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Emerging Strategic Challenges for Rural Carriers: Financial Outlook and Directions Georgia Telecommunications Association Francis X. Gallagher June 19, 2012 2 GTA June 19, 2012 Overview Purpose ▫ Financial perspectives on current ILEC challenges and opportunities ▫ Potential directions Presentation ▫ Telecom industry operating trends ▫ Financial import of the regulatory sea change ▫ Opportunities for Georgia ILECs Philosophical view ▫ Industry has been remarkable for more than a century ▫ Fundamental changes—technology, competition, regulation ▫ Next epoch will emerge from insightful, correct strategic choices 3 GTA June 19, 2012 4 GTA June 19, 2012 Detailed Quarterly Wireline Trends Revenue Growth ALSK CTL CNSL FTR TDS WIN Average Median 1Q10 -4.3% -6.7% -3.4% -3.4% -2.9% -2.8% -3.9% -3.4% 2Q10 -1.6% -7.0% -6.2% -3.0% -0.8% -3.0% -3.6% -3.0% Access Line Growth 3Q10 -1.5% -6.8% -5.9% -7.3% 0.7% -1.5% -3.7% -3.7% 4Q10 2.1% -6.4% -7.0% -6.6% 0.3% -2.2% -3.3% -4.3% 1Q11 5.0% -5.8% -2.9% -7.5% 3.0% -1.8% -1.7% -2.3% 2Q11 0.5% 0.7% -3.3% -7.8% 3.8% 0.1% -1.0% 0.3% 3Q11 0.6% -4.6% -3.2% -8.0% 4.7% -1.4% -2.0% -2.3% 4Q11 3.2% -3.2% -0.1% -5.6% 4.0% 0.7% -0.2% 0.3% EBITDA Margin ALSK CTL CNSL FTR TDS WIN Average Median 1Q10 36.1% 42.8% 47.9% 47.9% 24.3% 49.7% 41.4% 45.3% 2Q10 37.3% 45.2% 48.0% 45.7% 22.5% 49.5% 41.4% 45.4% ALSK CTL CNSL FTR TDS WIN Average Median 1Q10 -6.1% -8.4% -5.8% -6.0% -4.7% -3.9% -5.8% -6.0% 2Q10 -5.7% -8.0% -4.8% -6.3% -4.2% -3.7% -5.4% -5.7% 3Q10 -5.1% -7.8% -4.3% -9.3% -4.2% -3.7% -5.7% -5.1% 4Q10 -4.4% -7.6% -4.1% -9.0% -5.3% -3.6% -5.7% -5.3% 1Q11 -3.9% -7.5% -4.0% -9.0% -5.5% -3.6% -5.6% -5.5% 2Q11 -4.6% -7.4% -4.1% -8.6% -5.5% -3.6% -5.6% -5.5% 3Q11 -5.2% -7.1% -3.9% -8.5% -5.2% -3.9% -5.6% -5.2% 4Q11 -5.9% -6.6% -3.9% -8.3% -5.1% -4.0% -5.6% -5.9% 1Q11 -1.5% 6.1% 5.4% -0.2% 4.2% 5.7% 3.3% 4.8% 2Q11 -1.0% 4.3% 5.0% 2.5% 3.4% 4.8% 3.2% 3.9% 3Q11 -1.5% 4.0% 4.4% 2.5% 3.8% 4.3% 2.9% 3.9% 4Q11 -3.0% 4.5% 4.3% 2.6% 2.5% 4.2% 2.5% 3.4% Broadband Sub Growth 3Q10 38.7% 44.8% 48.9% 47.9% 21.8% 49.5% 41.9% 46.3% 4Q10 36.0% 44.9% 48.9% 45.8% 16.8% 39.1% 38.6% 42.0% 1Q11 36.6% 45.7% 48.8% 46.5% 22.3% 50.1% 41.7% 46.1% 2Q11 36.1% 41.1% 49.5% 47.9% 25.3% 49.8% 41.6% 44.5% 3Q11 36.3% 43.2% 50.0% 47.2% 23.2% 49.6% 41.6% 45.2% 4Q11 34.7% 39.7% 51.6% 48.0% 16.4% 39.0% 38.2% 39.3% ALSK CTL CNSL FTR TDS WIN Average Median 1Q10 -1.3% 8.9% 8.0% 7.3% 11.2% 9.9% 7.4% 8.5% 2Q10 -1.9% 8.9% 8.1% 5.5% 9.5% 9.2% 6.5% 8.5% 3Q10 -1.9% 8.0% 7.3% 2.2% 8.2% 8.0% 5.3% 7.7% 4Q10 -2.0% 7.1% 6.3% 1.4% 6.4% 6.5% 4.3% 6.3% Access line losses at rates that show no material sign of improvement Revenues stable year-over-year Margins weakening, but negative seasonal effect in the fourth quarter Broadband sub growth is stable; except results reported at ALSK 5 GTA June 19, 2012 Broadband Trends HSD Subscriber Growth HSD Market Share Source: UBS Investment Research, company data Broadband growth has weakened precipitously since mid-2011 ▫ ▫ ▫ DSL growth stopped and then began to contract materially in 2Q11 ILEC growth has slowed v. cable growth; cable offerings more robust Market share shift toward cable since mid-2010; has cable “won” the wireline battle in non-FTTH markets ILEC / total broadband growth driven by fiber-based adds 6 GTA June 19, 2012 Revenue Generating Unit Trends Year-over-Year Change in Revenue Generating Units Cable Index (1) Source: Company filings and press releases (1) Cable index is comprised of CVC, CHTR, CMCSA, MCCC, and TWC. (2) RLEC index is comprised of ALSK, CTL, CNSL, FTR, TDS, and WIN. Cable losing basic video subs, replacing with High Speed Data and voice RLEC RGUs contracting since 3Q08, as broadband adds can’t fully offset access line losses RLEC Index (2) 7 GTA June 19, 2012 Revenue and EBITDA Trends Year-over-Year Change in Revenue and EBITDA Cable Index (1) : Revenue EBITDA Source: Company filings and press releases (1) Cable index is comprised of CVC, CHTR, CMCSA, MCCC, and TWC. (2) RLEC index is comprised of ALSK, CTL, CNSL, FTR, TDS, and WIN. Trends generally mirror RGUs RLEC trends improving since mid-2010, largely due to diversification efforts (broadband, business, data centers, etc.), and management of costs RLEC Index (2) : Revenue EBITDA 8 GTA June 19, 2012 Wireless Overview VZ/AT&T generate ~90% of U.S. wireless FCF Question about service revenues (w/o handset revs) and profitability quarterly through 4Q11 ▫ ▫ ▫ AT&T 4Q11 service revs slipped to 4% growth VZ service rev growth more stable; ~6% in 4Q11 ATT 4Q11 EBITDA growth -12.7%; for VZW -5.3% Total Service Revenue Growth ARPU growth pressured, suggesting weakness in the future in spite of data volume growth ▫ ▫ ▫ ▫ AT&T ARPU 4Q11 growth contracted (-4.0%) VZW ARPU growth in 4Q11 was 0.0% Industry-wide ARPU growth negative since late 2008 High-margin smartphones v. lower-margin devices (tablets, dongles, data cards, etc.) EBITDA Growth 9 GTA June 19, 2012 The Race to 4th Generation Services Long Term Evolution WiMAX Verizon completes LTE network build 2014 Clearwire committed to WiMAX through 2015 Clearwire launches LTE network Verizon LTE coverage equal to 2010 3G coverage 2013 T-Mobile launches LTE network Verizon offers service to ~200M POPS 2012 Clearwire offers service to ~130M POPs U.S. Cellular launches LTE network AT&T launches LTE network 2011 Verizon launches service to ~110M POPs MetroPCS launches LTE network Source: Company websites and press releases 2010 Clearwire offers service to ~120M POPs 10 GTA June 19, 2012 11 GTA June 19, 2012 Order Provisions by Carrier Type Price Cap & ROR Price Cap Only ROR Only Wireless Universal Service Fund / Connect America Fund (CAF) • • • • Public interest obligations for voice, broadband in supported areas (based on speed, latency, capacity) Annual budget of $4.5B; up to $1.8B price cap, $2B ROR Rate floors ($10 beg. 7/12 and $14 beg. 7/13) Per line caps on USF; 3-yr. phasein; no more than $250/month after 7/14 • • • • • • • Freeze support at 2011 levels From 2015, 100% used on BB where no subsidized comp. Phase I: up to $300 million in one-time support ($775/line) Phase II: ongoing support of ≤ $1.8 mil./yr. for 5 yrs.; optional 4/1 up Mbps to all supported locations statewide by end yr. 5 Forward-looking cost model Auction if LEC declines • 6-year transition to bill-and-keep (see p. 271) ARM baseline is 90% of 2011 2011 MOUs reduced 10% annually Limitations on charges passed through to customers If use CAF (with obligs.) to offset ICC reduction, phase-out over 3 years starting in 2017 Bill-and-keep for LEC-CMRS nonaccess traffic begins in July 2012 Caps intrastate originating rates • • • • • By July 2012, 4/1 BB must be provided upon request by LECs drawing ICLS, HCLS, or CAF Limits on reimbursable capex and opex beg. in July 2012 SNA eliminated; LSS frozen 1/126/12, eliminated 7/12 Phase out support over 3 yrs. where unsubsidized competitor Evaluate 11.25% ROR • No cap on originating intrastate access 9-year transition to bill-and-keep termin. interstate (p. 271) Inter- and intrastate transport capped at current interstate ARM based on 2011 interstate, intrastate, net recip. comp. 5%/yr. reduction to baseline ICC-replacement CAF support phases out as eligible recovery decreases over time Bill-and-keep for LEC-CMRS nonaccess traffic begins in July 2012 • • • • • • Phase I: $300 mil. one-time for currently unserved areas Reverse auction to award support; no identical support 3G (200/50 kbps) in 2 yrs.; 4G (768/200 kbps) in 3 yrs.; 75% of road miles in unserved blocks Eligible provided no publicly disclosed plan before 1/2013 Phase II: $500 mil./yr. ongoing 5-yr. transition of CETC funds Intercarrier compensation • • • • • • • • Transition interstate terminating to bill-and-keep Interstate elements capped Terminating intrastate rates capped for all carriers Caps price cap intrastate originating rates (not ROR) Recovery mechanism (ARM) transitional, not revenue neutral Recovery through ARC + CAF No ARC above $30 res. rate ceiling; no multi-line bus. ARC if SLC+ARC above $12.20/line If recovery > ARC rev., then CAF • • • • • • • • • • • • • • • • 6-yr. transition to bill-and-keep for terminating interstate access Bill-and-keep for LEC-CMRS nonaccess traffic begins in July 2012 Rules for transport within and outside rural ROR LEC’s service area (to interconnection point or meet point) Traffic to/from CMRS provider in same MTA is subject to recip. comp., not access 12 GTA June 19, 2012 Rural Financials 2012 L-T effects of initial reform Pending “reforms” Caps and other limits reduce rural funding USF remains capped; carriers hesitant to accept restrictive obligations; CAF not defined More reductions: proposed ROR, safety net additive, $250 cap target in 3 steps, comp. overlay, low rate adj. Access funding + Wireless recip. comp and initial step-down in intrastate access revenues (RM from capped fund) Estimated $1.215 billion in rural-related total access revenues (~60% terminating) Orig. access (~$500 mill) Competitive pressures = Increased rates, ongoing losses in denser, more profitable regions; shift of operations toward unprofitable regions with lesser internal cross-subsidization from profitable regions; increasing costs to meet evolving broadband challenges Net effect Reductions in cash flows; operating/investing contraction in uneconomic regions USF + Net reduced cash flow from access and USF, possibly $1.5 billion annually Re-prescription of ROR reduces cash flows and raises risk (cost of capital) 13 GTA Approximate Revenue Outlook Rural USF/ICC loss ▫ 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 reductions of nearly $1 billion in support in 2020 Cumulative reductions could be $5.2 billion from 2012 to 2020 Source: NECA estimates June 19, 2012 14 GTA June 19, 2012 Small Company Metrics 7500+ lines USF Network access Total access/USF EBITDA margin Interest expense 1,000-3,000 lines USF Network access Total access/USF EBITDA margin Interest expense <1,000 lines USF Network access Total access/USF EBITDA margin Interest expense Company 1 Company 2 Company 3 Company 4 Company 5 Company 6 Average 0.0% 50.7% 50.7% 22.8% 59.5% 82.3% 13.9% 54.6% 68.5% 8.6% 51.9% 60.5% 36.8% 43.5% 80.3% 37.6% 55.5% 93.1% 20.0% 52.6% 72.6% 25.5% -0.7% 49.2% -6.5% 29.4% -3.9% 34.0% -1.6% 40.1% -5.3% 49.1% -7.2% 37.9% -4.2% Company 1 Company 2 Company 3 Company 4 Company 5 0.0% 57.5% 57.5% 27.2% 39.7% 66.9% 13.4% 56.8% 70.2% 24.3% 70.3% 94.6% 31.9% 35.4% 67.3% 19.4% 52.0% 71.3% 26.2% -6.2% 30.0% -4.5% 30.5% -3.8% 48.8% -9.2% 45.6% -0.3% 36.2% -4.8% Company 1 Company 2 Company 3 Company 4 18.2% 65.5% 83.6% 3.0% 72.6% 75.6% 19.3% 68.5% 87.8% 19.1% 55.8% 74.9% 14.9% 65.6% 80.5% 36.4% -3.2% 30.7% 0.0% 18.0% -1.3% 27.2% -6.1% 28.1% -2.6% Source: Confidential company information; Balhoff & Williams, LLC 15 GTA Illustrative EBITDA Outlook Simplifying assumptions ▫ EBITDA margin = 36% ▫ USF + access = 75% of revenues ▫ Cost benefits of reforms = 0% USF reform and effect of rural growth factor reduces EBITDA margin in this illustrative analysis slips from 36% to 13% by 2020 Interest expense (typically 4%-6% of today’s revenues) would eliminate more than half of the residual cash flow by 2020, leaving ILEC with little cash for capex or principal repayment Source: Estimates by Balhoff & Williams, LLC June 19, 2012 16 GTA June 19, 2012 Focus on Operating Cash Flow Operating CF margin Sensitivity of Operating CF to Percentage of Revenues Lost 0.0% 15% 20% 25% 30% 35% 40% 45% 50% 5% 33% 25% 20% 17% 14% 13% 11% 10% Percentage of revenues lost 10% 15% 20% 67% 100% 133% 50% 75% 100% 40% 60% 80% 33% 50% 67% 29% 43% 57% 25% 38% 50% 22% 33% 44% 20% 30% 40% 25% 167% 125% 100% 83% 71% 63% 56% 50% 30% 200% 150% 120% 100% 86% 75% 67% 60% Minimal revenue impact can be substantial in terms of cash flow Contracting cash flows put pressure on interest payments, appropriate returns to equity holders, principal repayment, capex and new business development 17 GTA June 19, 2012 Potential/Probable Outcomes Operating Reduced or eliminated near-term capital investment (almost certainly no increase) Proximate reductions in personnel and other operating costs Financial Increased cost of capital Insufficient recovery, skepticism about or avoidance of sector by debt (primary concern for RUS companies) and equity investors Companies will evaluate consolidation, made more complex by financial risks and concern over potential bankruptcies Customer service Growing urban-rural divide in terms of investment and telecommunications services Rates will rise in rural regions for services less than comparable to those in urban areas Policy COLR becomes more problematic if uneconomic mandates are underfunded or unfunded Services will no longer be “comparable” in urban and rural regions Potential exists that private-public partnership fails; no one may bid at reverse auctions 18 GTA June 19, 2012 19 GTA June 19, 2012 Telecommunications Industry Dynamics Challenges Opportunities Increased organic growth Regulatory reforms Broadband Continued cable competition Video CLEC Continued wireless voice substitution Wholesale fiber transport Increasing costs of capital Decreasing credit availability Wireless data substitution Hosted and managed services Acquisitions of assets/ operations: CLEC, Fiber, Hosted/managed services, ILEC 20 GTA June 19, 2012 ILEC Strategic Approaches Strategic clarity is critical ▫ ▫ Fundamental industry changes lead to value creation or destruction Focus on opportunities and challenges In view of the prevailing industry dynamics, ILECs have tended to pursue four broad strategic approaches (or some combination thereof) ▫ ▫ ▫ ▫ Increase ILEC scope/scale through M&A (rationalizing cost structure) Diversification Reducing regulatory exposure Geographic diversification Expansion of network assets and business lines – CLEC and fiber Entry into business-centric internet / data services Hybrid – grow ILEC scope and scale while seeking business diversification In-region organic opportunities 21 GTA ILEC M&A Valuations Purchase Price as a Multiple of LTM EBITDA Source: Company press releases and filings (1) Windstream / Iowa transaction value includes the value of Iowa’s net operating loss carry-forwards (multiple would have been lower without NOLs). June 19, 2012 22 GTA ILEC Enterprise Valuation Trends Enterprise Value as a Multiple of LTM EBITDA RBOCs Source: Company filings and press releases Integrated ILECs High Yielding ILECs Pure Play ILECs June 19, 2012 23 GTA June 19, 2012 The Power of Synergies Creating synergies in ILEC transactions ▫ ▫ Approximately 11% of revenues Approximately 27% of earnings before interest, taxes, depreciation, and amortization (operating cash flow or EBITDA) Potential Synergies Public Company Expenses Executive Expenses Enterprise value to EBITDA ▫ ▫ Pre-synergy valuations about 6.9x Post-synergy valuations about 5.5x Valuations declining more recently Regulatory pressures will depress valuations Back Office Support Information Technology and Systems Transport Synergies Revenue Synergies 24 GTA EATEL Acquires Vision Communications Announced: September 20, 2011 Target: Vision Communications (“Vision”) (a portfolio company of BV Investment Partners) (“BV”) Buyer: EATELCORP, LLC (“EATEL”) Price: Not disclosed Assets: Founded in 1945, Vision provides a broad array of advanced telecommunications services including digital cable TV, high-speed Internet access, local and long distance voice, and commercial data services. Headquartered in Larose, Louisiana, Vision serves residential and commercial customers throughout central and southern Lafourche and southern Jefferson Parishes. Vision served approximately 9,850 access lines at announcement. Closed: January 5, 2012 Comments: The acquisition enables EATEL to expand and diversify its service territory throughout southeastern Louisiana from Livingston Parish to southern Jefferson Parish. Charlesmead Advisors, LLC served as exclusive financial advisor to EATEL in this transaction. Source: EATEL press release and JSI Service Territory Map June 19, 2012 25 GTA June 19, 2012 Internet Infrastructure—Smaller ILEC Acquisitions •ILEC •Data Center Operation •Description > Two data centers / 10,000 total square feet > First enterprise level data center in South Carolina > Provides an integrated suite of managed services and infrastructure solutions for critical business applications > Colocation, dedicated Internet access, data backup/ recovery, network monitoring, and network security > Two data centers / over 70,000 gross square feet > Serves 10,000 business and residential customers > Colocation, managed services, cloud computing, web and application hosting, and Internet services and support > Customers includes 3M, Caribou Coffee, HealthPartners, and Miracle-Ear > Three data centers / over 5,000 net square feet / WA state > Provides colocation, transport, and dedicated Internet access services via multiple Tier 1 Internet connections > Also offers managed Internet, hosting, and e-mail services 26 GTA June 19, 2012 North State Communications Acquires DataChambers Announced: December 15, 2011 Target: DataChambers, LLC Buyer: North State Communications (OTC: NORSA.PK) Price: Not disclosed Assets: DataChambers provides information technology services, including electronic data storage, managed information technology solutions and secure co-location services for mission-critical infrastructure. Two data centers and disaster recovery space in its 120,000 square foot facility located in Winston-Salem, North Carolina. Valuation Multiples: Not disclosed Closed: December 28, 2011 Comments: Acquisition enables North State to accelerate its strategy of diversifying its business and revenue mix. Transaction will strengthen North State’s efforts to become becoming a preferred business communications and data solutions provider. Charlesmead Advisors, LLC served as exclusive financial advisor to North State Communications in this transaction. Source: North State Communications press release and DataChambers website DataChambers Data Center Facility DataChambers Products and Services Data center services with remote hands services Managed services incl. databases, firewalls, VPNs Advanced monitoring services for servers, desktops, routers, switches, and applications Data protection/backup with IBM’s Tivoli Storage Manager & eChambers Intelligent Data Protection Virtualization and cloud solutions Business continuity space w/ redundant networks Desktop management/support to configure PCs, install patches, managed security and firewalls 24/7 help desk provides Tier 1 to Tier 3 services 27 GTA Import for Georgia ILECs . . . Georgia ILECs ▫ ▫ ▫ Significant competition from cable and wireless that will increase Regulatory support revenues will erode rapidly State regulatory oversight has limited acquisition activity Regulators, however, recognize the changing environment Lingering negative perceptions among potential acquirors ▫ ▫ Several major ILECs in state with defined strategies Many small ILECs in state with less strategic clarity ▫ ▫ Engage soon in a realistic strategic assessment Focus on value preservation/creation A small ILEC will need to . . . Operating focus Scope and scale Diversification Reduced reliance on regulation June 19, 2012 28 GTA June 19, 2012 Focused Alternatives Create/evaluate a ten-year financial model (consistent with reforms) Responding to the new public mandate ▫ ▫ ▫ ▫ Assume the operating model is not the same as historical model Create a “no-support” model that generates appropriate returns New obligation—survive to serve customers for the long term Communicate with customers/regulators about reasonable model ▫ ▫ ▫ ▫ ▫ Evaluate all non-strategic assets with a view to divestiture Assess whether company is buyer or seller of strategic assets Focus on efficiencies and optimization of operations List and evaluate diversification opportunities Consider all strategic approaches/combinations ▫ ▫ Shareholders Lenders Develop alternatives for improving the operating outlook Evaluate/discuss capital resources with all key parties 29 GTA Representative Transactions Has Agreed to sell Spectrum to Has Acquired Spectrum from Advisor to Seller Advisor to Buyer Advisor to Buyer Advisor to Buyer Pending February 2012 January 2012 December 2011 Has Acquired Has Acquired June 19, 2012