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

June 19, 2012GTA

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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

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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

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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

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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

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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

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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

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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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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

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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).

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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

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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

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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

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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

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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

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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

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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

Representative TransactionsRepresentative Transactions

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Has Acquired

Advisor to BuyerDecember 2011

Has Acquired

Advisor to BuyerJanuary 2012

Has Agreed to sell Spectrum to

Advisor to SellerPending

Has Acquired Spectrum from

Advisor to BuyerFebruary 2012