The following article will delve into the potential effects of three major regulatory changes affecting the telecommunications industry: net neutrality, corporate tax law changes, and copper plant retirement requirements. While the discussion aims to address the latest developments on each of the issues as of the date of publication, please note that the final outcomes of each of these decisions will involve changes that cannot be accurately foreseen at this time. In short, these are to some extent moving targets.
Therefore, while this discussion should be very helpful to investors to capsulize these regulatory issues facing telecom, any potential investment decisions by the reader should carefully consider multiple possible outcomes within the scope of *each* regulatory issue. Don't put your money to work until you have done your own due diligence and modeled the outcomes YOU think are the most likely, and equally that fit within your individual risk paradigm and investing strategies.
Also note that the discussion focuses on possible effects on the telecom industry; be careful in applying these conclusions equally for a company outside this industry which may have been structured differently or may have substantially different operational characteristics than the telecom industry does.
Network Neutrality has been a hot topic of debate for some years. On the surface, it appears to pit consumers of network services with the network providers. I will discuss the legislation first in order to explain its origins and effects, before putting forth an opinion the upcoming vote on December 14th will likely have on the industry.
One of the original research pieces on whether or not net neutrality is needed was done by Wharton economist Gerald Faulhaber.
His conclusions of the study in 2011 indicate that scant examples exist where ISPs substantially discriminated against users or abused power over customers without net neutrality rules in place. Only four examples of misconduct were found, one of which was "denied by the courts" and the other which "didn't even rise to the level of a complaint".
Further, his paper indicates that the implementing of net neutrality rules would cost more money to network companies and stifle overall investment by a likewise amount. In a test performed by the FCC during a wireless spectrum auction, Gerald noted that the regulated spectrum at auction had a 60% decreased value and was purchased by only one company. Unregulated spectrum in the same auction sold for much more, indicating more willingness to spend to upgrade network performance.
The evidence speaks loudly and eloquently: imposing network neutrality regulation reduces the value of the affected telecommunication asset and thus reduces the incentive to invest in such assets.
According to a Forbes article, the costs were prophetic.
So it's not hard to extrapolate the results of the FCC's "natural experiment" on the C block to the impact of the new rules, assuming they ever go into effect. Billions of dollars in potential investments in mobile services and equipment could be lost, traded for "prophylactic" rules with no estimated benefits to offset them.
Therefore, costs would rise without reason to suggest the rules were even warranted. This sentiment has been echoed recently by FCC Chairman Pai regarding the regulations.
I think the most important thing that people need to know is that this is a solution that won't work to a problem that simply doesn't exist. Nowhere in the 332-page document that I've received will anyone find the FCC detailing any kind of systemic harm to consumers, and it seems to me that should be the predicate for certainly any kind of preemptive regulation-some kind of systemic problem that requires an industry-wide solution. That simply isn't here.
Net Neutrality proponents argue that more wide spread violations have occurred, and have petitioned the FCC through the FOIA to post the results of consumer complaints made under the new laws. The National Hispanic Media Coalition FOIA request netted a lot of data on net neutrality complaints.
I examined several of the extracts available on the site and here are my thoughts after reading. Please do your own due diligence here.
Many of the complaints have to do with data caps and throttling, which can be allowed under 'network management' rules.
Note that while some of the complaints in the above sample seem to address legitimate blocking issues, others are not regulated by net neutrality such as exclusive agreements of commercial management companies with ISPs (which has to do with private local contract between real estate company and ISP and nothing to do with net neutrality), a neighbor's ham radio overpowering their Wifi signal, and complaints about not receiving promotional items such as a $300 gift card.
Further, a sample of 'Privacy' related complaints related to spamming and phishing attempts make up a significant portion of the reported 'open internet' complaints to the FCC, which are not in reality related to net neutrality.
Other complaints have to do with billing disputes, inaccurate ISP disclosures, and complaints about advertising.
Clearly the complaints need to be categorized into legitimate and non-legitimate before assessing the results, but some analysts have argued the FCC is not providing the full context of compliant information for the public to truly decide.
Pai's proposal to deregulate the Internet under Title II says the following:
T]he majority of these informal complaints do not allege conduct implicating the Open Internet rules. Of the complaints that do discuss ISPs, they often allege frustration with a person or entity, but do not allege wrongdoing under the Open Internet rules. Further, we are not required to resolve all of these informal complaints before proceeding with a rulemaking. Since we do not rely on these informal complaints as the basis for the decisions we make today, we do not have an obligation to incorporate them into the record.
In my sampled research regarding the complaints, the majority of them are not covered under the current net neutrality legislation. For the rest, the root causes need to be determined as to whether they are an operational problem (e.g. network or server outages) or a conscious attempt by the ISP to restrict service proliferation or access to content. The results indicate to me that the data is not conclusive regarding the complaints supporting the need for Title II government regulation of the Internet. Whether this is due to cover-up by the FCC and the ISP's, or just lack of enough legitimate issues will be left up to the reader to decide.
Peering provider Cogent says overturning net neutrality is bad because:
The regulatory oversight that was put in place in June 2015 was beneficial to us and it helped us go to a group of 8 ISPs who methodically began blocking their customers' connectivity to the internet by refusing the upgrade the interconnection points," Schaeffer said. "In doing so they were looking to harm some of our customers, particularly some of our largest video customers.
The question is whether ISPs should be required to upgrade their connections for customers that wanted enhanced service, without being able to subsequently charge for these improvements. This would be important to the telecoms because it would allow them to fund the network improvements needed to expand broadband coverage.
While companies like Netflix (NASDAQ:NFLX) may not be affected by rate based fees due to their size, concern exists that "new market entrants and smaller OTT providers" could be affected by the change in rules.
This seems to indicate that the loss of net neutrality will stifle new entrants and decrease competition, which was not supported in the 2011 research by Wharton economist Gerald Faulhaber. Further, the comments by Netflix CEO Reed Hastings that 10 years ago it would have mattered to Netflix seem to contradict reality; 10 years ago net neutrality rules were not enforced, and Netflix did just fine as a smaller service provider. In fact, their growth has been outstanding in this time frame.
Netflix has a history of changing positions on net neutrality. It may be that Netflix is not concerned now because the expectation that Netflix be available to consumers is already ingrained now that net neutrality has been put into place, so it's easy to see where the benefits of existing legislation have already paid off for the company regardless of future FCC decisions.
I think upon reflection, the Cogent and Netflix positions had a lot to do with peering agreements, in which no charges were leveled between providers on either end of a connection where bandwidth was reasonably believed to be equal going both ways. However when Netflix traffic started taking up 30% of data one way across a network, ISP's like Verizon (NYSE:VZ) wanted to charge for the surge in traffic. The peering company Cogent (NASDAQ:CCOI) and Netflix didn't like this arrangement, because they wanted the connection to remain free to reduce their costs of service, despite the increase traffic the service would place on the peering connection.
At the end of the day in this case, Netflix cut out Cogent as the middle man, and paid Comcast for a direct connection to their network. Which is what should have happened in a free market, as without such the government has no sound basis for setting price limits or restrictions.
The results of the likely FCC decision to rescind these rules will be net positive for the telecom industry. As shown by the examples above, it is likely that ISPs will be able to reduce costs for network enhancements, specifically in wireless spectrum auctions and other bandwidth expanding technologies, and better able to recover investment costs by adjusting network use rates.
What should be still of interest to investors is whether a spate of class-action lawsuits will ensue, post the changing of the rules, where consumers sue the telecoms for perceived wrongs in equal access to the Internet. I believe there to be enough negative consumer sentiment to network providers that the popular perspectives on the open Internet have not reached their legal conclusion. However, I do not believe there is enough data to show that any lawsuits regarding equal access will materially affect the overall performance of the sector.
Corporate Tax Changes
Another huge topic of discussion now is the impending changes to the tax codes by the Republicans in Congress. There are several implications to telecoms were the expected provisions of the House and Senate legislation to pass and be signed by the president, which I will discuss here.
Please note, however, that the final legislation has not been written. Right now we have two versions that have not gone through the reconciliation process. Further, there are handwritten notes and seemingly incomplete sections of the legislation that need to be vetted by Congress. Until that is done, the final provisions can only be speculated on. For that reason, I will not address all 479 pages of the proposed document. I will, however, examine a bit of history leading up to this bill that may shed some light on potential key provisions we should all be aware of as related to telecom.
Per Big 4 accounting firm EY, the current legislation in Congress was preceded by a plan put forth by then House Ways and Means Committee Chairman Dave Camp.
Camp's plan had several provisions which would materially affect the telecom industry, and some of them may make it into the final tax legislation. Therefore, we will start the discussion there and look at how the current blueprint would benefit or hurt the telecoms.
In February 2014, then-House Ways and Means Committee Chairman Dave Camp released as a discussion draft a comprehensive proposal for tax reform (the Camp Plan). When it was issued, the Camp Plan was the product of three-plus years of work from the Chairman and his staff and, like the Blueprint, embraced the many trade-offs necessary to significantly lower tax rates, a critical component of realizing economic growth associated with tax reform. Given the similarity of their policy objectives, many believe the Camp Plan to be a precursor of the Blueprint and a ready source of potential tax reform legislative language.
It is believed the corporate tax rate will fall to somewhere between 20 and 22, and the corporate AMT (alternative minimum tax) will be eliminated. This is a net reduction in tax on net income for the industry, with a bonus of allowing companies to more fully recognize deductions and take credit.
For telecoms that have accrued large depreciation deductions for plant and equipment will benefit. Depreciation is a key accounting item for this capital expense heavy industry. In addition, those companies with carryover losses may be able to decrease their tax liabilities. This may apply to certain companies who have spent billions on network investment which have exceeded prior year net profits. Lastly, the lack of corporate AMT may increase the tax exempt interest a corporation is allowed to recognize without hitting the prior AMT requirements.
The tax plan may also allow immediate expensing of capital expenditures, rather than deducting them over the useful life of the asset. For network companies spending billions on property, plant, and equipment, this creates a strong financial incentive for near term investment.
A company like CenturyLink (CTL), who just acquired $10 billion in net operating losses in the Level 3 deal, will not only be able to purchase new facilities and equipment but as a result will also now be able to extend the acquired losses to additional future years because of the additional near term write-offs. This should provide the company with a longer runway to re-build the portfolio and expand their networks without worrying about paying taxes on any income received.
Corporate interest expense deduction may fall off to anywhere from 70% to 0%. This means less interest expense can be deducted than before, which indirectly increases the cost of borrowing by the same amount. Telecoms, who typically carry heavy debt loads to pay for CAPEX, may be more reluctant to increase debt to finance improvements if their near term interest deductions lead to higher overall taxes.
The possibility of the US moving to a territorial tax system is being discussed. What this means is companies that earn foreign profits would not be taxed on them like they are domestic income, as they are now. On the one hand, this should encourage reinvestment of existing dollars stored overseas, but will likely be tempered somewhat by the one-time up-front tax on repatriated profits (expected to be from 5-10%).
Several telecoms have expanded internationally in Europe, South America, and Asia whom have more internationally friendly tax regimes. They implication is that they can now, for a one time charge, bring those dollars back and use them for US investment. In reality, the companies will put the dollars where they will return the highest ROI, which means any US investment with a higher return may result in increased investment domestically, versus internationally financed projects that were made to avoid US taxes.
The amortization of goodwill (intangible assets) may be extended to 20 years, which would include items such as "going concern value, licenses, permits, or rights granted by governmental units."
In telecom, goodwill is typically represented by 'post acquisition subscriber growth, value in bundles offers of different products which result in ARPU gains, access to distribution networks, geographical expansion by winning new markets, acquiring profitable businesses, especially competitors. So the increased amortization timeline may benefit telecoms who consistently create value through acquisition, expand geographically, and create average revenue per user gains through smart marketing.
The move to software defined network, which separates the control and data planes and allows telecoms to build networks without expensive proprietary vendor products, may be substantially affected by how the tax rules are written. Per EY:
Expenditures incurred for the development of software would have been treated as R&E expenditures. [Note: the Camp Bill would have also made permanent the then-temporary section 41 tax credit; as part of this proposal, the general 20% credit would have been repealed and replaced with a 15% credit of the qualified research expenses that exceed 50% of the average basic research payments for the three tax years preceding the tax year for which the credit is determined (thus making the Alternative Simplified Credit permanent); but, amounts paid for supplies or with respect to computer software would no longer have qualified as qualified research expenses - a potentially significant exclusion for software-enabled telecommunication networks and associated taxpayer credit claims.]
From a tax rate perspective, EY has this to say:
However, we further expect that the guidance will fall far short in reforming and simplifying cost recovery rules for the telecom industry in comparison with other industries. It is in this regard that we further consider the CBO's estimates that the effective marginal tax rate on investments in computers and software is nearly 40%, while the rate on railroad track and mining structures is about 15%.
The potential impact to the telecom sector can be pretty substantial.
With expectations that telecom network operators will have software controlling 75% of their networks by 2020, it is clear that a continued bias across industries fails to account for and thus disadvantages new technologies and a modern economy.
Lastly, asset valuation may change substantially. How companies value assets in light of the tax changes may prompt them to make material changes to their business model which could substantially affect their balance sheets.
Those companies with substantial NOLs, such as CenturyLink will now have, may find previous losses less valuable.
Currently the highest effective U.S. corporate tax rate is 35% and is used by large corporations to value their DTAs [deferred tax assets]. If the Republican-controlled Congress and President Trump reduce this rate to 15%, the value of these assets will decrease. For example, a company with a $1 million federal NOL carryforward could value the DTA under current law at $350K. If the 15% rate becomes law, then the potential future value of the NOL will be $150K. This $200K reduction in value is charged to tax expense during the period in which the law is signed by the president-assuming the new rate takes effect immediately.
Telecom industry investors should take heed of any changes that occur to corporate tax laws, and apply the adjustments as needed to their valuations. While much of the proposed tax law changes appear favorable to the industry, some lesser known provisions could adversely affect investor positions. Now is the time to examine your telecom company and how all of these potential changes may affect the company positions you hold.
More Aggressive Copper Retirement Rules
Currently, copper retirement requires 180 day notice, but this has hurt some companies have shorter timelines to complete the process. For instance, CenturyLink has said it could not replace copper in Richfield, Minnesota with fiber because it only had 140 day timeline to do so, which was shorter than the required FCC notice period.
This additional work cost CenturyLink $36,000- money that more productively could have been used for deployment of new or upgraded broadband facilities," CenturyLink said. "Given the short construction season in many parts of the country, such timeframes are not unusual and are consistent with the schedules for CenturyLink-initiated projects as well."
FCC Chairman Pai has recognized the value in shortening the retirement period.
We will vote on making it easier for broadband providers to move from the copper networks of yesterday to the fiber networks of tomorrow," Pai said during the Reason Media awards, according to a transcript. "Some of these copper lines have been in the ground for a century. They're nowhere near as resilient or robust as fiber. But our rules too often still demand that companies maintain those fading networks. That comes at a cost to consumers. By definition, every dollar that a company spends propping up copper is a dollar that can't be spent building a next-generation network. That's the kind of red tape that needs to be cut.
Product costs, such as MPLS, may be reduced by the reduction of copper networks. For example, many last mile networks using copper result in significantly higher costs for subscribers than their all-fiber counterparts.
Verizon has already started replacing copper phone networks with wireless alternatives, such as in the case of damage to copper networks in Hurricane Sandy. The process may speed up on other areas when copper retirement timelines are enacted. From an investment perspective, replacing copper with other technologies significantly reduces ongoing maintenance costs for telecom companies and will add valuable dollars to the bottom line.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.