Defining the Broadband and Technology Future for Your State Transitioning to Internet in Rural America Michael J. Balhoff, CFA July 27, 2012

Slide 2 Michael J. Balhoff, CFA  Headed sell-side equity telecom research group (16 yrs)  Six annual Wall Street Journal All-Star awards  Focused coverage of rural telephony and regulation Balhoff & Williams/Charlesmead Advisors Representative clients  Telecom: NCTA, Comcast, AT&T, Verizon, SBC, Embarq, CenturyLink, Frontier, FairPoint, Windstream  Energy: NorthWestern Energy, Anchorage ML&P  Financial Community: Merrill Lynch, Silver Point Capital Recent briefings for White House, FCC, Secretary of Agriculture, Rural Utilities Service, NARUC, MACRUC Background ALEC, July 27, 2012

Slide 3 The rural problem  Confused concepts—tax/subsidy v. investment  Confused beneficiary—companies v. consumers  Significant and ongoing investment  Little factual/financial discipline in assessing policy Federal reforms affect the states  Significant cuts in federally-supported funding  States left to address problems with services and rates Recommendations about state USF  The state’s choice is unavoidable  More rigorous analysis of problem and policy  Evaluate potential mechanisms to support investment Overview ALEC, July 27, 2012

T HE P ROBLEM ALEC, July 27, 2012

Slide 5 Critics use terminology that confuses/biases the dialogue  “Subsidy” is a payout to an individual or industry  “Taxes” are unpopular assessments  Support “inefficient LECs” (real beneficiaries: consumers)  Conceptual USF history—wide customer base supports ubiquitous network “investment” creating value for all Easier concept when telecom was a monopoly USF is even more critical, but complicated, in competitive world Need to target USF on regions where competitive markets fail USF/implicit support were not and are not subsidies/taxes  USF and ICC support are investments  Generate ROI in terms of social and economic benefits  Efficient investments supplement other investor dollars Confusion: Tax or Investment ALEC, July 27, 2012

Slide 6 Policy Drivers of Higher Fund ALEC, July 27, 2012 ILEC non-access funding from $2.16B (’03) to $1.37B (’11) Total ILEC USF from $3.15B (’04) to $2.92B (’11) Growth in overall USF is due to new policy factors

Slide 7 Texas Study (2007) on 350,000 rural lines excluding USF...  77% WCs -9.7% ROI  13% WCs 2.9% ROI  10% generated 10%+ ROI Rural Customer Networks ALEC, July 27, 2012 Financial Performance of All Wire Centers without USF Payments

Slide 8 More striking is the finding that outside of rural towns, 52% of the lines generate negative returns (average -7% return on investment) Total uneconomic lines are...  All lines outside towns, which were 52% of the total  Plus 18% of total lines (in towns generating a negative return)  Equals 70% of total lines uneconomic without USF Outside of Rural Towns ALEC, July 27, 2012 Source: Balhoff, Rowe & Williams, LLC 2007

Slide 9 June 2012 rural broadband usage data Wireless today is not a real BB solution  Net neutrality questions (wireline v. wireless rules)  Rates of $30-$60 for wired services that are unlimited  Wireless LTE—$100/month for 10 GB; $10/GB overage  Wireless: 20GB/month~$200; 30GB~$300; 40GB~$400  Assumption about wireless fails the USF rate-test Discipline in Evaluating Problem ALEC, July 27, 2012

Slide 10 Core problem in many rural areas—economic market failure  Critics say that “competition” will solve, however... Verizon is getting out of rural business AT&T announced it has no rural broadband solution Cable avoids economically irrational areas  No one will bid where there is a market failure The real problem is high cost to build/operate consumer networks in certain regions  Problem for large and small carriers  Greenfield builds will be expensive and probably risky  Cable, wireless, urban carriers do not have same problem Focus on the Real Problem ALEC, July 27, 2012

F EDERAL R EFORMS A FFECT S TATES ALEC, July 27, 2012

Slide 12 Approximate USF/ICC Reductions ALEC, July 27, 2012 Federal reforms (2011) Rural USF/ICC rev. loss  Revenue 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 annual revenue reductions of nearly $1 billion in 2020 from reforms  Cumulative reductions could be $5.2 billion from 2012 to 2020 according to NECA Estimates by National Exchange Carrier Association

Slide 13 USF/ICC as % of Total Revenues ALEC, July 27, 2012 Source: Confidential company information; Balhoff & Williams, LLC

Slide 14 Illustrative EBITDA Outlook ALEC, July 27, 2012 Simplifying assumptions  EBITDA margin = 33%  USF + access = 75% of revenues  Cost benefits of reforms = 0% USF reform and effect of ICC reduces EBITDA margin in this illustrative analysis; the margin slips from 33% to 12.6% by 2020 Interest expense (4%-6% of today’s revenues) would eliminate much of residual cash flow by 2020, leaving ILEC with little cash for capex or principal repayment Source: Estimates by Balhoff & Williams, LLC

R ECOMMENDATIONS ALEC, July 27, 2012

Slide 16 Understand the Outcomes ALEC, July 27, 2012  Increased cost of capital  Insufficient recovery, skepticism/avoidance of sector by debt and equity investors  Consolidation may occur (complicated by financial risks/potential bankruptcies) Operating  Reduced or eliminated near-term capital investment (likely no increase)  Proximate reductions in personnel and other operating costs Financial Customer service  Growing urban-rural divide in terms of investment/telecommunications services  Rates will rise for rural services less-than-comparable to those in urban areas Policy  COLR becomes more problematic due to underfunded or unfunded mandates  Services will no longer be “comparable” in urban and rural regions  Private-public partnership fails; no one may bid at reverse auctions

Slide 17 Focus state policymakers on reforms  Reforms’ effects on all state consumers  State USF investments Analyze and understand the policy issues  Escalating rural customer demand for BB services  How economic welfare can be achieved most effectively Understand the options in terms of state mechanisms  Dollars required for state supplemental funding  How funding might be collected and distributed Specific Recommendations ALEC, July 27, 2012