionally, beginning this quarter, to better align with recent updates to the SEC's Reg G Compliance and Disclosure Interpretations, we will no longer report revenue, adjusted EBITDA, adjusted EBITDA margin, or CapEx on a modified basis, which excludes the impacts of our divested businesses, as well as CAF II within historical periods. Instead, we will provide supplemental information on these discrete impacts as footnotes where applicable in our earnings presentation and a separate page in our Financial Trending Schedule. Accordingly, on this call, I will reference our financial performance primarily on a sequential basis for better comparability and to provide color on the impact that CAF II, the divestitures, and commercial agreements had on select year-over-year results. It's important to note that excluding the impacts, our year-over-year growth rates are substantially better than the reported rates and are showing improvement in key areas. Our first quarter total revenue declined 1.6% on a sequential basis to $3.738 billion. Adjusted EBITDA was $1.251 billion in the first quarter, with a 33.5% margin. Free cash flow was negative $75 million in the first quarter, including $90 million of taxes paid related to our two divestitures in 2022. We now expect total transaction-related taxes of around $1 billion, with the majority of the balance being paid in the second quarter of this year from cash on hand. We reduced net debt by $582 million during the first quarter. Next, I'll review our detailed revenue results for the quarter. Reported revenue was down 20.1%, with the impact of CAF II, the divestitures, and commercial agreements representing approximately 80% of the reported decline. Within our two key segments, business revenue declined 1.6% sequentially to $2.956 billion. Mass Markets revenue also declined 1.6% sequentially to $782 million. Business revenue declined 13.1% year-over-year, with the impact of the divestitures and commercial agreements representing approximately three-quarters of the reported decline. Mass Markets revenue declined 38.7% year-over-year, with the impact of CAF II and the divesture impact representing approximately 86% of the reported decline. Within our Enterprise Channels, which is our business segment excluding wholesale, revenue declined 1.4% sequentially. Our exposure to legacy voice revenue continues to improve and is now approximately 11% of Enterprise Channel revenue and is down approximately 50 basis points sequentially. Large Enterprise revenue declined 1.9% sequentially in the first quarter. Large Enterprise revenue trends improved year-over-year, excluding the impact of divested businesses, driven primarily by IP and co-location. Public sector revenue declined 0.2% sequentially. Excluding the impacts of our divested businesses, public sector improved significantly from the year-over-year decline last quarter on the same basis. As you know, we've had major wins in this channel over the last two years and those wins are ramping up in revenue. You may have also seen a recent U.S. Defense Information Systems $223 million contract win for providing modern hybrid cloud voice and conferencing services. Our partnership with the public sector is strong, and we appreciate the confidence these entities have in Lumen and our significant capabilities to deliver these mission-critical solutions. Mid-market revenue declined 1.3% sequentially. Excluding the impacts of our divested businesses, there was a similar level of year-over-year decline compared to last quarter. Strength in IP and UC&C was offset by declines in other product categories. Wholesale revenue declined 2.2% sequentially. This is the channel that will continue to decline over time, and we manage for cash. Moving to our business product lifecycle reporting, Grow products revenue grew 3.4% sequentially. Importantly, if we exclude the impacts of our divested businesses, this quarter's results showed significant improvement in year-over-year growth at close to double the quarterly sequential growth rate. While this level of improvement may not be linear as we move forward, we expect continued strength in this area as we execute on our overall pivot to growth. The Grow category now represents approximately 38% of our business segment and carried an approximate 83% direct margin this quarter. For added color, Grow products represented 58% of our enterprise sales in the first quarter, an improvement from Q4 2022. Getting the Grow product category to grow faster is a key focus of our strategy, and we're pleased with these early results. Nurture products revenue declined 3.1% sequentially, driven by VPN and Ethernet. We will likely face headwinds within both Nurture and Harvest product categories as we actively work to maintain customer relationships and maximize customer lifetime value by migrating customers to newer technology solutions. Nurture now represents about 31% of our business segment and carried an approximate 65% direct margin this quarter. Harvest products revenue declined 4.9% sequentially. As with Nurture, we will see headwinds in this category as we pivot customers to newer technologies with a significant focus on voice migration. Our Harvest team continues to manage these products, both by extending the life of some products while also managing customers back to Grow products. Recall that Harvest is an important part of our business and generates cash to fuel our growth initiatives. Harvest now represents approximately 25% of our business segment and carried an approximate 78% direct margin this quarter. Other product revenue declined 9.4% sequentially. As I mentioned earlier, our other product revenue tends to experience fluctuations due to the variable nature of these products. Moving on to Mass Markets, revenue declined 1.6% sequentially. Our Mass Market fiber broadband revenue grew 2.7% sequentially and represented approximately 29% of Mass Markets broadband revenue. Also, note that our exposure to legacy voice and other services revenue continues to improve with a nearly 60 basis point reduction sequentially. During the quarter, total fiber broadband enablements were approximately 120,000, bringing the total fiber-enabled locations to approximately 3.3 million as of March 31. We had a strong ramp in fiber enablements during the quarter, and as Kate mentioned, we are confident in our ability to meet or exceed our 500,000 new enabled locations target for 2023. We expect to continue ramping this build pace in 2024 and look forward to sharing a longer-term view at our Investor Day on June 5. In the first quarter, we added 24,000 Quantum Fiber customers. This brings our total Quantum Fiber subscribers to 856,000. As Kate noted, we are ramping quickly with enablement and subscriber momentum building. Our installs of fiber broadband customers exceeded our copper installs, a trend that we expect to continue to widen going forward. Fiber ARPU was approximately $60 in the first quarter, and we see ARPU expansion opportunities with the adoption of in-home Wi-Fi solutions, up-tiering Enterprise-grade security solutions, and our recently launched Multi-Gig offerings delivering up to 8-gig symmetric services. The plant we are building is capable of further cost-effective multi-gig speed enhancements going forward. As of March 31, our penetration of legacy copper broadband was less than 12%, highlighting the significant share-taking opportunity as we accelerate the Quantum Fiber build. Our Quantum Fiber penetration stood at approximately 26%, and as we expand our footprint, we expect penetration to fall as we increase our addressable market at a higher rate when new customers are added. Many investors have asked about competing fiber activity. What we're typically seeing is activity on the distant fringes of our core growth markets. Our six core metros are hard markets to build out. Zoning and permitting hurdles, as well as the underground network infrastructure in these markets, which carries a higher build cost per location, may make other regions more appealing to competitors. While we took a small risk with our Quantum reevaluation phase, we did not see any meaningful change in competitive activity during that short window. As our enablement and subscriber results this quarter demonstrate, we are now focused on accelerating our deployment of fiber-enabled locations and adding subscribers. Our Quantum Fiber 2020 vintage frozen penetration is now above 30%, and we will provide an update next quarter with our 18-month penetration rate of the 2021 vintage. Our Quantum Fiber NPS score is now greater than positive 60, an indication of the quality, value, and superior service that Quantum Fiber delivers. Quantum Fiber is an all-digital, multi-gig capable prepaid product that features simple pricing with no contracts, helping reduce call center volumes and supporting our very strong NPS scores. We continue to experience no discernible change in customer payment patterns. Turning to adjusted EBITDA for the first quarter of 2023, adjusted EBITDA was $1.251 billion compared to $1.966 billion in the year-ago quarter. The first quarter of last year included $415 million related to the divestitures and $59 million for CAF II. In the first quarter of this year, we included a negative impact of $48 million from divestiture-related commercial agreements. These items represent roughly three-quarters of the year-over-year decline. As we discussed in our fourth quarter 2022 earnings call, EBITDA will be pressured from a year-over-year perspective based on higher inflationary impacts, dissynergies from divested businesses, investments in growth and optimization initiatives, and the impact of customer migrations as we focus on improving our customer experience with newer technologies and enhancing customer lifetime value. We incorporated these impacts into our annual guidance and are not changing those assumptions. Special Items impacting adjusted EBITDA this quarter totaled $114 million. Our first quarter 2023 adjusted EBITDA margin excluding special items was 33.5%. Capital expenditures for the first quarter of 2023 were $640 million. In the first quarter of 2023, the company generated free cash flow of negative $75 million. As previously noted, this includes $90 million of taxes paid related to our two divestitures that closed last year. Our reported net debt was $18.876 billion. Moving on to our 2023 financial outlook, as a result of the debt exchange offer I discussed earlier, we now expect cash income taxes to be in the range of $300 million to $400 million for the full year 2023. We anticipate offsetting this increase through our cost optimization efforts. In closing, our team remains focused on executing on our growth initiatives to drive long-term profitable revenue growth. We look forward to sharing more about our strategy and our path to growth with you at our Investor Day on June 5. With that, we're ready for your questions.

And our first question comes from Simon Flannery with Morgan Stanley. Please proceed with your question.

Great, thank you very much. Good evening. Kate, I wonder if you could talk a little bit about your conversations with the customers and how that's changed over the last few months since you've taken over, and perhaps how they're thinking about optimizing their spend in light of the uncertain macro environment. It sounded like payment patterns on the consumer side were okay, but any color you could provide on what you're hearing from the CIOs? And then maybe, Chris, just an update on the EMEA deal, what's the latest timing, is that still kind of right at the end of the year, the start of next year, and any updates on any other potential transactions?

Hi, Simon. Thank you for the question. Regarding what CIOs are saying, the environment is indeed complex, but it presents a significant opportunity, especially when collaborating closely with customers to innovate and address their biggest business challenges. They seek our assistance in providing cost-effective, reliable core operations, securing their data and applications, and fostering innovation. We aim to leverage our capabilities in partnership with other excellent companies to pursue genuine business opportunities. There’s a compelling narrative developing in AI and machine learning, as well as a substantial range of possibilities in the metaverse, where 3D rendering demands a vast amount of data and minimal latency. All the companies we're engaging with are embracing this mindset. The ecosystem partnerships we are creating, which merge our strengths with those of other software companies, are resonating well. More importantly, we are approaching them with a collaborative spirit, and this new initiative has been met with positive enthusiasm year after year. So, Chris, would you like to delve deeper into this?

Yes, so on the EMEA transaction, Simon, everything's on schedule as anticipated. No speed bumps and we still expect that to close late this year or early next year. And just as a reminder, we will use the proceeds from that transaction to reduce debt.

And then anything else that you're looking at real estate sales or anything else?

Yes, we continue to prune the portfolio. We're prudent. We've embraced the hybrid work environment and have announced that we are selling our Broomfield campus. It's underutilized even if everybody showed up that was assigned to this facility. So like a lot of other companies, we're going to monetize that. There are other real estate assets that will be closing on later this year as well. That has been in the works for a few years. As it relates to other business lines, we continue to look at options as to whether we harvest or resell, but don’t expect big moves from those kinds of things; that's more of a pruning exercise, and then any kind of major restructuring.

Great. And just one follow-up, Kate, on your comments. In the past, management talked about delayed decision-making; have you noted any changes in the kind of time it takes from customers to actually get a contract signed?

There hasn't been a material change, and I think what we're really thinking about is how do we show the value, how do we position our capabilities such that it cuts through any additional approval processes that the global macroeconomic environment might have been pushing on over the past 18 months to two years.

Thanks, Simon. Next question, please.

Our next question comes from the line of Michael Rollins with Citi. You may proceed.

Thanks, and good afternoon. Two topics if I could. First on the sales front, just curious with all the locations that you pass and that your fiber is near, is there a quantification of the low-hanging fruit of customer opportunities in terms of size or revenue opportunity? And then secondly, as you look at the EBITDA performance for the quarter versus the year, can you frame the potential costs or the revenue dilution over the next few quarters that there's one quarter or two quarters in particular that takes the annualized number for Q1 and puts you back into the range for the full year guidance? Thanks.

Michael, I'll take the first one on sales, and I'll let Chris hit the second one. From a sales productivity perspective, putting the right field force in the right locations is obviously incredibly important and what we're doing is over time, we're thinking through what business outcomes customers want to chase aligned with their particular industry or vertical, and that's really where the story is. It's about how we can stitch together our unique capabilities across networking, edge cloud, and security to show up in solutions that matter most to customers depending on not just where they're located, but that obviously is deeply connected to our edge capabilities. But that covers 98% of businesses. So I think we've got ubiquity there. It's really about the outcomes aligned with their business models. Chris?

Yes, and on the OpEx trend through the year, I mean, obviously, as we entered the year, we gave guidance. When we talked about the investments we were going to be making to position Lumen for success, we weren't at run rate when we came into the year, so that will be building as we go through the year and that's why that spend level was a little lower in Q1.

Thanks, Mike. Next question, please.

Our next question comes from the line of Philip Cusick with JPMorgan. Please proceed with your question.

Hi guys, thank you. A couple if I can. I appreciate the details, Chris, on the Grow, Nurture, Harvest buckets in the commentary and on Page 7. I'll go back and read it a few times so I understand it. In the meantime, what can you add on recent trends in sales and funnel and things like that? And when do you expect we will see these improvements come through in the net revenue trends? And then secondly, if you could just talk about any further debt swaps from here or are you sort of done with that would be helpful. Thank you.

Yes, I mean, as I mentioned in my prepared remarks, we're pleased with what we're seeing in the Grow category. There's obviously a lot of work around how we migrate customers from legacy technologies to newer technologies, but I do feel that things will ebb and flow as it relates to additional metrics behind it. We're not prepared to really talk about that yet today. We will at our Investor Day talk about operational metrics that we can provide on an ongoing basis to give you guys better visibility to where we are on this journey. But again, so far, so good. As it relates to the capital structure side of things, there's a lot of options we continue to evaluate, and obviously, it's a dynamic external environment, and so we're certainly not finished, but there's nothing that's firm right now, and obviously, as we firm those things up, we'll keep everybody apprised.

Maybe if I can ask the first one a little bit differently, the Grow bucket, 3.4% growth in the first quarter, quarter-to-quarter in the Grow bucket; how much of that do you think is attributable to new efforts or new products that are being pushed, is this sort of a revitalized sales effort, or I don't know if this is seasonal?

Okay. So I'll take that one. Basically, as I said in my opening remarks, we have a ton of work to do to galvanize our Enterprise selling machine. That's everything from sales running this program, digital marketing campaigns, making sure that we're driving analytics on what's the next best thing to do on our sales platform, and it's upskilling our talent across the field organization. If you think about that we’ve already started doing that, and we're seeing improvements in mid-market green shoots and large Enterprise green shoots where we're seeing more funnel, we're seeing bigger deal sizes, etc., but we're not where we need to be. If I anchored ourselves in the goal, it would be to be executing at or better than market in every one of the product categories.

Thanks, Phil. Next question, please.

Our next question comes from the line of David Barden with Bank of America. Please proceed with your question.

Hi everyone, thank you for taking my questions. First, Kate, are you beginning to address the opportunity to provide solutions and be a partner to your customers? Considering that you may need to introduce new offerings beyond what you currently sell, you need to enhance your capabilities. One approach is to develop applications in-house. Another is to acquire companies with the necessary capabilities or hire skilled individuals. You could also consider outsourcing these opportunities. However, each of these strategies brings its own expenses and complexities. Could you provide some insight into how you plan to transition from where the company was a year ago, or even six months ago, to where you aim to be? What does that look like, and how do you anticipate generating additional revenue by solving customer problems while maintaining a healthy margin? Additionally, Chris, regarding the direct margin breakdown you've provided; it seems that in the Harvest segment, losing predominantly voice revenue would essentially mean losing that at a full margin. However, I believe you mentioned that 58% of new sales are in the growth segment. This growth segment appears to have more challenges and lower margins at the initial phase. So, for every dollar lost in Harvest, how many new growth dollars would we need to generate to maintain that EBITDA level? Thank you.

Okay. Let me start with your question, and I will say there was a lot to it, David, so I'd like to just sort of give you my simple answer, which is we have a three-pronged strategy. Number one, we're going to stem organic decline. That's like VPN, SASE, and voice migration efforts. And I can talk a little more about what that looks like under the hood in just a second. Number two, we're going to better execute against the core, and that's where we're going to hit or exceed market growth rates and things like IP, waves, and Ethernet in the Grow bucket. And then we're going to innovate for growth. And that's both commercializing the things that are on the truck today, which we are under-commercialized, period. We just don't flex our muscles in a way that we can and should, and you'll see us doing that more and more. We're also going to collaborate with partners and customers to create net new capabilities, obviously leveraging our proprietary offerings in security and the edge and the network. Then there's the third thing, that is basically the main lever for creating operating leverage, which is network-as-a-service or NaaS, which is where we digitize everything. So three legs of the stool: stem organic decline, better execute on the core, and innovate for growth. When you talk about sitting with customers and reshaping the company to actually follow the dollars, which tend to stem out of complex business problems that our customers are trying to solve, they need the capabilities that we have, and their need to consume data is just going to increase. The more we can digitize our physical assets and bring those capabilities to bear in all of the existing and net new business problems, the more you'll see Lumen being recognized as not just customer-obsessed but a very innovative company. How do we afford that? All the things I said, we're simplifying. We're driving a digital enterprise. We're getting rid of the stuff that doesn't make sense. We're optimizing not just for efficiency, we're optimizing for growth. So let's talk about your question to Chris, and then Chris, I'll ask you to add comments. If we're cannibalizing ourselves, which I think is what you're asking about in the Harvest bucket, we've got cash coming off of those products. Why would you actually go after those customers? And I come from tech; I'm new to telecom, so this is sort of mind-blowing for me to think about this notion of not touching anything. Because the whole idea of customer life cycle management is how you increase the value of a customer relationship over the lifetime of that customer. If we do nothing, those customers will churn, so we go from 100 pennies to 0. We could go after them and do a one-for-one product swap. Yes, some of the newer technologies might result in less margin, but that's not how we're thinking about it. We go after them to get them to net new technologies to modernize their businesses. And we think about it from the perspective of maintaining the customer relationship and maintaining the customer data, understanding how they behave, and upselling them in our IP and third-party IP. Net-net, I think what we're finding, and it's early in this process so we don't have all of the tricks yet, but what we're finding is an opportunity to increase all of those revenue and EBITDA flows. Chris, do you have anything to add?

No, I think Kate explained that as well as it could be explained, David. The key thing is, and I've been asked this question a lot, obviously, at conferences, it's not an either/or scenario. It's not either you get to keep the legacy voice customer and milk it for as long as you can; the alternative is just a low-margin replacement. It really is this bundle. And oh, by the way, when you're thinking about the future with a customer and the day after that and the day after that, it's a very different way of thinking about the space than what I think people are normally accustomed to out of telecom. So that's what we're trying to do here.

Thanks, David. Darcey, next question please.

The next question comes from the line of Batya Levi with UBS. Please proceed with your question.

Thanks. Just a follow-up on that point. Actually, can you talk a little bit more about why the growth bucket direct margins are above Harvest, where you're running it for cash, and what's driving that upside? Also, maybe a little more specific for the quarter, but what drove the pickup in the growth bucket in the quarter? Are there any kind of shifts from the Nurture bucket that we should think about as clients take hybrid products? And if you could elaborate a bit on the pricing in the segment and any change in who you compete with as you change the approach in this category?

Thanks, Batya. Let’s begin with what we discussed last quarter regarding our sales team’s incentive structure. We’ve adjusted it so that the team is encouraged to focus on growth products rather than relying on legacy revenues that we anticipate will decline, as Kate mentioned. This change will help maintain our focus in the right areas. Concerning margins, while legacy voice has high margins, it comes with substantial maintenance costs. In contrast, new technologies like IP and waves are very efficient to operate once the initial capital is invested. Additionally, as we introduce security services, as noted by Kate in her remarks, with some Lumen IP added, it also enhances our margins. To summarize, we observed strong performance in IP and colocation products during the quarter.

Thanks, Batya. Darcey, next question please.

The next question comes from the line of Nick Del Deo with MoffettNathanson. Please proceed with your question.

Hi. Thanks for taking my questions. Kate, you noted some really encouraging new logos in revenue per customer data in Q1 versus Q4. I assume you're looking at sequential trends to strip out the noise from the divestitures. I'd still be interested if you're able to bring those metrics to sort of a broader historical context. Or even if you can't quantify it, can you say those sorts of changes in logos and revenues per customer are well outside the bands of what was historically typical?

I want to go back to our philosophy of customer lifetime value. The choice between not chasing the customer and allowing for churn versus moving to a modern platform where you can upsell them on your first-party technology and security and the like versus third-party. I think going after the organic decline strategically is going to pay off in a material way. It's so early right now, Nick, that it's really hard to characterize. I will be very honest and tell you that the data we have about our sales efforts and our customers has been revamped, and we put new analytics in place, and we have transparency down to the rep level that we never had before. So it's extremely hard for me to give you the sort of comparison that you're looking for. I think it's sort of a new set of efforts, and we're excited by the early results.

Okay, understandable. And I guess you're obviously doing a lot of prep work for some of the systems changes you've talked about. Any early developments or learnings there, whether encouraging or challenging that you think was calling out as we think about the work you have to undertake over the next couple of years?

I think when you think about a telecom company that's a collection of companies, you need to assume that we have an antiquated IT backbone that's extremely complex, and there's a lot of work to do in order to simplify it. So, unfortunately, this is not something that we can just snap our fingers and correct quickly, easily, or cheaply. It takes investment. But something that I think is new is our ability to fund our future. Funding our future includes making these systemic changes to enable better coverage of the market, better customer experience, and streamlined operations capability. There's a huge amount of work to do and an enormous opportunity for this company.

Okay, just one last one if I can. Chris, are you able to share the level of growth and optimization spend in the quarter?

No, we're not disclosing that. But again, if you took our annual guidance and divided it by four, we were less than that in the quarter, as I said, because we're obviously ramping those efforts. So you'll see a little more spend later in the year than you did at the beginning of the year.

Thanks, Nick. Darcey, next question please.

Our next question comes from the line of Greg Williams with TD Cowen. Please proceed with your question.

Great. Thanks for taking my questions. A few questions on Quantum Fiber. You noted that the factory is back, so to speak. Can you help us with the fiber subscriber build cadence from here? Typically, the second quarter is a little weaker in broadband, but with this engine up and running, could we expect sequential growth in fiber subscriber additions? And then the second is just on the increased cost of homes passed. I know you guess to get up to $1,200 a home passed, but as I think about labor, it could be in short supply when you're trying to accelerate later this year in 2024 as money chases the same labor pool. Just curious to hear your thoughts and expectations on comfort levels there.

I'll hit the first one, and then Chris can tackle the second. If you think about the factory, we've got the enablement piece up and running, and we're excited about the breakthroughs we've made. We've aligned the team, streamlined operations, and our advisory services are helping us do better engineering assessments for how to tackle all the enablements. The first thing you need to get a subscriber is need an enablement. What do you need in between those two outcomes? You need a marketing engine. Now that we've got the enablement, really high-quality ones up and running, you're going to see us putting gas into the marketing campaigns, digital marketing campaigns to really turn the needle on subscriber growth.

Yes, on the cost side, we feel good about the guidance we provided at the beginning of the year. More importantly, we believe there is potential for an increase in ARPU, which we will be focusing on going forward. This means that if we see changes in costs, they will have less impact on our long-term returns compared to ARPU. We will keep monitoring this, and I want to emphasize that we are not facing any pressure in this area currently. The team is actively seeking efficiencies and, in some cases, has managed to build at a more cost-effective rate than initially planned. We will keep pushing for that, but I'm less worried about that number in relation to overall returns. The focus really is on penetration and ARPU, and we feel positive about both.

Thanks, Greg. Next question, Darcey.

Our next question is from the line of Frank Louthan with Raymond James. Please proceed with your question.

Great. Thank you. One of your peers is looking to pursue exiting some copper locations as they're sort of way under their collar obligations. Are there any opportunities there for you as you look forward? And then secondly, when you run fiber into an area, how long is it before you can retire the copper there and not have to support two networks?

Yes, I'll take that, Frank. So on opportunities for additional copper consolidation, I'd say just simply that's not our focus; we've got to pivot to the new. It's where the future lies for us and that's what we're focused on. As it relates to the copper, I don't have an exact answer for you, but I can tell you that in a way, our job on that front is easy because we're starting from such a poor place in terms of copper penetration. It's at 12%. When we go into a market, we can really blast it with fiber. There are no major issues in terms of turning copper down. The team's all over that, and they make those decisions on a market-to-market basis.

Thanks, Frank. Darcey, next question please.

Our next question is from the line of Eric Luebchow with Wells Fargo. Please proceed with your question.

Thanks for taking the question. In your earlier remarks, you talked about retiring more than 60% of your enterprise SKUs, primarily from legacy products. I am wondering, has that had any impact on revenue contribution? Maybe you can provide some early color on what those SKUs were, what type of success you've seen thus far migrating those customers up the stack? And then secondly, one for Chris, given your desire to invest more in Quantum Fiber, any way to break down enterprise CapEx? If we see any more market dislocation, how much of that is success-based CapEx that you could potentially adjust to help keep leverage in line?

Yes. Regarding the portfolio simplification, the reduction of 60% of the SKUs was non-revenue impacting. What it did was clean up the database of product capabilities that we offer today and seek revenue on, which enables simplification from ordering all the way down through billing. So it was the first step. Now we've got to take the next couple of steps, which is, A, further simplification. And then b, as we look to upgrade our ERP and do all the complicated work of reducing our application portfolio, we'll probably have some harder decisions to make, but that's the next tranche of work.

Yes, and as it relates to the CapEx, again, there's a lot of math that we've shared on this. But I would say simply and directionally, high level, we've said that of our roughly $3 billion in CapEx guidance for the year, it was split roughly two-thirds enterprise business, I should say, and one-third Mass Markets with about $250 million in each of those for maintenance. Quantum had about $600 million, and then there's the CapEx that goes into in-home enablements and turnups. So that's the $1 million for consumer. On the enterprise side, after maintenance, you've got $1.75 billion left. We've said that the enterprise business is really going to be the beneficiary of a lot of the optimization investments we're doing on the CapEx side, which left about $1.25 billion for success-based CapEx. Entering the year, for success-based, we probably have visibility to where about 30% of that is going because of contracts that were sold last year that will be turned up this year. The rest of it is based on what we sell this year. There’s enormous flexibility as we go through the year. If enterprise goes through a period of significant softness, we'll spend less. There's a natural governor and correlation between those two numbers. But as we go through this year, we're confident that we can stay within our guidance, given what the Mass Markets team is seeing. As we look to future years, we'll talk more about that on June 5.

Thanks, Eric. Darcey, we have time for just one last question.

Certainly. Our last question comes from the line of Jonathan Chaplin with New Street Research. Please proceed with your question.

Thanks. I have two quick questions. First, do you have an estimate of the BEAD opportunity within your service area? How many locations might qualify for BEAD funding among those that you do not plan to upgrade to fiber? Secondly, I have a technical question for Chris. Regarding the proceeds from the EMEA transaction, I understand that they will be used to reduce debt. Can you specify which part of the debt these proceeds will address? Will they be used within the Level 3 segment to pay down debt there, or can they be applied across the entire capital structure?

Sure. I'll take the first one, and I'll let Chris do the second one. With respect to BEAD, all of our numbers that we've shared with you, the 8 million to 10 million we've talked about a couple of different times, that's without BEAD funding at all. So anything from BEAD would be a net positive add to the story. It's early days yet, and we're not exactly sure how it's flowing down, so we can't give you that kind of transparency or precision yet. But we look at it as potential upside for sure.

Yes, and on the EMEA proceeds, we'll get more specific about where those proceeds go as time goes on, but we do have a certain amount of flexibility. The biggest thing is, we've got to be thoughtful about where we are on covenants, and that's part of what goes into our decision-making.

Great. Thank you very much.

Thanks, Jonathan.

Thank you. So thanks, everybody. That concludes our call today. I appreciate your time and look forward to seeing you or hearing from you on June 5. Have a great day.

We would like to thank everyone for your participation and for using the Lumen conferencing service today. This does conclude the conference call, and we ask that you please disconnect your lines. Have a great day, everyone.