Tuesday, November 20, 2007

Sidebar: PUC filings: Selections from the redacted text

Published as an online exclusive at thePhoenix.com

1: condition 1, p 3

The proposed transaction must be restructured to allow FairPoint to reduce its bond debt level by $600 million, thereby reducing the associated interest expense and debt leverage levels. A $600 million reduction in bond debt for the new enterprise is important and appropriate because:

the bond debt will carry a materially higher interest cost than the bank loan;

the bond debt issuance is at this point entirely uncommitted and subject to prevailing difficult credit market conditions;

bond debt reduction results in debt leverage ratios that are lower and more consistent with the Embarq and Alltel spin-offs (although still not as low);

bond debt reduction results in debt leverage ratios that are more consistent with investment grade bond ratings, which in turn are crucial for a public utility providing a necessary and essential service under challenging business conditions;

bond debt reduction will increase cash flow and permit further discretionary reduction of bank loan debt;

even if bond debt is reduced at this level, proceeds to Verizon [BEGIN SUPER CONFIDENTIAL] will still exceed the implied wireline valuation as calculated by Verizon. [END SUPER CONFIDENTIAL]

2. (footnote 17, p 12)
17 The amount of debt that would be borne by FairPoint was an important consideration for Verizon. Its original information letter, sent to sent to parties possibly interested in purchasing the NNE properties, asked for [BEGIN CONFIDENTIAL] “the specific total dollar amount of debt” that the FairPoint could support. [END CONFIDENTIAL]

3. (footnote 34, p 20)
34 There is no doubt about the risk that interest rates will rise, and FairPoint recognizes that risk. The federal funds rate that is contained in [BEGIN CONFIDENTIAL] the “Control” page of the FairPoint financial model is 4.75%. [END CONFIDENTIAL] However, the federal funds rate, as of July 12, 2007, was already higher -- at 5.25%. Brevitz Direct, p. 41, ll. 20-24.

4. p 21
FairPoint is not [BEGIN CONFIDENTIAL] making a commitment to use its surplus cash to reduce [END CONFIDENTIAL] its debt. 39 FairPoint’s financial model suggests that by the year [BEGIN CONFIDENTIAL] 2015, FairPoint would have reduced its debt by $318 million. However, as Walter Leach confirmed at hearing, that reduction is only an assumption, made for modeling purposes. FairPoint is making no plan and no commitment to reduce its debt over the next seven-year period. [END CONFIDENTIAL]40Id

5. p 21, footnote 38
38 Id., p. 43, ll. 1-3. Even with its limited ability to hedge interest rates, FairPoint remains exposed to trends of increasing interest rates, particularly since [BEGIN CONFIDENTIAL] its financial projections show that it will continue to have significant long term debt, and will have to refinance most if not all of that debt, $1.5 billion or more, at or before maturity. [END CONFIDENTIAL]Brevitz Direct, p. 43, ll. 3-8.

6. p 21, footnote 40
40 In its response to OPA-I-30-6, FairPoint states [BEGIN CONFIDENTIAL] “FairPoint has not made and is unwilling to make a binding commitment to use cash flows after dividends solely for debt reduction.” [END CONFIDENTIAL]OPA Exhibit# 25.

7. p 23, footnote 45
45 Originally FairPoint proposed a debt leverage ratio for the new entity of “3.25 to 3.5 times earnings before interest, taxes, depreciation and amortization, referred to as EBITDA, which would result in a leverage ratio of 3.6 to 3.7 times EBITDA for the combined company.” FairPoint Communications Form S-4A, filed July 2, 2007, p. 55. FairPoint expressed reservations about taking on higher levels of debt: [BEGIN CONFIDENTIAL] “although we believe that pro forma leverage for NewCo could potentially be raised as high as 4.5x, providing maximum de-leveraging for Verizon, we do not believe this would be positively received by the equity markets as a more conservative leverage level.” [ENDCONFIDENTIAL]Brevitz Direct, p.24, ll. 21-24, fn.28. However, it appears that Verizon’s interests prevailed in negotiations because the debt leverage of the proposed transaction as announced is 4.1x. Brevitz Direct, p.25, ll. 1-3.

8. p 23, footnote 46
46 The advice provided to FairPoint by Lehman Brothers concludes: [BEGIN CONFIDENTIAL] “For tax reasons, a cash sale is not attractive for Viper whereas the Spin/RMT structure would be tax-free; to qualify as a tax-free transaction, Viper must retain 51% of equity following the transaction, but can own more; Viper also intends to use a debt-for-debt swap to achieve greater tax-free deleveraging.” [END CONFIDENTIAL]OPA #112 (FairPoint HSR documents, attachment 4(c)-3, Project Nor’easter Discussion Materials, Lehman Brothers, February 20, 2006, page 6.)

9. p 28
There is no “low hanging fruit” here.


& LD
$ 371 ALSK
$ 385 IWA
$ 400 CTL
$ 422 CNSL
$ 443 CZN
$ 465 NNE
$ 501 WIN

10. p 29
There is no “low hanging fruit” here.


Services &
$ 197 CZN
$ 210 NNE
$ 347 ALSK
$ 377 IWA
$ 399 WIN
$ 408 CTL
$ 486 CNSL

11. p 29
The results of the disaggregated analysis of the data & internet category are also shown in Table IV. It shows that NNE’s revenues per access line from this category are at the bottom of a wide range. There is revenue opportunity here, but it is not “low hanging fruit” due to the fact that DSL service revenues [BEGIN CONFIDENTIAL] as projected in the model are driven by very substantial penetration rate assumptions already accounted for. (“Detail” tab, rows 55 and 58). The model has consumed the fruit in its assumptions. [END CONFIDENTIAL]

12. p 30
Furthermore, the DSL model results show the importance of assumptions regarding charges between affiliates, in particular the DSL line sharing charge assumed in the model.


2006 Revenue Per Line

Data & Internet
$ 40 NNE
$ 51 WIN
$ 96 ALSK
$ 130 CNSL
$ 155 IWA
$ 163 CTL
$ 195 CZN

13. p 33, note 61
61 Loube Direct, p. 28, ll.14-16. According to FairPoint’s financial model, “Other ISP” revenue increases from [BEGIN CONFIDENTIAL] $5.6 million in 2008 to $16 million in 2010 and then drops back to $5.3 million in 2012. Those estimates are driven by percentage change estimates. However, there is no connection between the percentage change estimates and other features of the model. [END CONFIDENTIAL]Loube Direct, p. 28, ll. 14-19.

14. p 33, note 63
63 The Commission should also question the reasonableness of the assumptions made in FairPoint’s model regarding revenues from local service. However, it is difficult to identify those assumptions. [BEGIN CONFIDENTIAL] Reviewing the model, it is not possible to assess what FairPoint’s underlying assumption might be regarding loss of access lines over time. Nevertheless, it is clear from Verizon’s due-diligence materials that Verizon believes FairPoint is underestimating future line loss rates. [END CONFIDENTIAL]Brevitz Direct, pp. 76-77.

15. p 34
** Unrealistic Assumptions As to Annual Operating Expenses.
With respect to operating expenses, the assumption in the financial model is that for the 2008-2015 period FairPoint is expecting those expenses [BEGIN CONFIDENTIAL] to remain virtually flat [END CONFIDENTIAL]64

However, that assumption is completely unrealistic. For, example, it is not reasonable to assume, as the model does, that FairPoint NNE will have [BEGIN CONFIDENTIAL] zero [END CONFIDENTIAL] wage increases for seven years. There is no reason to believe that, over the next seven years FairPoint’s operating expenses will not be affected by cost increases from suppliers, increases in the cost of gasoline and electricity, wage increases, and other inflationary increases. Over the last five years, Verizon’s NNE properties have had a unit operating-expense growth rate of about 6% to 7%.65 In the twelve months ending March 31, 2007, FairPoint’s per-unit operating expense increased by 8.1%.66 Iunreasonable to expect that FairPoint can reduce that growth rate to the rate of growth assumed in its financial model.

16. p 35, note 67
67 For the key years of 2005, 2006, 2007, and 2008, [BEGIN CONFIDENTIAL] 79% to 82% of the operating expenses in the model cannot be tied to a verifiable source. [END CONFIDENTIAL]
Brevitz Direct, p. 81, ll.17-22.

17. p 35, note 68
68 FairPoint’s projections of the up-take for DSL over the next four years cannot be accurate because it has not been able to develop the specifics of its broadband deployment plans:[BEGIN CONFIDENTIAL] FairPoint will not have access to detailed plant records until after the closing of the proposed transaction. “Due to the fact that detailed plant and engineering records and resource relating to the to-be-acquired properties will not be available until after the transaction closes, FairPoint had to make a number of assumptions in generating the Maine Broadband Plan.…”[END CONFIDENTIAL]Brevtz Direct, p. 85, ll. 3-8, citing FairPoint’s response to OPA II-10-1.

18. p 36
** Different Balances for Shareholders Equity. The inputs to FairPoint’s financial model with respect to the balances of shareholders equity are not reasonable. The model projects negative balances for shareholders equity that are significantly different than the balances that FairPoint has projected in its Form S-4A report to the Securities Exchange Commission (SEC). Negative equity is an indication of the financial weakness of FairPoint. In its SEC report, FairPoint projects that starting in 2007 shareholders equity will decline almost $900 million dollars, to a negative $218 million in 2015.71 However, FairPoint’s financial model projects different balances for shareholders equity – balances that are significantly [BEGIN CONFIDENTIAL] more negative. [END CONFIDENTIAL] 72 In short, the inputs used in the model—which do not reflect reality -- appear to be part of an effort to “sell” the proposed transaction.

19. p 36, note 70
70 For UNE-L’s, for the years 2008 through 2012, FairPoint’s model projects [BEGIN CONFIDENTIAL] growth rates in the range of 14% to 20% annually. Those projected growth rates are substantially higher [END CONFIDENTIAL] than the annual growth rates experienced for UNE-L’s nationwide. Brevitz Direct,p. 86, ll. 4-13. Dr. Loube makes the same points at pages 33-34 of his Direct Testimony.

20. p 36, note 72
72 The financial model projects that, starting in 2008, the balances for shareholders equity will decline [BEGIN CONFIDENTIAL] by approximately $590 million dollars, to a negative $452 million in 2015. [END CONFIDENTIAL]Brevitz Direct, p. 87, ll. 9-11.

21. p 37, note 76
76 Indeed, in one of its Hart/Scott/Rodino documents, FairPoint’s senior management acknowledged the risk of unplanned capital expenditures that exists because FairPoint does not know the condition of the NNE operating plant. FairPoint acknowledged a “challenge” regarding [BEGIN CONFIDENTIAL] “unknown plant quality—probably poor—may consume a lot of capex to compete with Time Warner”. [END CONFIDENTIAL]Brevitz Direct, p. 60. ll.13-15; OPA Exhibit #112(FairPoint HSR Documents, Attachment 4(c)-11, at page 1). The FairPoint financial model simply [BEGIN CONFIDENTIAL] extends past Verizon capital-expenditure patterns forward, and does not adjust for the “unknown plant quality—probably poor” that it will begin operating after close of the proposed transaction. [END CONFIDENTIAL]Brevitz, Direct, p. 60, ll.16.19.

22. p 39, note 83
83 In its financial modeling, FairPoint did perform one “Material Adverse Change” scenario that was designed essentially to assume that no synergies occurred. That scenario shows that, with no synergy effect, [BEGIN CONFIDENTIAL] each year FairPoint would face climbing leverage ratios, and have essentially no cash left after payment of expenses, interest, taxes and dividends. [END CONFIDENTIAL]Brevitz Direct, p. 58, ll.4-11. That scenario suggests that the financial success of the transaction depends, in part, on full achievement of the estimated synergy savings – which, in turn, suggests that the proposed transaction is pretty risky.

23. p 42
** Employee Pensions or Other Post-Employment Benefits. The model makes the (inappropriate) assumption that, post closing, FairPoint will [BEGIN CONFIDENTIAL] have no expenses for either employee pensions or other post-employment benefits (OPEB). The model assumes (also inappropriately) that FairPoint will not incur those types of expenses for its newly hired “incremental” employees. [END CONFIDENTIAL] 95

24. p 47
This analysis indicated that, based on the Verizon stock price at that time, its wireline business had an [BEGIN CONFIDENTIAL] implied wireline multiple of 3.7x 2007 EBITDA. [END CONFIDENTIAL]99 Comparison of that EBITDA multiple to the proposed NNE transaction multiple of 5.6x 2007 EBITDA shows the extent to which FairPoint is overpaying for the NNE wireline business compared to the market’s judgment as to what that wireline business is worth.

25. p 48
Verizon’s valuation materials demonstrate that the upper end of valuation estimates is [BEGIN HIGHLY CONFIDENTIAL] produced by “acquisition comparables”, and is $3.04 billion, compared to the $2.715 billion proposed transaction price.100 The lower end of the valuation range is produced by discounted cash flow analysis, and is $2.064 billion. Hence, it can be seen that the transaction valuation as proposed is in the upper third of the valuation range—and for “a car without the engine”. [END HIGHLY CONFIDENTIAL]

Furthermore, the same document demonstrates that the proposed transaction price is well above [BEGIN HIGHLY CONFIDENTIAL] the implied valuation of Verizon’s wireline business in its stock price. Verizon’s own analysis demonstrates that the market values Verizon’s wireline business at 3.7 times 2007 EBITDA. On the other hand the transaction price results in FairPoint paying 5.6 times 2007 EBITDA. [END HIGHLY CONFIDENTIAL]

26. p 49
100 OPA # 94 Verizon HSR documents, “Confidential Presentation Materials prepared for the Verizon Board of Directors Regarding Project Noreaster”, Merrill Lynch, January 15, 2007, page 13.

101 CITE, Transcript, Brevitz, xxx.

Verizon’s own data and analysis support Mr. Brevitz’s statement at hearing that Verizon is charging FairPoint too much for the transaction, even though FairPoint has agreed to it. In effect, FairPoint has agreed to a “bad deal”.101 The fact that the transaction is for “a car without the engine” greatly exacerbates this “bad deal”. The Public Advocate’s recommendation that the amount of debt proposed for FairPoint be reduced by $600 million serves to bring the proposed transaction to a place that ameliorates the considerations above, but still results in proceeds to Verizon [BEGIN HIGHLY CONFIDENTIAL] that are well above Verizon’s implied wireline valuation of 3.7x, down from the transaction price of 5.6x to 4.4x. END HIGHLY CONFIDENTIAL]

27. p 73
Of particular note is the fact that FairPoint’s financial model assumes a monthly payment from the unregulated entity to the regulated telephone company of [BEGIN SUPER CONFIDENTIAL] $30.11 [END SUPER CONFIDENTIAL] per DSL line per month.133 See, Ex RL-10 of Loube Surrebuttal, Response to ODR-16. While examining super confidential exhibit RL-10 attached to the surrebuttal testimony of Dr. Loube, Mr. Leach agreed that, when viewed as a stand-alone business, the DSL business BEGIN SUPER CONFIDENTIAL: loses more and more money as time goes on:

MR. JORTNER: Okay, now let’s turn to the gross margin which is line 296 which is the line that the OPA added and this -- on the margin reported on row 296 are all negative and getting larger all the time, is that correct?

MR. LEACH: Generally that’s correct, yes sir.

MR. JORTNER: And if those numbers are correct it would indicate that the company is losing money on all these services correct?

MR. LEACH: No, that’s not correct. I think you cannot look at that number without the inner-company eliminations because part of the reason those margins are negative is because part of the cost structure is revenue being paid to the telephone company for providing these kind of services.

MR. JORTNER: Right and that’s what I’m getting to next because we’re trying to look at the DSL business by itself. So when we -- I’ll get to that issue. In fact the difference between the two pictures of profit has to do with the cost of goods sold, eliminations which are row 297, correct?

MR. LEACH: That’s correct. [END SUPER CONFIDENTIAL]. TR Oct. 3 at 45-46.

28. p 86
In addition, evidence in this proceeding reveals two other bases to conclude that FairPoint would be acquiring a utility with rates that are already inflated. [BEGIN CONFIDENTIAL]: On cross-examination, FairPoint witness King was asked to explain the large distinction between the higher costs allocated by Verizon to northern New England’s regulated utilities and the much lower comparable costs of other ILECs that Mr. King analyzed. Although Mr., King was hesitant to agree with Mr. Hagler that this necessarily represented “regulatory failure,” Mr. King candidly admitted that Verizon’s high cost allocations did not seem reasonable based on his experience. TR Oct. 5, at 11. Moreover, in Verizon’s HSR document, Confidential OPA Ex. 94, Verizon describes as one of FairPoint’s interests as (under “Access Line Market Characteristics), “Potential disposition lines are less dense, have fewer business customers and fewer areas targeted for FTTP, but produce higher margins than VZ average.144(emphasis added) [END CONFIDENTIAL]