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May 31, 2007

What Does Verizon Selling Northern New England Landlines Mean?

Verizon’s proposed sale of its landline business in Vermont, Maine, and New Hampshire is an indicator of the turmoil to come in telecom during the next five years.  Verizon is open that it needs to concentrate its assets on upgrading its access in the part of its territory which it’s keeping to FiOS (fiber).  What is not clear is how FairPoint can survive and continue to provide service let alone upgrade in its new service area.

Back in January, Verizon announced a definitive agreement with FairPoint Communications on a complex deal which, when consummated, will leave FairPoint owning all of Verizon’s landline (but not wireless) business in northern New England.  Verizon shareholders (but not Verizon itself) will end up owning 60% of FairPoint; FairPoint will end up with $1.7 billion of new debt; and Verizon will receive a combination of cash and debt instruments from FairPoint totaling $1.7 billion.  The deal is subject to many regulatory approvals including the Public Service Boards or equivalent in the three states.

OK, who’s FairPoint?  Well, currently they’re a New York Stock Exchange listed company (FRP) with a market cap of $634 million, up almost 30% since the deal was announced.  They’ve made a living by buying and operating small rural telcos (which get large subsidies from access charges and the Universal Service Fund).  They’re profitable; they pay a pretty high dividend. 

As of  September 30, 2006 FairPoint said they served 252,000 access lines.  The Verizon landline network in three northern New England States includes 1.6 million access lines – but it’s shrinking!  Nationwide, Verizon reported that traditional (copper) access lines declined by 7.9% from the end of the first quarter of 2006 to the end of the first quarter of 2007.

FairPoint announced “…its commitment to maintaining union jobs, working with the union in a collaborative fashion, and continuing to honor the existing collective bargaining agreements…  FairPoint will assume pension and other post employment benefit obligations for all active, continuing employees of Verizon companies.” Verizon keeps the pension obligations for those who are already retired.  The unions, however, are not convinced and oppose the deal.

FairPoint also says it anticipates spending $100 of capital per access line in each of the next three years to upgrade the lines in the three states (which they need) and enhance their revenue potential.

All of these good things, they say, plus servicing the debt, will be financed out of cash flow from the operations they are buying.  Initially, you can make a case for this if you believe their assertion that they can realize operational savings of $60 to $75 million while maintaining the union contract.

The problem is that the cash flow from the business they bought is going to decline faster than they can generate new revenue to replace it from enhanced services and that they won’t generate the capital or borrowing capacity they need to make the upgrades needed to preserve the cash flow.  After all, if Verizon thought the cash flow was going to stay positive, they could’ve stayed. But let’s ignore that and believe Verizon’s claim that it has to focus on other regions.

Here’s what’s happening using Vermont as an example:

In the most profitable part of the market, Verizon has competition from Burlington Telecom which is doing a great job of bringing fiber to residences in that city and taking market share from both Comcast and Verizon.  Ironically, this is in an area where the current copper plant Verizon has could be upgraded fairly cheaply to provide good Internet access.

Other cities and towns in Vermont are lining up to make deals which would result in Burlington Telecom helping bring 50 meg fiber to the premises of their residences.  BT will only make deals on the basis of 100% availability in each town.  There goes more market share.

Verizon doesn’t offer cable services in Vermont; Comcast does and Comcast is getting more aggressive with its offer of Internet access, telephony, and traditional cable entertainment in the State. According to the Burlington Free PressThe …company is eager to trumpet its work so it doesn't get lost amid all the discussion of the new Vermont Telecommunications Authority lawmakers authorized this year, or the proposed sale of Verizon's landline business in northern New England to FairPoint Communications.” The article says the company is planning line extensions in 58 communities.  Many of these new customers represent a loss of current telephone revenue to Verizon/Fairpoint AND a loss of a future upgrade to DSL.

In the most rural areas wireless access is proving a higher speed alternative than DSL for many  - especially those who can’t get DSL at all.  Those customers have a tendency to use VoIP and leave Verizon once they get broadband access.

I believe that the minimum acceptable Internet access by 2010 will 3 megabits per second in each direction.  Many people will need more.  By 2013 this number is likely (in my opinion) to be more like 20 megabits. VoIP, if it hasn’t completely displaced traditional phone service, will further push down voice profit margins.  BTW, VoIP and cellular service will have converged on a single instrument and a single number per person.

Even by the end of this year, the shrinkage in the number of copper access lines in use will accelerate.  The revenue FairPoint needs will be shrinking. DSL service Verizon does install will counteract that decline but not enough.

Assuming the merger is approved and goes through at the beginning of 2008, FairPoint will have shrinking revenues, fixed commitments to pay off its large debt, an expensive workforce with obsolete work rules which it is also very expensive to trim, and a geographically large physical plant which needs both maintenance and upgrades.  Given the need for ever faster speeds, that infrastructure will keep losing customers to fiber, cable, and wireless.  It’s a vicious cycle because the loss of customers makes it harder to upgrade to keep the rest.

Does that means the states should turn down the mergers?  It’s not at all clear that’s an option; states have laws and contracts to follow and not the unlimited right to stop any deal that would hurt their residents.  Also, Verizon hasn’t shown much inclination to invest here, either.

What is clear is that state telecommunication policy must help assure that there are viable alternatives.  If FairPoint succeeds, great.  If they fail because competition beat them, presumably we who live here will be well-served by that competition – so long as service is available in urban AND rural areas.  Vermont’s recently passed e-state bill is a step in that direction.

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