Defining the Broadband and Technology Future for Your State

Transitioning to Internet in Rural America

Michael J. Balhoff, CFAJuly 27, 2012

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Michael J. Balhoff, CFA Headed sell-side equity telecom research group

(16 yrs) Six annual Wall Street Journal All-Star awards Focused coverage of rural telephony and

regulation Balhoff & Williams/Charlesmead Advisors Representative clients

Telecom: NCTA, Comcast, AT&T, Verizon, SBC, Embarq, CenturyLink, Frontier, FairPoint, Windstream

Energy: NorthWestern Energy, Anchorage ML&P Financial Community: Merrill Lynch, Silver Point

Capital Recent briefings for White House, FCC, Secretary of

Agriculture, Rural Utilities Service, NARUC, MACRUC

Background

ALEC, July 27, 2012

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The rural problem Confused concepts—tax/subsidy v. investment Confused beneficiary—companies v. consumers Significant and ongoing investment Little factual/financial discipline in assessing

policy Federal reforms affect the states

Significant cuts in federally-supported funding States left to address problems with services

and rates Recommendations about state USF

The state’s choice is unavoidable More rigorous analysis of problem and policy Evaluate potential mechanisms to support

investment

Overview

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THE PROBLEM

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Critics use terminology that confuses/biases the dialogue “Subsidy” is a payout to an individual or industry “Taxes” are unpopular assessments Support “inefficient LECs” (real beneficiaries:

consumers) Conceptual USF history—wide customer base

supports ubiquitous network “investment” creating value for all

Easier concept when telecom was a monopoly USF is even more critical, but complicated, in

competitive world Need to target USF on regions where competitive

markets fail USF/implicit support were not and are not

subsidies/taxes USF and ICC support are investments Generate ROI in terms of social and economic

benefits Efficient investments supplement other investor

dollars

Confusion: Tax or Investment

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Policy Drivers of Higher Fund

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ILEC non-access funding from $2.16B (’03) to $1.37B (’11)

Total ILEC USF from $3.15B (’04) to $2.92B (’11) Growth in overall USF is due to new policy factors

Slide 7

Texas Study (2007) on 350,000 rural lines excluding USF . . . 77% WCs

-9.7% ROI 13% WCs

2.9% ROI 10%

generated 10%+ ROI

Rural Customer Networks

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Financial Performance of All Wire Centers without USF Payments

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More striking is the finding that outside of rural towns, 52% of the lines generate negative returns (average -7% return on investment)

Total uneconomic lines are . . . All lines outside towns,

which were 52% of the total

Plus 18% of total lines (in towns generating a negative return)

Equals 70% of total lines uneconomic without USF

Outside of Rural Towns

ALEC, July 27, 2012

Source: Balhoff, Rowe & Williams, LLC 2007

Slide 9

June 2012 rural broadband usage data

Wireless today is not a real BB solution Net

neutrality questions (wireline v. wireless rules)

Rates of $30-$60 for wired services that are unlimited

Wireless LTE—$100/month for 10 GB; $10/GB overage

Wireless: 20GB/month~$200; 30GB~$300; 40GB~$400

Assumption about wireless fails the USF rate-test

Discipline in Evaluating Problem

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Core problem in many rural areas—economic market failure Critics say that “competition” will solve,

however . . . Verizon is getting out of rural business AT&T announced it has no rural broadband

solution Cable avoids economically irrational areas

No one will bid where there is a market failure The real problem is high cost to build/operate

consumer networks in certain regions Problem for large and small carriers Greenfield builds will be expensive and probably

risky Cable, wireless, urban carriers do not have same

problem

Focus on the Real Problem

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FEDERAL REFORMS AFFECT STATES

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Approximate USF/ICC Reductions

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Federal reforms (2011) Rural USF/ICC rev. loss

Revenue reductions assume changes in HCLS, ICLS, Safety Net Additive, $250 per line per month cap, ICC reductions, and changes to ROR

The rural industry could have annual revenue reductions of nearly $1 billion in 2020 from reforms

Cumulative reductions could be $5.2 billion from 2012 to 2020 according to NECA

Estimates by National Exchange Carrier Association

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USF/ICC as % of Total Revenues

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Source: Confidential company information; Balhoff & Williams, LLC

7500+ lines ILEC 1 ILEC 2 ILEC 3 ILEC 4 ILEC 5 ILEC 6 AverageUSF 0.0% 22.8% 13.9% 8.6% 36.8% 37.6% 20.0%

Network access 50.7% 59.5% 54.6% 51.9% 43.5% 55.5% 52.6% Total access/USF 50.7% 82.3% 68.5% 60.5% 80.3% 93.1% 72.6%

EBITDA margin 25.5% 49.2% 29.4% 34.0% 40.1% 49.1% 37.9%

Interest expense -0.7% -6.5% -3.9% -1.6% -5.3% -7.2% -4.2%

1,000-3,000 lines ILEC 1 ILEC 2 ILEC 3 ILEC 4 ILEC 5USF 0.0% 27.2% 13.4% 24.3% 31.9% 19.4%Network access 57.5% 39.7% 56.8% 70.3% 35.4% 52.0%

Total access/USF 57.5% 66.9% 70.2% 94.6% 67.3% 71.3%

EBITDA margin 26.2% 30.0% 30.5% 48.8% 45.6% 36.2%Interest expense -6.2% -4.5% -3.8% -9.2% -0.3% -4.8%

<1,000 lines ILEC 1 ILEC 2 ILEC 3 ILEC 4

USF 18.2% 3.0% 19.3% 19.1% 14.9%Network access 65.5% 72.6% 68.5% 55.8% 65.6%

Total access/USF 83.6% 75.6% 87.8% 74.9% 80.5%

EBITDA margin 36.4% 30.7% 18.0% 27.2% 28.1%Interest expense -3.2% 0.0% -1.3% -6.1% -2.6%

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Illustrative EBITDA Outlook

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Simplifying assumptions EBITDA margin = 33% USF + access =

75% of revenues Cost benefits

of reforms = 0% USF reform and effect of ICC reduces EBITDA

margin in this illustrative analysis; the margin slips from 33% to 12.6% by 2020

Interest expense (4%-6% of today’s revenues) would eliminate much of residual cash flow by 2020, leaving ILEC with little cash for capex or principal repayment

Source: Estimates by Balhoff & Williams, LLC

RECOMMENDATIONS

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Understand the Outcomes

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Increased cost of capital Insufficient recovery, skepticism/avoidance of sector by debt and equity

investors Consolidation may occur (complicated by financial risks/potential

bankruptcies)

Operating

Reduced or eliminated near-term capital investment (likely no increase)

Proximate reductions in personnel and other operating costs

Financial

Customer service

Growing urban-rural divide in terms of investment/telecommunications services

Rates will rise for rural services less-than-comparable to those in urban areas Policy

COLR becomes more problematic due to underfunded or unfunded mandates

Services will no longer be “comparable” in urban and rural regions Private-public partnership fails; no one may bid at reverse auctions

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Focus state policymakers on reforms Reforms’ effects on all state consumers State USF investments

Analyze and understand the policy issues Escalating rural customer demand for BB

services How economic welfare can be achieved most

effectively Understand the options in terms of state

mechanisms Dollars required for state supplemental funding How funding might be collected and distributed

Specific Recommendations

ALEC, July 27, 2012