Financial Pro Speaks Out on USF Reform

A respected financial analyst who has facilitated numerous carrier mergers and acquisitions expressed strong concerns about Universal Service reforms adopted by the Federal Communications Commission in an interview with Telecompetitor this week.

Although the FCC has touted the idea that the reforms will spur broadband deployment, network operators may not step up to deploy broadband to some unserved areas because target support levels may be too low, said Mike Balhoff, chartered financial analyst previously at Legg Mason Wood Walker and now at Balhoff & Williams. And if incumbent carriers opt out, Balhoff said there is a “distinct possibility” that no one will participate in planned reverse auctions for unserved areas.

Balhoff noted his respect for FCC personnel and the complexity of the problems they are addressing.  However, he raised questions about several moves that have been made by the FCC on Universal Service. Of particular concern, he said, is the FCC’s plan to phase out inter-carrier compensation (ICC), or access charges.

Traditionally per-minute access charges on long-distance calls have been higher in rural areas to help cover the higher costs of providing communications service in those areas – an approach known as implicit support.  And although Balhoff did not dispute the need for access charge reform, he noted that previously, when an implicit subsidy was eliminated, an explicit subsidy was created to replace the reductions so that the impact was revenue- neutral for carriers with obligations to build and maintain networks in high-cost regions.

It’s true that the FCC plans to create an access revenue replacement mechanism to enable rural carriers to recover some of their costs as ICC is phased out. But Balhoff noted that the mechanism is designed to be an interim measure that eventually will go away — and with strict limits placed on Universal Service funding, rural carriers are likely to have difficulty in replacing the lost funding.

When reforms are completed, the rural telecom industry will still be eligible for approximately $2 billion in support through the broadband-focused Connect America Fund (CAF) but ICC essentially will be reduced to zero, with no offset. That amounts to a reduction of more than one third from more than $3.3 billion that rural carriers collect today in USF and ICC funding combined, according to Balhoff & Williams.

Noting that most network costs are fixed, Balhoff said, “If you lose a third of your revenues, it’s a very serious problem, and the lost operating cash flows will be significantly higher.”

“The FCC seems to believe these companies are run too richly,” Balhoff added. But he argued that, “The vast majority of these companies are well run, and they are not going to find opportunities for proportionate reduction of costs at their companies.”

The net result of the reform of ICC, he said, will be that the revenues rural carriers previously collected in access charges will be transferred to long-distance carriers – and by the FCC’s own estimate, only about 75% of those savings will be passed on to consumers, Balhoff said.

These issues already have put a damper on broadband investment, said Balhoff. “Every carrier we have met with is looking to be more conservative about the way it dedicates capital; they’re very cautious about the future,” he said. “This reluctance to invest could have a meaningful negative effect on customers and rural economies over the next years.”

Of particular concern is the fact that, as revenues are reduced, the impact on cash flow is magnified, Balhoff said. By Balhoff & Williams estimates, a 10% loss of revenues and an operating cash flow margin of 40% with no reduction in costs results in a 25% loss of operating cash flow, and the same revenue reduction with an operating cash flow margin of 30% results in a 33% reduction in operating cash flow.

If carriers do not have sufficient cash flow, they can’t invest. This message is not lost on equity and debt investors who also are gravely concerned and are beginning to ask for higher risk-adjusted returns or are reporting that there may be more restrictions on available capital, Balhoff said.

Reverse auction concerns
Balhoff also questioned two FCC mechanisms related to USF reform – one which arrived at an estimated level of support of $775 per line for price cap carriers to bring broadband to unserved areas and one which uses a regression model to cap high-cost loop support (HCLS) for rate of return carriers under today’s voice-focused USF program. Although the current Universal Service program is nominally voice-focused, it has helped fund broadband construction in rural areas because some network infrastructure is shared between the two service offerings.

Going forward, Balhoff believes the $775 number set out in the CAF Phase 1 for price cap carriers is too low – at least in some unserved areas. Even if a carrier were willing to invest $3,000 per line of its own, Balhoff said, “The reality is that the costs associated per line with most of those very high cost areas is far in excess of that figure. A rational company that expects an appropriate investment return will assess its own available capital and the supplemental $775 and say it doesn’t work in many, if not most, of the unserved areas of rural America.”

Windstream Senior Vice President of Government Affairs Mike Rhoda expressed similar concerns last week, telling Telecompetitor it was highly unlikely that price cap carriers would agree to bring broadband to all of their unserved areas at the target support level.

Any unserved areas rejected by the price cap carriers will be subject to a reverse auction. But Balhoff questioned how many people will want to bid on some of these areas. Like the 700 MHz D-block auction several years ago, the reverse auction for price cap territories could end up as a failure, Balhoff said.  “They may hold an auction and find that no one shows up,” he said.

If that occurs, there is a possibility that some areas of the U.S. will remain without broadband and the pressure will be on local residents to move to more densely populated areas, Balhoff noted.

And that’s a scenario that ultimately could precipitate the decline of unserved rural areas.

Regression analysis
As for the FCC’s cost model for HCLS, Balhoff argued that the use of a regression model was troublesome. The commission’s goal, he said, was to create more accountable funding and to identify statistical outliers, but he noted that regression analysis is a “crude mechanism” for doing that. The FCC’s model, he said, only explains about 65% of a carrier’s HCLS costs, which means that more than one-third of a rural carrier’s costs are not predicted properly.

It might have been appropriate to use such a model to identify carriers with costs that were outlier statistics, and then focus on a review of their costs, he said. But, in this case, carriers simply lose the portion of their funding above the regression’s caps, and they have little recourse if their HCLS is reduced in this manner. In order to obtain a waiver, Balhoff said a carrier must prove, among other things, that there is no terrestrial voice alternative in its service area, an explanation that seems to fall short of the new broadband goal of the FCC.

One last thought
Amid all the debate about USF reform, one sometimes hears the argument that large carriers have experienced a lot of pain and have had to adjust their business models in recent years and that small carriers shouldn’t expect any different. People who make these arguments tend to believe small carriers need to consolidate to survive.

I asked Balhoff for his take on that and he said, “Many small carriers probably should be consolidated if it is possible to do so in their service regions. But the current reform process does not contemplate an economically viable path to that goal.”  He suggested that the FCC is not wrestling with how a financially sound model might be realized in rural regions.

If consolidation to assure universal services is the desired goal, he said reforms ought to have assessed what a viable financial model might be in areas that are uneconomic, and the reforms should have included some incentives for carriers achieving such consolidation.