emerging strategic challenges for rural carriers: financial outlook and directions francis x....
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Emerging Strategic Challenges for Rural Emerging Strategic Challenges for Rural Carriers: Financial Outlook and DirectionsCarriers: Financial Outlook and Directions
Francis X. GallagherJune 19, 2012
Georgia Telecommunications Association
June 19, 2012GTA
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OverviewOverview
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
Detailed Quarterly Wireline TrendsDetailed Quarterly Wireline TrendsRevenue Growth Access Line Growth
EBITDA Margin Broadband Sub Growth
1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11ALSK -6.1% -5.7% -5.1% -4.4% -3.9% -4.6% -5.2% -5.9%CTL -8.4% -8.0% -7.8% -7.6% -7.5% -7.4% -7.1% -6.6%CNSL -5.8% -4.8% -4.3% -4.1% -4.0% -4.1% -3.9% -3.9%FTR -6.0% -6.3% -9.3% -9.0% -9.0% -8.6% -8.5% -8.3%TDS -4.7% -4.2% -4.2% -5.3% -5.5% -5.5% -5.2% -5.1%WIN -3.9% -3.7% -3.7% -3.6% -3.6% -3.6% -3.9% -4.0%Average -5.8% -5.4% -5.7% -5.7% -5.6% -5.6% -5.6% -5.6%Median -6.0% -5.7% -5.1% -5.3% -5.5% -5.5% -5.2% -5.9%
1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11ALSK -1.3% -1.9% -1.9% -2.0% -1.5% -1.0% -1.5% -3.0%CTL 8.9% 8.9% 8.0% 7.1% 6.1% 4.3% 4.0% 4.5%CNSL 8.0% 8.1% 7.3% 6.3% 5.4% 5.0% 4.4% 4.3%FTR 7.3% 5.5% 2.2% 1.4% -0.2% 2.5% 2.5% 2.6%TDS 11.2% 9.5% 8.2% 6.4% 4.2% 3.4% 3.8% 2.5%WIN 9.9% 9.2% 8.0% 6.5% 5.7% 4.8% 4.3% 4.2%Average 7.4% 6.5% 5.3% 4.3% 3.3% 3.2% 2.9% 2.5%Median 8.5% 8.5% 7.7% 6.3% 4.8% 3.9% 3.9% 3.4%
1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11ALSK -4.3% -1.6% -1.5% 2.1% 5.0% 0.5% 0.6% 3.2%CTL -6.7% -7.0% -6.8% -6.4% -5.8% 0.7% -4.6% -3.2%CNSL -3.4% -6.2% -5.9% -7.0% -2.9% -3.3% -3.2% -0.1%FTR -3.4% -3.0% -7.3% -6.6% -7.5% -7.8% -8.0% -5.6%TDS -2.9% -0.8% 0.7% 0.3% 3.0% 3.8% 4.7% 4.0%WIN -2.8% -3.0% -1.5% -2.2% -1.8% 0.1% -1.4% 0.7%Average -3.9% -3.6% -3.7% -3.3% -1.7% -1.0% -2.0% -0.2%Median -3.4% -3.0% -3.7% -4.3% -2.3% 0.3% -2.3% 0.3%
1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11ALSK 36.1% 37.3% 38.7% 36.0% 36.6% 36.1% 36.3% 34.7%CTL 42.8% 45.2% 44.8% 44.9% 45.7% 41.1% 43.2% 39.7%CNSL 47.9% 48.0% 48.9% 48.9% 48.8% 49.5% 50.0% 51.6%FTR 47.9% 45.7% 47.9% 45.8% 46.5% 47.9% 47.2% 48.0%TDS 24.3% 22.5% 21.8% 16.8% 22.3% 25.3% 23.2% 16.4%WIN 49.7% 49.5% 49.5% 39.1% 50.1% 49.8% 49.6% 39.0%Average 41.4% 41.4% 41.9% 38.6% 41.7% 41.6% 41.6% 38.2%Median 45.3% 45.4% 46.3% 42.0% 46.1% 44.5% 45.2% 39.3%
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
June 19, 2012GTA
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Broadband TrendsBroadband Trends
June 19, 2012GTA
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
Source: UBS Investment Research, company data
HSD Subscriber Growth HSD Market Share
5
Year-over-Year Change in Revenue Generating Units
Revenue Generating Unit TrendsRevenue Generating Unit Trends
(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.
Source: Company filings and press releases
Cable Index (1) RLEC Index (2)
Cable Index (1) RLEC Index (2)
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
June 19, 2012GTA
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Year-over-Year Change in Revenue and EBITDA
Revenue and EBITDA TrendsRevenue and EBITDA Trends
(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.
Source: Company filings and press releases
Cable Index (1) : Revenue EBITDA RLEC Index (2) : Revenue EBITDACable Index (1) : Revenue EBITDA RLEC Index (2) : Revenue EBITDA
Trends generally mirror RGUs RLEC trends improving since mid-2010,
largely due to diversification efforts (broadband, business, data centers, etc.), and management of costs
June 19, 2012GTA
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Wireless OverviewWireless Overview
June 19, 2012GTA
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% 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.)
Total Service Revenue Growth
EBITDA Growth
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The Race to 4The Race to 4thth Generation Services Generation ServicesWiMAXLong Term Evolution
Source: Company websites and press releases
2010
2012
2013
2014
2011AT&T launches LTE networkAT&T launches LTE network
Verizon launches service to ~110M POPsVerizon launches service to ~110M POPs
Verizon offers service to ~200M POPSVerizon offers service to ~200M POPS
T-Mobile launches LTE networkT-Mobile launches LTE network
MetroPCS launches LTE networkMetroPCS launches LTE network
Clearwire committed to WiMAX through 2015Clearwire committed to WiMAX through 2015
Clearwire offers service to ~120M POPsClearwire offers service to ~120M POPs
Clearwire offers service to ~130M POPsClearwire offers service to ~130M POPs
Verizon completes LTE network buildVerizon completes LTE network build
Verizon LTE coverage equal to 2010 3G coverage
Verizon LTE coverage equal to 2010 3G coverage
U.S. Cellular launches LTE networkU.S. Cellular launches LTE network
Clearwire launches LTE networkClearwire launches LTE network
June 19, 2012GTA
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June 19, 2012
Order Provisions by Carrier TypeOrder Provisions by Carrier TypePrice 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. phase-in; 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
• 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 1/12-6/12, eliminated 7/12
• Phase out support over 3 yrs. where unsubsidized competitor
• Evaluate 11.25% ROR
• 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-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 non-access traffic begins in July 2012
• Caps intrastate originating rates
• 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 non-access traffic begins in July 2012
• 6-yr. transition to bill-and-keep for terminating interstate access
• Bill-and-keep for LEC-CMRS non-access 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
GTA
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Rural FinancialsRural Financials
2012 L-T effects of initial reform
Pending “reforms”
USF +
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
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)
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June 19, 2012GTA
Approximate Revenue OutlookApproximate 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
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June 19, 2012GTA
Small Company MetricsSmall Company Metrics
Source: Confidential company information; Balhoff & Williams, LLC
Company 1 Company 2 Company 3 Company 4 Company 5 Company 6 Average
7500+ lines
USF 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%
Company 1 Company 2 Company 3 Company 4 Company 5
1,000-3,000 lines
USF 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%
Company 1 Company 2 Company 3 Company 4
<1,000 lines
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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June 19, 2012GTA
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
Illustrative EBITDA OutlookIllustrative EBITDA Outlook
Source: Estimates by Balhoff & Williams, LLC
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June 19, 2012GTA
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
Focus on Operating Cash FlowFocus on Operating Cash Flow
Percentage of revenues lost0.0% 5% 10% 15% 20% 25% 30%
15% 33% 67% 100% 133% 167% 200%20% 25% 50% 75% 100% 125% 150%25% 20% 40% 60% 80% 100% 120%30% 17% 33% 50% 67% 83% 100%35% 14% 29% 43% 57% 71% 86%40% 13% 25% 38% 50% 63% 75%45% 11% 22% 33% 44% 56% 67%50% 10% 20% 30% 40% 50% 60%
Op
era
tin
g C
F m
arg
in
Sensitivity of Operating CF to Percentage of Revenues Lost
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June 19, 2012GTA
Potential/Probable Potential/Probable OutcomesOutcomes
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
Operating
Reduced or eliminated near-term capital investment (almost certainly no increase)
Proximate reductions in personnel and other operating costs
Financial
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
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June 19, 2012GTA
Telecommunications Industry DynamicsTelecommunications Industry Dynamics
Increased organic growth
Broadband
Video
CLEC
Wholesale fiber transport
Hosted and managed services
Acquisitions of assets/ operations: CLEC, Fiber, Hosted/managed services, ILEC
Increased organic growth
Broadband
Video
CLEC
Wholesale fiber transport
Hosted and managed services
Acquisitions of assets/ operations: CLEC, Fiber, Hosted/managed services, ILEC
Opportunities
Regulatory reforms
Continued cable competition
Continued wireless voice substitution
Increasing costs of capital
Decreasing credit availability
Wireless data substitution
Regulatory reforms
Continued cable competition
Continued wireless voice substitution
Increasing costs of capital
Decreasing credit availability
Wireless data substitution
Challenges
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ILEC Strategic ApproachesILEC 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
June 19, 2012GTA
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ILEC M&A ValuationsILEC M&A ValuationsPurchase 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, 2012GTA
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ILEC Enterprise Valuation TrendsILEC Enterprise Valuation Trends
Enterprise Value as a Multiple of LTM EBITDA
Source: Company filings and press releases
RBOCs Integrated ILECs High Yielding ILECs Pure Play ILECsRBOCs Integrated ILECs High Yielding ILECs Pure Play ILECs
June 19, 2012GTA
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The Power of SynergiesThe Power of Synergies
Information Technology and Systems
Information Technology and Systems
Back Office SupportBack Office Support
Public Company ExpensesPublic Company Expenses
Potential SynergiesPotential Synergies
Executive ExpensesExecutive Expenses
Revenue SynergiesRevenue Synergies
Transport SynergiesTransport Synergies
June 19, 2012GTA
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Creating synergies in ILEC transactions▫Approximately 11% of revenues▫Approximately 27% of earnings before
interest, taxes, depreciation, and amortization (operating cash flow or EBITDA)
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
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EATEL Acquires Vision CommunicationsEATEL Acquires Vision Communications
June 19, 2012GTA
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, 2012GTA
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Internet Infrastructure—Smaller ILEC AcquisitionsInternet Infrastructure—Smaller ILEC Acquisitions
>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
•ILEC•Data Center
Operation•Description
26
North State Communications Acquires DataChambersNorth State Communications Acquires DataChambers
June 19, 2012GTA
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.
DataChambers Data Center Facility
Source: North State Communications press release and DataChambers website
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
June 19, 2012GTA
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Import for Georgia ILECs . . .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
A small ILEC will need to . . .▫Engage soon in a realistic strategic assessment▫Focus on value preservation/creation
Operating focus Scope and scale Diversification Reduced reliance on regulation
June 19, 2012GTA
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Focused AlternativesFocused 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
Develop alternatives for improving the operating outlook▫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
Evaluate/discuss capital resources with all key parties▫Shareholders▫Lenders