FCC Weighs in on Wireless Competition

The FCC, on May 20, 2010, released its Annual Mobile Wireless Competition Report to Congress. As part of the Telecommunications Act of 1996, Congress instructed the FCC to report on the state of competition in the mobile services market on an annual basis.  According to the FCC, this year’s report, the FCC’s 14th annual report on competition in the wireless marketplace, “goes beyond previous reports in reflecting the transformative importance of mobile wireless broadband, which has resulted in a shift from devices that can place traditional phone calls to pocketable devices that can access the entire Internet.” 

This year’s report highlights the wireless industry’s maturation and its move towards a more data-centric business model.  The report also acknowledges the impact of industry consolidation, both in terms of market share and the concentration of spectrum holdings.  The following is a summary of significant wireless market trends noted by the FCC. 

Maturation of the Mobile Voice Segment 

The FCC noted that, as of the end of 2008, 90% of all Americans had a mobile wireless device and used these devices to talk an average of 708 minutes each month.  Usage statistics had generally increased over time but the 2010 report marks the first instance of reduced voice usage.  The FCC suggests that the decrease in voice usage is perhaps due to increased reliance on text and multimedia messaging. 

Morgan Stanley has estimated that 96% of all 18 to 24 year olds have a cell phone.  That percentage stays above 90% for all age groups except 65 and over, of which 89% own cell phones.  According to the Pew Internet & American Life Project, 75% of all 12 to 17 year olds owned a cell phone, up from 45% in 2004. 

Transition to a Data-Centric Market 

The increasing popularity of smartphones such as the iPhone, Android, and the Blackberry has fueled a significant increase in data consumption per device and overall data traffic.  The FCC notes that with overall revenue per mobile customer generally remaining flat over the past several years, revenue from newer data services is replacing revenue from traditional services. 

According to statistics included in the FCC’s report, during the period 2004 through 2008 average revenue per user (ARPU) decreased from $49.41 per month to $47.09 per month.  Voice ARPU declined from $47.23 to $36.98 while text ARPU increased from $0.63 to $3.55 and data ARPU increased from $1.55 to $6.56. 

In 2005, the average user sent 476 texts message.  By 2008, the average user sent 4183 text messages.  Average revenue per text message fell from 3.7¢ in 2005 to 1.1¢ in 2008. 

According to the CTIA, total U.S wireless industry revenues increased from $104.2b in 2004 to $150.6b in 2008, but annual percentage increases have continued to decline.  Total revenues increased 16% in 2004 but only 6.8% in 2008. 

Proliferation of Devices and Applications 

The FCC cites the introduction of a growing number of smartphones that provide mobile Internet access and other data services, and use operating systems that provide many of the functionalities of personal computers. 

An estimated 42% of all cell phone users owned a smartphone as of the end of 2009, up from 15% at the end of 2006.  Credit Suisse has estimated that as of the end of 2009 there were 180m mobile data subscribers, or about 63% of all mobile subscribers.  That’s up from 21.6m mobile data subscribers as of the end of 2000, or 19.7% of all subscribers. 

Continued Industry Concentration 

The FCC notes that, over the past five years, concentration has increased in the provision of mobile wireless services.  According to the FCC, AT&T (NYSE:T, “AT&T”) and Verizon Wireless (NYSE:VZ, “VzW”) control 60% of both subscribers and revenue and accounted for 12.3m net additions in 2008 and 14.1m during 2009.  T-Mobile USA and Sprint Nextel Corp. (NYSE:S, “Sprint”), the nation’s third and fourth largest wireless carriers, had a combined 1.7m net loss in subscribers in 2008 and gained 827k subscribers in 2009. 

The FCC used the Herfindahl-Hirschman Index (HHI) to measure market concentration.  HHI measures concentration on a scale up to 10,000, with the top of the scale representing a monopoly.  The HHI index for a hypothetical market in which there are four facilities-based providers with equal shares of subscribers is 2500.  The Department of Justice antitrust guidelines consider a market to be “highly concentrated” if the post-merger HHI exceeds 1800, with antitrust scrutiny applied to a merger if it would trigger an increase of in the HHI of 100 or greater when the post-merger HHI is between 1000 and 1800, and an increase of 50 or greater when the post-merger HHI is above 1800.  For wireless mergers, the FCC has previously used a higher screen, 2800 for the HHI and 100 for the change in HHI. 

As of the end of 2008, prior to VzW’s acquisition of Alltel Wireless on January 9, 2009 (The Deal Advisor, 2/09, p.12), the mobile wireless industry’s HHI index was 2848, up from 2674 at the end of 2007. 

Robust Capital Investment but Declining Relative to Industry Size             

According to the FCC, the wireless industry continues to spend between $20b and $25b in inflation-adjusted dollars into their networks each year.  However, because industry revenues have continued to increase, capital investment as a percentage of revenue has decline from about 22% in 2005 to 14% in 2008. 

During the period 1998 through 2008, the wireless industry invested an estimated $240b into their networks.  However, data from CTIA suggests that, while the mobile wireless industry has continued to invest in network expansions and upgrades, capital investment has been declining over the past four years.  CTIA reports that incremental capital investment by wireless operators totaled $20.2b in 2008, a 4.4% decrease from the $21.14b spent in 2007 and a 20% decrease from the $25.2b spent in 2005.  CTIA also reports that capital investment during the first half of 2009 totaled $8.9b, a 7.4% drop from the first half of 2008. 

Role of Spectrum for Mobile Broadband 

Spectrum is critical, particularly as mobile wireless data usage continues to grow.  The FCC notes that lower-frequency spectrum possesses superior propagation characteristics that create certain advantages in the provision of mobile wireless services, particularly in rural areas.  Higher-frequency spectrum is more effective for increasing capacity, particularly within smaller, more densely populated geographic areas.  The FCC also notes that a significant portion of spectrum below 1 GHZ is owned by AT&T and VzW – 67% of the 700 MHz spectrum and 91% of the cellular spectrum, based on megahertz-POPs.

A More than Highly Concentrated Market 

For some time now, we have been predicting that as the wireless sector matures, it will look to the wireline industry to find growth.  As evidenced by the latest study by the Centers for Disease Control and Prevention (see below), this prediction is clearly occurring in the voice market.  Given the LTE deployments scheduled to launch over the next few years (see related story at p.1), increased wireless penetration of broadband and data services is sure to follow. 

Attributing factors such as advances in technology and changes in consumer habits to the consequences of policies espoused by the FCC, it would appear that the Commission has been effective in encouraging intermodal competition.  However, the same cannot be said about the effectiveness of its policies with respect to competition within the wireless sector.  By the FCC’s own measurement – a HHI index of 2848 as of the end of 2008 – the wireless industry is more than “highly concentrated.”  It may not be a monopoly, but it is certainly a comfy duopoly with AT&T and VzW controlling 60% of the industry’s $150b of revenue, most of the available wireless spectrum under 1 GHz, and virtually all the industry’s net subscriber additions. 

It’s not like the trends noted in the FCC’s report come as a surprise.  Most anyone following the wireless industry would have noted all of these trends long ago.  And while the FCC doesn’t come right out and say that competition in the wireless industry has been impaired by the market dominance of VzW and AT&T, it dances all around that conclusion.  Hopefully it’s an initial step towards policies that provide both an incentive and a means for smaller providers to effectively compete against the now firmly entrenched wireless establishment.

FCC Plan to put Pressure on RLEC Values

The National Broadband Plan (NBP) is a beast of a tome!  In early 2009, Congress asked the FCC to develop the NBP to ensure that every American has “access to broadband capability.”  Congress also required that the NBP include a detailed strategy for achieving affordability and maximizing use of broadband to advance “consumer welfare, civic participation, public safety and homeland security, community development, health care delivery, energy independence and efficiency, education, employee training, private sector investment, entrepreneurial activity, job creation and economic growth, and other national purposes.”  It will be some time before we can objectively assess the merits and success of the strategies set forth in the NBP, but with the document weighing in at 360 pages and coming complete with 213 “recommendations” for Congress to ponder, along with 1,599 explanatory footnotes to supplement the discussion, we’ll definitely cede to the FCC the “detailed” requirement. 

We are only going to spend a little time discussing the goals and recommendations of the NBP.  Frankly, the length and scope of the NBP restricts our ability to do it justice by way of a summary, at least within the space we have available in this newsletter.  In any event, there are already several summaries offering observations and interpretation of the NBP from a number of perspectives.  For example, John Staurulakis, Inc., in their March 26, 2010 JSI News & Commentary (which can be downloaded from their web site at www.jsitel.com) provides a 17 page summary focused on the 15 NBP recommendations addressing universal service and intercarrier compensation reform.

Instead, beyond a high-level review of the plan’s goals along with some commentary regarding certain notable recommendations, we’re going to focus on the NBP’s potential impacts on RLEC values.  Since before the passage of the 1996 Telecommunications Act, regulatory uncertainty has clouded RLEC values and, we believe, hampered deal flow within the industry.  Sadly, the NBP has done little to assuage these concerns.

Government Recommendations and Goals

The NBP identifies four ways in which the government can help shape the broadband “ecosystem” including: 1) designing policies to ensure robust competition; 2) ensuring efficient allocation and management of government-controlled or influenced assets such as spectrum, poles, and rights-of-way to encourage network upgrades and competitive entry; 3) reforming current universal service mechanisms to support deployment of broadband and voice in high-cost areas; and 4) reforming laws, policies, standards and incentives to maximize the benefits of broadband in sectors government influences significantly, such as public education, health care and government operations.

The FCC provides a number of recommendations as to how the government might encourage the formation of the sought-after broadband Nirvana ranging from collecting and publishing comprehensive market-by-market data on broadband pricing and competition to increasing the amount of spectrum available for mobile broadband applications to, most notably for our readers, phasing out the “legacy” high-cost component of the USF in favor of a new “Connect America Fund” (CAF).  The FCC also recommends creating a “Mobility Fund” to facilitate the deployment of 3G wireless networks, reforming the current intercarrier compensation (ICC) regime by eliminating per-minute charges over the next ten years, and broadening the USF contribution base to ensure the Fund remains sustainable over time.   

Beyond recommendations on how the government can influence and steer broadband evolution, the NBP recommends the country adopt and track the six specific goals over the next ten years:

The FCC’s long-term goals seem laudable but, as with any effort of this type, there are areas of disagreement.  For example, the first articulated goal – what has come to be known as FCC chairman Genachowski’s “100 Squared” goal - has already drawn wide-spread and extensive criticism due to its implied acceptance of a digital divide (perhaps “chasm”) between those 100m with access to 100 Mbps service and the 200m or so other Americans who will apparently need to get by with only 4 Mbps service.  But it’s the details of the FCC’s recommendations, particularly those dealing with USF and intercarrier compensation, that have the RLEC industry up in arms.       

A “Fundamentally Flawed” Plan

OPASTCO’s John Rose has characterized the NBP’s universal service proposals as “fundamentally flawed” and notes that OPASTCO, NTCA, NECA and the Western Telecommunications Alliance have already begun working together to fight chairman Genachowski’s “Cut, Cap and Transform” plan for universal service.  According to Rose, “This is the biggest fight the rural industry has ever faced, and it is a fight that requires unified resources and a unified voice.”

To get a better appreciation of the origin of Rose’s consternation, we recommend you read Chapter 8 of the NBP.  That chapter, entitled “Availability,” details the FCC’s vision regarding the reform of universal service and intercarrier compensation.  Over the next two years, the FCC hopes to lay the foundation for reform through the enhancement of USF performance and accountability and through the creation of the CAF and the Mobility Fund.  In fact, the FCC has already acted on this objective by, on April 21, 2010, issuing its first NOI and NPRM providing details on its recommendations concerning the reform of the USF’s High-Cost program.   

Beginning in 2012 and continuing through 2016, the FCC hopes to accelerate reform by beginning to make disbursements from the CAF, broadening the universal service contribution base and beginning a staged transition of reducing per-minute rates for intercarrier compensation.  The FCC hopes to complete the transition during the 2017 through 2020 period by eliminating the USF’s legacy High-Cost program and the phase out of per-minute intercarrier compensation for the origination and termination of telecommunications.

The Impact on RLEC Values

The process of enacting the goals and recommendations of the NBP with be neither brief or easy.  The rural telephone industry is already mobilizing in opposition to the NBP’s universal service and intercarrier compensation proposals.  No doubt others will voice strong opposition to other facets of the plan.  Over the last 14 years, ever since enactment of the 1996 Telecommunications Act, the FCC has had little success in its efforts to reform the USF and intercarrier compensation.  In reality, over the last decade technological change, particularly the move to wireless and IP, has done more to force (and in some cases make irrelevant) the need for comprehensive change than has the regulatory process.  We expect this will be the case over the next ten years as well.

The question before us is not the merits of specific NBP proposals or the timetable over which the plan will unfold.  Rather, our focus is gauging how the NBP, as envisioned, will affect RLEC values?  We address this question through an examination of the potential impact on the three inputs of our core definition of value: Value = NCF/(d-g).  As we have previously written, the value of an RLEC property can be influenced by changes to its net cash flow (NCF), changes to its discount rate or cost of capital (d), and changes to its growth rate (g).  Value is positively stimulated by increases in NCF or g, and/or by decreases in d.  Alternatively, value is impaired by decreases in NCF or g, and/or by increases in d.  Here’s how we assess the NBP’s impact on each input:

Net Cash Flow: Trending Down

Perhaps we are stating the obvious, but for many RLECs the monies received from the USF’s High-Cost program and intercarrier compensation collected under current mechanisms are essential to their continued viability.  Even for those RLECs with lesser dependence on those revenue sources, their underlying value is hugely dependent on these funds.  Simply stated, if you eliminate or reduce these sources of revenue, and fail to adequately replace it with funding from the CAF, cash flows will decline and value will decline.

But there is more than one way to skin the NCF cat.  Chairman Genachowski hopes that by reforming universal service and freeing up 500 MHz of new wireless spectrum, he’ll unleash an entrepreneurial surge that will benefit the business plans of incumbents and competitive providers alike.  Perhaps, but for RLECs that currently have USF and per-minute termination and origination rates in hand, that has the sound of two birds tweeting in a distant bush.    

Cost of Capital: Trending Up

As we continue to watch values decline in the RLEC industry, and with the economy and employment not yet fully recovered, it is easy to forget that we are currently benefiting from historically low interest rates.  At a macro level, that will change at some point in the future and there is likely to be an ugly jolt to all equity values, not just those of telephone companies. 

More specific to RLEC values is the risk built into required debt and equity returns as a result of regulatory uncertainty.  Although esoteric and difficult to quantify, somewhere baked into required debt and equity returns is the risk that the expected life of current regulatory revenues mechanisms – notably USF and intercarrier compensation – is finite.  While uncertainty generally increases risk, it can decrease risk if the underlying event or development is unfavorable and there remains a chance that the event will not occur.  Arguably, the risk cooked into required RLEC returns has been somewhat diminished by hope or expectations that little will change or that any change will be less disruptive. 

Based on the reactions of most RLEC advocates, the NBP’s universal service and intercarrier compensation recommendations are not viewed as a step in the right direction.  While there remains considerable uncertainty regarding the ultimate shape of reform, the direction of that reform is now somewhat more focused.  In our view, that focus increases the market’s perception of risk associated with the RLEC industry, which will translate into lower RLEC values.

Growth: Trending Down

When we speak of growth, we speak of growth in net cash flow – the revenue dollars you keep after you pay all your expenses, pay your taxes and maintain or enhance your plant.  Growth in net cash flow doesn’t necessarily correspond to growth in subscribers.  Even in an environment where the number of connections is in decline, growth can occur if it is possible to sell more services to an existing base of customers.  Over the last few years, that’s been the driving force behind efforts to bundle voice, video and data services.  Chairman Genachowski’s entrepreneurial surge, in fact, represents a potential future growth opportunity for RLECs.

But when it comes to growth, RLECs have two strikes against them.  First, for many RLECs USF and per-minute and cost-based intercarrier compensation are such a significant portion of their total revenue that it is difficult to envision how the FCC’s universal service reform will accomplish its stated objectives of replacing RLEC revenues lost through reform, capping the total size of the fund at 2010 levels and, at the same time, successfully shifting up to $15.5b of funds from the USF to broadband support.  Second, RLECs already have what is typically considered a dominant market share, albeit often reduced in recent years by encroachment by cable and wireless providers.  Growth in market share is possible, but it’s often more likely that growth will be realized by a more risky competitive entry into new markets.     

Until more clarity is provided as to how and on what basis the CAF will distribute funds to RLECs, we can only conclude that the combined impact of declines in USF and intercarrier compensation along with the anticipated decline in market share will swamp reasonably foreseeable growth in out-of-market or vertical services.  Lower, perhaps negative, growth translates to lower values.

The Next Ten Years

OPASTCO’s Rose is right – this is a battle that the RLEC industry can’t afford to lose!  All available resources need to be focused on efforts to ensure the industry’s perspective and concerns are heard.  Inequities, inaccuracies and bias reflected in the NBP need to be identified and exposed.  With so much of the NBP focused on enhancing broadband availability to a relatively small percentage of the U.S. population, the industry needs to ensure that Congress knows how effective the RLEC industry, with the assistance of current USF and intercarrier compensation mechanisms, has been in addressing the broadband needs of rural customers.  In our opinion, the NBP ignores this fact in favor of statistics that better frame what we view to be a pro-wireless/ anti-RLEC agenda.

Having said that, we can’t help but think that much of the change over the next decade will be driven less by regulatory dictum and more by changes in what technology will allow us to do and in the way consumers communicate (or perhaps how Steve Jobs decides they should communicate).  These largely unpredictable trends, coupled with the FCC’s focus on encouraging competition, will likely force change that looks more like the proposals outlined in the NBP than the status quo.

In other words, continued decline in “same store” RLEC values is inevitable.  The relentless march of technology, competition, changes in consumer habits and the coming rise in interest rates all support that premise.  The loss or decline of favorable regulatory revenues would break the camel’s back.  All RLEC stakeholders need to generously support the efforts of the associations and advocates to ensure the industry’s voice is heard.  But, even more, RLEC stakeholders that hope to have a viable business ten years from now need to identify and capitalize on alternative opportunities in anticipation of a very different tomorrow.